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Operations Handbook for the Financial Markets Professional

Lex van der Wielen

Operations Handbook for the Financial Markets Professional

Financial Markets Books

Financial Markets Books Geelvinckstraat 56, 1901 AJ Castricum, Netherlands Cover by Magenta Designers, Bussum Photo author: Jeanet Cochius Printed by Boekdrukdeal, Utrecht ISBN 978-90-816351-1-0 NUR 793 Financial Markets Books, Castricum All rights reserved. Subject to the exceptions provided by the law, no part of this publication may be reproduced in any form or by any means without the written consent of Financial Markets Books.

The Financial Markets Academy The Financial Markets Academy is a Dutch training company that offers a broad variety of financial markets courses. The mission of the Academy is to be the leading center of competence for the financial markets in the Benelux. The markets and instruments courses of the Academy are designed to be as close to the real day to day practice as possible. To achieve this, the Academy uses, amongst others, a number of professional simulation tools. The Academy also offers courses that focus on back office operations and risk management with banks and other financial institutions. The Financial Markets Academy is market leader in the Benelux for ACI exam training courses. It is the only supplier that offers training courses for all three ACI exams. The Academy operates in close cooperation with the Dutch ACI.

Double Effect A bank implementing a new international payment system, an insurer setting up a digital portal, a pension fund seeking for higher returns. Financial service providers are complex and continuously evolving organizations. Change has an immediate impact on processes, people and technology. In order to realize improvements, one must enter into the heart of the organization. And that is exactly what Double Effect does. It is our ambition to surpass our clients' expectations with results based on knowledge, skills and our intrinsic motivation to walk the extra mile. Understanding our clients' need is what drives our consultants every day. Building and actively sharing knowledge is a central theme within Double Effect. In that respect, we are proud to present you the Operations handbook for the Financial Markets professional. This book, written by Lex van der Wielen, is a complete reference guide and a "must have". It covers all operational activities related to financial instruments trading, from initiation to settlement. We invite you to discover this book and hope it will help you to strengthen your business.

Many thanks to the following professionals in the field for sharing their expertise: Jaco Buiter Betsy Hertsenberg Rob van Hout Thijmen van Kooij Gerda Mooij Nicolette Kral Sandy Rijs And a special thanks to June Dwyer-Aerts for reviewing this English edition.


Chapter 1 - The financial markets division of a bank 1 1. The responsibilities of a bank's financial markets division 1 1.1 Cash management 2 1.2 Funding 3 1.3 Foreign exchange risk management 3 1.4 Interest rate risk management 4 1.5 Proprietary trading 4 1.6 Sales 5 1.7 Arranging securities issues 6 2. The internal organization of the financial markets division 6 2.1 Front office 7 2.2 Back office 7 2.3 Product control and middle office 9 2.4 Finance 10 2.5 Risk management 10 2.6 Importance of separation of duties 11 2.7 Internal control 11

Chapter 2 - Alternative ways of closing transactions 13 1. 2. 3. 4. Exchange 13 Multilateral trading facility 14 The OTC market 14 Systematic internalization 15

Chapter 3 - Product mandate and trading limits 17 1. New product approval process 17 2. Limit control sheet 18 3. Trading limits 19 3.1 Nominal limits 20 3.2 Value at Risk limit 21

Chapter 4 - Client acceptance and credit risk 25 1. Customer due diligence 25 1.1 Client acceptance 26 1.2 Identification and verification 26 1.3 Reporting 26 2. Counterparty limits, types of credit risk and risk mitigating measures 27 2.1 Types of credit risk 27 2.1 Risk mitigating measures 29

Chapter 5 - P&L measurement 33 1. 2. 3. 4. 5. The responsibilities of the P&L unit 33 Fluctuations in the value of the financial instruments 34 Provisions 35 Interest costs and revenues 35 Broker fees 36

Chapter 6 - Deal capture, confirmations and settlement instructions 39 1. Closing transactions and capturing transaction data 39 1.1 Transaction data 40 1.2 Master agreements 41 2. Verification 43 3. Confirmation 44 4. Settlement instructions 48 4.1 Shadow accounts 48 4.2 Standard settlement instructions (SSI) 49 4.3 Settlement risk 49 5. Event calendar 51 6. Diagrams of processing methods 52

Chapter 7 - Money settlement 57 1. Bank accounts 57 2. Money transfers in the local currency 58 2.1 RTGS systems 59 2.2 Clearing systems 60 3. Money transfers in foreign currencies 61 4. Bank holidays 65


Chapter 8 - Securities settlement 67 1. Central securities depositories 67 1.1 Account holders and responsibilities of a CSD 68 1.2 Role of a CSD with the settlement of securities transactions 68 1.3 Execution conditions 70 1.4 Feedback on the status of settlement instructions 71 1.5 The role of CSDs in the administration of foreign securities 71 2. Clearing institutions 72 2.1 Clearing members 73 2.2 The clearing process for cash transactions 73 2.3 Risk management 75 2.4 The tasks of clearing institutions with derivatives 77 3. Custodians 80 3.1 Local and global custodians 80 3.2 Role of custodians with the settlement of securities transactions 81 3.3 Role of custodians with tri-parti repos 83 4. Overview of the process of an exchange traded transaction 84

Chapter 9 - Nostro reconciliation 85 1. Reconciliation 85 2. Investigations 86 3. Compensation 88

Chapter 10 - Treasury systems 89 1. Front office and back office systems 89 1.1. Information exchange between systems 90 1.2 Static data and standing files 91 2. Capturing deals in the ledger 92 3. Computer systems requirements 93

Chapter 11 - Money market instruments and interest calculations 97 1. Deposit 97 2. Calculation of interest amounts 98 2.1 The duration of the coupon period 98 2.2 Daycount conventions 100 3. Repurchase agreement 105 4. Money market paper 106 5. Money market benchmarks 108


Chapter 12 - Capital market instruments and corporate actions 109 1. Shares 109 2. Fixed-income securities 110 2.1 The yield of a fixed-income security112 2.2 Clean and dirty price 114 3. Special types of fixed-interest securities 115 4. The role of the bank with a securities issue 118 5. Corporate actions 120 5.1 Reasons for corporate actions 120 5.2 Corporate action categories 120 5.3 Implementation of corporate actions 121 5.4 Pending transactions 125

Chapter 13 - FX instruments and settlement of FX transactions 127 1. 2. 3. 4. FX spot 127 FX forward 129 FX swap 132 Settlement of FX transactions 132 4.1 The role of the CLS Bank 132 4.2 The settlement procedure of the CLS Bank 133

Chapter 14 - Derivatives 137 1. 2. 3. 4. General features of derivatives 137 Option 138 FRA 140 Financial future 141 4.1. Shares future and index future 142 4.2. Bond future 143 4.3. Money market future 143 5. Interest rate swap 145 6. Overnight index swap 147 7. Non-deliverable forward 149 8. Contract for difference 150 9. Cap and floor 151 10. Swaption 152

Index 153


Chapter 1

The financial markets division of a bank

A bank's financial markets division carries out financial market transactions on behalf of the bank. These transactions have to do with the various tasks the financial markets division is responsible for. All of these tasks are performed in the front office department. In addition to the front office, there are various other departments within the financial markets division. They play an important role in the processing of the transactions, the management of risks resulting from the transactions and the drawing up of reports, for instance management information reports and reports to the regulators.

1 The responsibilities of a bank's financial markets division

A bank's financial markets division is in some ways comparable to the treasury department of a non-bank entity. This is because, just like every other treasury department, the financial markets division is, amongst others, responsible for the banks cash management and the management of the bank's financial risks. In addition to these normal treasury responsibilities, however, the financial markets division has several other tasks. It is responsible for attracting funding, functions as the market maker for its clients and advises them on transactions in financial instruments. In order to be able to carry out their role of market maker properly, banks often also take positions in financial instruments. This is called proprietary trading. In addition to these tasks resulting from commercial banking, the financial markets division sometimes also supervises securities issues of its clients. This activity is part of merchant banking or investment banking. Another merchant bank activity is supporting clients with mergers and acquisitions. All tasks described here are executed at the financial markets division's front office department.

1.1 Cash management Cash management is the daily management of an organization's current account balances. Dutch banks hold a euro account with the Dutch Central Bank and foreign currency accounts with foreign commercial banks. Banks also hold cash accounts at the organizations that register their securities, the custodians. The cash accounts that banks hold at other institutions are called Nostro accounts. Banks hold multiple Nostro accounts in every currency. In practice, one of the Nostro accounts in each currency acts as a principal account. For the own currency, this is the account at the central bank. The principal account for a foreign currency is usually the account the bank uses for having payments in that currency processed. For instance, for US dollars, Barclays uses JP Morgan Chase and for euro, United Bank of India uses Deutsche Bank, for this purpose. The balances of the other Nostro accounts are transferred to the principal account during the day. One of the employees in the dealing room, the fund manager, is responsible for ensuring that positive balances on the principal accounts earn interest by investing them in the money market or that deficits are covered by attracting deposits. Banks make a daily forecast of the final balance of each principal Nostro account. If a fund manager foresees that a surplus in a certain currency will occur by the end of the day, he will try to invest this surplus on the money market gradually during the day. If, on the other hand, he foresees a deficit, he will try to attract the money during the day in order to cover this. At the end of every trading day, the balance of each Nostro account must be zero, in principle. A positive balance on a current account generates hardly any interest income and high interest costs are associated with a negative balance. An exception to this rule is the bank's account at its national central bank. This is because most central banks require commercial banks to maintain a certain average positive balance on their account, the mandatory cash reserve. The fund manager must see to it that the account balance at the central bank account is on average identical to the mandatory cash reserve over a given period. Because the total, combined mandatory cash reserve of all banks is higher than their combined balances at the central bank, the banks have a collective central bank money deficit. The European Central Bank, for instance, gives the banks in the euro area the opportunity to fund this deficit through refinancing transactions with itself. The fund manager determines to what extent he wants to use this refinancing facility.

1.2 Funding Part of the money banks lend to their customers is financed through the balances clients keep in current accounts or saving accounts. These balances are called entrusted funds. Another part is financed on the financial markets using bank deposits or bonds. This is called interbank funding. The dealing room is responsible for attracting this funding. Some dealing rooms also function as an in-house bank. The dealing room then actually grants inter-company loans to business units that grant loans to their clients. And when a business unit attracts a deposit, the dealing room functions as this unit's borrowing counterparty. The dealing room, in turn, then invests this balance in the money market. Because the financial markets division is well-informed of the interest rates on the financial markets, it is responsible for determining the basic interest rates used by all other business units. This basic rate is called the cost of fund. Account managers that provide credit may only determine the credit surcharge or credit spread they use in addition to the cost of fund. The cost of fund thus functions as the minimum rate for loans. The cost of fund also functions as the maximum rate for deposits attracted.

1.3 Foreign exchange risk management The fact that the foreign currency Nostro accounts have a zero balance at the end of each day as a result of the cash management activities does not mean that the bank no longer has any foreign currency asset. The foreign currency account balances have been invested in the money market. There are, therefore, still foreign currency assets in the form of, for example, a deposit or short-term note like a certificate of deposit. A bank would run a currency risk if it did not have liabilities equal to these foreign currency assets. This is because the value of the bank's assets will decrease if foreign currency exchange rates decrease without there being an equal reduction in the bank's liabilities. The foreign exchange trader must see to it that the foreign currency assets and liabilities equal each other, with the exception of the trade positions he wants to take himself. This is called foreign exchange risk management. Many bank clients hold accounts with their banks in foreign currencies like US dollars with a non US bank, for instance. If a client of a German bank, for instance, wants to create a positive balance on his US dollar account, he can withdraw money from his euro account, convert it into US dollars and deposit it into his US dollar account. In this case, an obligation in US dollars is created

for the German bank. The foreign exchange dealer of this bank must then buy US dollars himself and deposit these into the bank's US dollar Nostro account. By doing so, there is a asset that balances the US dollar obligation and the currency position is again balanced. It is important for the foreign exchange dealer to be kept up to date on all changes in foreign currency claims and obligations of the bank. If the foreign exchange dealer is not well-informed, he cannot determine the bank's exact currency position and the bank may run a currency risk without knowing it.

1.4 Interest rate risk management Interest rate risk is the risk of a bank's net interest income falling as a result of a change in interest rates. The fixed-rate periods of a bank's assets are usually longer than the fixed-rate periods of its liabilities. Examples of assets are, for instance, mortgage loans and company loans with long interest maturities. Examples of liabilities are deposits with short interest maturities. As a result, the interest conditions of the assets are adjusted more slowly than the interest conditions of the liabilities. This effect causes the net interest income to fall in the case of an interest rate increase. The management of the interest rate risk is called interest rate risk management. The policy regarding the interest rate risk of a bank is determined by a special committee, the Asset & Liability Committee (ALCO). If the ALCO finds that the bank should reduce the interest risk, it will order the dealing room to effect interest rate swaps. Large banks have special departments set up in their dealing room for this very purpose. These departments are often called Asset & Liability Management (ALM).

1.5 Proprietary trading In a dealing room, trading also takes place at the risk and account of a bank. This is called proprietary trading. The employees responsible for the proprietary trading of a bank are called traders. In order to make a profit, traders must run risks. They do this by taking positions in financial instruments. A position is an ownership or claim or a debt or obligation for which a party runs a price change risk, also known as a market risk. The market risk of a bond trader that has bought bonds is the risk that the bond price drops as the result of an increase in the long term interest rate on the capital market. A position can also result from the fact that banks operate as market maker for a large number of instruments. This means that banks are always prepared to be their clients' counterparty. A bank usually concludes a opposite transaction in

the market for every transaction it concludes with a client immediately. However, sometimes this is not possible or prudent and the bank is (temporarily) left with an open position.

1.6 Sales Sales involves the advising of clients on transactions in financial instruments and the concluding of these transactions at the expense and risk of these clients with the bank itself operating as counterparty. These transactions are sometimes also called client trade. The front office employees that carry out this task are called client advisors. Client advisors may themselves not take a position, which means that they may not personally run risks by trading in financial instruments. They act as an intermediary that passes a client's position on to a trader at their bank or the exchange. The client advisor's task is actually part of the account management of the bank. The client advisor takes on the advisory and sales role for a specialized range of instruments, i.e. the instruments that are traded in the financial markets. When giving advice on the use, application or outcome of financial instruments, client advisors should be mindful of the level of professionalism of their clients. This level is determined by their level of knowledge, sophistication and understanding. One obligation is that, prior to each transaction, a sales adviser should provide all necessary information reasonably requested by the customer so that the customer fully understands the effects and risks of the transaction. The advice should also be given in good faith and in a commercially reasonable manner. This is referred to as duty of care. In many countries this duty of care is included in the applicable laws and/or regulations. These laws, however, differ substantially from jurisdiction to jurisdiction.

As a precautionary measure against future adverse allegations or assertions of claims by the customer, many banks draw up a client folder and have it signed by the client before entering into transactions. In this folder the client is asked to state that he understands the terms, conditions and risks of the traded instruments; he makes his own assessment and independent decision to enter into transactions and is entering into the transactions at his own risk and expense; he understands that any information, explanation or other communication by the bank shall not be construed as an investment advice or recommendation to enter into that transaction except in a jurisdiction where laws, rules and regulations (such as the Mifid directive by the EC) would qualify the given information as an investment advice; no advisory or fiduciary relationship exists between the parties except where laws, rules and regulations would qualify the service provided by the financial market professional to the customer as an advisory or fiduciary relationship.

1.7 Arranging securities issues Companies that have large financial requirements can choose to issue securities themselves as an alternative to bank credit. The issues and syndicates department of the financial markets division supervises these issues. They assist in determining the issue price, compiling the prospectus, publishing the issue and often keeping the price stable after the issue. Sometimes a bank even guarantees a certain issue proceeds. In such cases, it undertakes to buy part of the stocks should the investors have no interest. The supervision of issues is part of investment or merchant banking.

2 The internal organization of the financial markets division

The various activities related to closing transactions in financial instruments are kept strictly separate within financial institutions. This is why several departments are involved in the process. Every department has a specific responsibility. At banks, the activities are carried out by the front office, back office, product control, finance, market risk management and credit risk management departments.

2.1 Front office Transactions are closed in the front office, which is also referred to as the dealing room. In connection with the execution of the cash management, the fund manager takes loans from, for instance, the central bank and other banks. As part of the bank's currency management, the foreign exchange dealer closes, for instance, FX spot transactions. As part of the interest risk management, interest rate swaps are closed. If a bank is involved in an issue, it will also be involved in the placement of the securities and thus closes securities transactions. The traders at many banks also hold positions in a large range of instruments, although this is becoming less common. For this purpose, they enter into transactions at the expense and risk of the bank. Traders only trade in so called plain vanilla instruments. These are instruments in their original form without all the extra features that transform them into structured products. Client advisors advise their clients on covering their risks or on how to invest on the basis of their risk profiles, among other matters. In this context, they enter into both transactions in plain vanilla instruments like deposits and shares and in the most exotic structured products, which are often tailor-made for their clients. Client advisors that service large corporations or other financial companies carry out their activities from within the central dealing room. They have direct contact with the traders and therefore get first-hand market information and are able to request prices quickly. Client advisors that service smaller relations often operate from within a regional dealing room or even from within a local branch office.

2.2 Back office A bank's back office is responsible for processing the transactions completed. This processing usually consists of three separate steps: verification: checking whether the transaction details are complete; confirmation: contacting the counterparty's back office to ensure that the trans action details match; sending settlement instructions: ensuring that the outgoing transfers associated with the closed transactions take place. At large banks, the processing of financial transactions is usually spread over several sub-departments, for example 1. money market and foreign exchange, 2. securities and derivatives and 3. interest and credit derivatives. At some banks, the processing departments are responsible for sending the payment orders themselves. At other banks, a separate payment group is established within the back office department for this purpose.

In addition to processing transactions, back office departments also have other tasks. Several specialized groups are formed for this purpose, such as operations control, cash management and brokerage control.

Operations control The operations control department is the department that is responsible for managing the back office's operational risk. Examples of checks that take place at operations control are the reconciliation of settlements and the comparison of balances of internal shadow securities accounts with the balances on the custodians' account statements. Operations control also produces reports on processing errors, like the number of errors in confirmations and settlements. A separate group within operations control is responsible for determining the cause of incorrect settlements. This group is called investigations and is tasked with assessing who is responsible for an incorrect settlement. If it is an error on the part of the counterparty, another group, sometimes called compensation, produces an interest claim and holds the counterparty liable. If an internal department, the front office or back office for instance, is to blame for the error, this department will be held liable for the damage.

Cash management A separate department that belongs to the back office is responsible for supporting the cash management task of the fund manager. This cash management unit provides the forecasts for the end-of-day balances of the Nostro accounts and is responsible for the sweeping of the balances of the sub-Nostro accounts to and from the principal account. The cash management department uses a separate cash management system for this purpose that provides real-time updates throughout the day on the expected final balance and automatically generates settlement instructions for the purpose of sweeping the balances to and from the sub-Nostro accounts. The cash management system receives trade data from the back office systems. Additionally, the system receives data from the central account system, which keeps track of the clients' accounts. For example, this system provides information on the payment traffic and credits granted. Finally, the cash management system has an interface with the SWIFT network. Information is taken from the SWIFT inbox on the status of the outgoing and incoming payments. If it appears that a settlement instruction has, unexpectedly, not been carried out, the final balance prognosis of the principal Nostro account in question is adjusted. The cash management department in the back office follows the opening and closing times of the central bank systems around the world. The first shift employees at a European bank in this department, for example, start work early

in the morning in order to be present at the end of the trading day in the Pacific zone and the last shift employees finish late in the evening in order to be present for the end of the trading day in the Pan-American zone.

Brokerage control Brokerage control is a department that is responsible for checking brokers' invoices. At some banks, this department is part of the back office department. At other banks, this activity takes place at a middle office department. The brokerage control department checks whether a broker is actually listed on the list of brokers with which dealers are allowed to do business and checks the amounts charged by the brokers.

2.3 Product control and middle office Banks periodically determine the value of the financial instruments they have in their portfolios. They have several reasons for doing this. The first reason is that traders' results are largely determined by the changes in the market value of the financial instruments in which they hold a position. The second reason is that financial contracts are sometimes cancelled, whereby the value of the contracts has to be settled between the contract parties (unwinding). The third reason is that banks that need to adhere to the IFRS accounting rules in their external reports must report the fair value of all financial instruments. The calculation of the market values of the financial instruments takes place in the traders' front office systems. However, it is unwise to let the front office employees perform the valuation of their positions unsupervised. The valuation is thus checked at a separate department. At banks, this department is often called product control. The product control department is part of the finance department at some banks and at others it is part of the market risk management department. The product control department monitors the prices and interest rates that are imported into the front office systems from data feed systems like those of Thomson Reuters or Bloomberg. However, not all data needed for the valuation of the value of a financial instrument can be imported from these systems without having integrity concerns. This applies to volatilities and the prices of unlisted shares, for instance. In such cases, traders are allowed to use their own data to value their positions. However, product control checks this data at least once a month. In addition to product control, a separate group is responsible for determining the traders' daily P&L.

2.4 Finance Every transaction that is conducted in the front office must be accounted for in the bank's balance sheet and its profit and loss account. This is performed by the finance department at banks. All the data on the concluded financial instruments are sent from the back office system into the bookkeeping system (legder) of the bank. In order to be able to convert transaction data like term, price and transaction size into journal entries, they usually need to be converted. A separate system called an accounting entry generator is often built for this purpose. Most banks must report in accordance with the International Accounting Standards Board (IASB) reporting regulations. The regulations for reporting on financial instruments are given in 'standard' IAS39. Finance is also responsible for creating the reports for the central bank.

2.5 Risk management When concluding transactions in financial instruments, financial companies expose themselves to three type of risk: market risk, credit risk and operational risk. In order to measure and control market and credit risks, two departments are created that are separate from the financial markets division and supervised by central risk departments. Operational risk, however, is controlled directly by the line managers, supported by the operational risk management department. The market risk management department records whether traders are operating within their trading limits. A trading limit indicates the maximum open position a trader is allowed to take. The trading limits are set by the line manager in consultation with the risk manager. Market risk also calculates the degree of risk traders run on their positions and reports any limit excesses to the line management. The market risk management department also plays an important role in the approval of pricing models and has an important say in the decision of whether a new instrument will be traded. The credit risk management department records whether traders and client advisors remain within their counterparty limits. A counterparty limit imposes a maximum on the credit risk that may be run on a certain counterparty. The counterparty limit is set by a credit commission, usually on the basis of a request from an account manager. This committee bases the limit mainly on the risk of the counterparty defaulting. This is one of the difficult risks to estimate, yet also one of the most important tasks performed at a bank. An additional challenge for the credit risk management department of financial markets is determining the exact degree of exposure on a certain counterparty. This is easy in the case of a deposit, yet it is often difficult in the case of a derivative or


structured product. A final task of the credit risk department is to control the collateral that the bank requests in the case of, for instance, derivative transactions and securities lending transactions.

2.6 Importance of separation of duties The different tasks within the financial markets department do not all necessarily have to be performed by different departments or even different employees. The functions of the product control, middle office and risk management departments, for instance, can easily be centred within one department. Some tasks, however, should remain separate under all circumstances. The front office function, for instance, should always be kept separate from the payment function, risk management function and results measurement function. Example In the case of Barings Bank, Nick Leeson was able to pass on entirely wrong positions to the head office. Not only was he allowed to capture his own deals, he was also able to authorize them. As head of the back office, moreover, he was able to authorize payments as well. The separation of functions was completely lacking in his case. Exaggerating the separation of functions, however, may also have disadvantages. There are a lot of organizations in which certain specific tasks are only performed by one or two employees or certain information is only known to one or two staff members. Problems may arise the moment these persons leave the organization, fall ill or take leave. This is referred to as key staff exposure.

2.7 Internal control Despite the fact that most financial organizations have set up their internal organization with the utmost care, a large share of their losses can still be attributed to a weak control structure or the fact that the control measures are not strictly enforced. Internal control refers to the complete range of measures taken by an organization to ensure that it operates effectively and efficiently, its financial data are reliable and all the relevant rules and regulations are followed properly. In order to achieve these goals, every organization has a structure of control measures in place and assesses the effectiveness of those measures. The control structure consists of three layers: self-control, dedicated control and operational audits. Self-control is a form of control by which departments keep track of the quality of their own activities, for instance by checking daily whether all transactions have been processed. Self-control is often based on the organizational principle


of dual control, also known as the four eye principle, which requires a minimum of two employees to be involved in certain specific tasks. A typical example is the transfer of large money transfers, whereby one employee prepares the payment and another sends it. Dedicated control is a form of control exerted by specially appointed business units, such as operations control, market risk management, credit risk management and compliance.

Compliance Banks and their employees must comply with many rules. In the first place, the rules of criminal law. For example, they may not act fraudulently. They must also comply with the law with regard to money laundering and terrorist financing. Also, a number of employees must comply with the code of conduct as laid down in the financial supervision act. Additionally, all employees of a financial enterprise are obliged to comply with the internal rules of the organisation. Each bank must appoint a compliance officer. The task of a compliance officer is to encourage employees to comply with the external and internal rules, to function as a contact point for breaches and then to report these breaches to management and external regulators. Compliance officers need to know exactly which laws are applicable within the organization and must follow all changes in the relevant legislation. With regard to financial markets, compliance officers are mostly occupied with customer due diligence, the duty of care, the prohibition on the use of insider information and the prohibition on market manipulation.

Internal Audit Service The Internal Audit Service (IAS) is the capstone of the control framework and is often called the third line of defence, after self-control and dedicated control. The IAS performs operational audits. These are risk analyses whereby the auditor assesses the quality of control within the organization, by examining how control measures are set up and how effectively they function.


Chapter 2

Alternative ways of closing transactions

Financial instruments can be traded in different ways. The first way is through a public market. This is an organized meeting place (usually in the form of a computer system) where multiple buyers and suppliers of financial instruments can conclude transactions in these instruments. Examples include exchanges and multilateral trading facilities. The second way to trade financial instruments is outside a public market. This is referred to as the private market or over-the-counter (OTC) market. An intermediate form is where banks use their own system to execute orders from their clients on a large scale. This is called systematic internalization. In order to gain access to this market place, clients must employ the services of a financial institution that is active in the conclusion of transactions. This is usually a bank.

1 Exchange

An exchange is a public marketplace where securities and/or derivatives are traded and where strict rules apply in relation to transparency and stability. An exchange is operated by an organization that holds a special licence, in some countries granted by the Minister of Finance. In Europe, exchanges are no longer hosted on a traditional 'floor', where traders shout in organized chaos to indicate which transactions they want to conclude. Normally, nowadays, an exchange is a computer system in which market parties can indicate at what rates and volumes they wish to conclude transactions (orders). This computer system is also known as a trading system. The price of exchange traded instruments is calculated in accordance with objective criteria and without discrimination by the trading system, based on the orders filed. Exchanges must provide information on the rate, size and time of all transactions concluded. This is called post-trade transparency. In addition, exchanges must provide a summary of the orders that have not yet been executed, i.e. the depth of the book. In this respect, they must indicate what the demand is for the


five rates that are immediately lower than the last traded rate and what the offers are for the five immediately higher rates. This is known as pre-trade transparency. There is a central counterparty (CCP) connected to nearly all exchanges. A CCP stands legally between buyers and sellers of financial instruments. Each transaction is broken down as a sale by the seller to the CCP and a purchase from the CCP by the buyer.

2 Multilateral trading facility

A multilateral trading facility (MTF) is a public trading system that has to comply with fewer requirements than an exchange, as a result of which the expenses and the charged fees are lower. The lower requirements are related to information on traded instruments and issuers. MTFs nevertheless have a duty of transparency before and after trade. A disadvantage of an MTF is that there is not always a central counterparty involved. Examples of MTFs are Chi-X and Turquoise. English, German, French and Dutch shares are traded on Chi-X. Turquoise also focuses on European equities.

3 The OTC market

In the over-the-counter market (OTC market), transactions are concluded outside an exchange or MTF. The OTC market is also known as the private market. Usually, one of the parties involved in an OTC transaction is a bank. Most derivatives are traded in the OTC market, some are even traded exclusively over-the-counter, such as interest rate swaps. There are no transparency requirements for OTC transactions. Parties that wish to conclude over-the-counter transactions may sometimes engage the services of a broker. This is a party that acts as an intermediary in transactions in financial instruments. Brokers look for a party to act as the counterparty to a specific transaction. When concluding transactions, brokers do not act as a contracting party. The contracting parties, also called principals, are the party that the broker has engaged and the designated counterparty. Once a transaction is closed, the broker sends a confirmation to both contracting parties. Brokers also provide their clients with information on the market conditions. They are able to do so because they are in contact with many market parties and therefore have a good understanding of the market conditions such as the liquidity and the sentiments in the market.


Transactions in the OTC market are often concluded by telephone, but increasingly also through special electronic trading systems. Examples of over-thecounter trading systems are Reuters dealing 3000 and EBS for foreign exchange transactions and Tradeweb and Bloomberg for fixed income transactions and interest rate swaps, amongst others. Market players connected to these systems can conclude transactions directly with other affiliated parties. Each participant enters a counterparty limit in the system for each party with whom he wants to do business. Parties that wish to act as market maker enter their bid and/or offer prices in the system. Parties that wish to conclude transactions based on these prices indicate this in the system. These parties are called market users. A major benefit of OTC contracts is that they can be customized. For every deal, the negotiating parties must themselves must reach agreements on the volume, duration, price, market references to be used and legal aspects. A disadvantage of OTC contracts is that existing contracts are difficult to trade, there is no secondary market. If a contract party wants to close his position in an OTC instrument, he can try to unwind the transaction with the existing counterparty or he must find a counterparty to conclude an opposing OTC transaction.

4 Systematic internalization

When a bank enters a large number of securities orders from its clients into a dedicated system of its own, rather than sending them to an exchange, in order to match them with other customer orders, it is referred to as systematic internalisation. The bank acts as central counterparty. In order to keep trade moving as much as possible, the bank also acts as liquidity provider. The difference with an exchange or MTF is that in the case of systematic internalization, the participants in the trading system are clients of the bank, in the case of an exchange or MTF, the participants are the banks themselves. With systematic internalization, the duty of transparency applies before and after the trade. The former means that banks must continuously publish the rates at which they are willing to conclude transactions. Figure 2.1 shows the four different ways in which transactions in financial instruments can be concluded.


Figure 2.1 Different ways of closing a transaction


Systematic Internalization OTC




Chapter 3

Product mandate and trading limits

The number of new financial instruments introduced by banks is great. These instruments are all developed by specialized departments. Before their introduction, all new instruments are assessed by a committee to value their suitability for the bank. This process is called the new product approval process. Once a new instrument has been approved, it is added to the limit control sheet. This is an overview of all mandates and limits set for all traded instruments. The limit control sheet is drawn up by a committee including representatives from market risk management, product control and credit risk management. An important example of the limits covered by the limit and control sheet are trading limits. The market risk management department is responsible for monitoring compliance with these trading limits.

1 New product approval process

Before a new instrument is introduced, it is assessed in a new product approval process. This process is designed to assess the suitability of a new product and includes representatives from a range of the bank's functions, including risk management, compliance, legal, accounting, IT and finance. The process should also include a clear definition of whether an instrument is really new. When determining whether an instrument is new, a bank may consider a number of factors including structural or pricing variations from existing products, whether the product targets a new group of customers or a new requirement from customers, whether it raises new compliance, legal or regulatory issues and whether it would be offered in a way that would be different from standard market practices.


The following topics, among other things, should be addressed in a new product approval process: whether the instrument complies with internal and external regulations; whether the computer systems are capable of capturing the instrument; whether staff and customers are able to understand the features of the instrument; the profitability of the instrument; policies to make sure the bank creates and collects sufficient documentation to document the terms of transactions, to enforce the material obligations of counterparties and to confirm that customers have received any information they require about the instrument; policies and procedures to be followed and controls used by internal audit to monitor compliance with those policies and procedures.

2 Limit control sheet

A limit control sheet (LCS) is a document in which a bank describes which instruments will be traded and in which currencies, which departments are allowed to trade these instruments and whether and the degree to which proprietary trading is allowed, i.e the limit control structure. The limit control sheet is drawn up by a committee in which staff from market risk management, product control, credit risk and departments that are responsible for the valuation models are represented. The LCS is reviewed periodically, e.g. annually, and on an ad-hoc basis, in the case of significant changes in market conditions, or with the introduction of a new instrument. The first section of the LCS defines the scope of the activities of the financial markets department. For all business locations and for each instrument, the LCS indicates whether only client business is allowed or whether proprietary trading is also allowed and, if so, in what proportion. For all locations and for all instruments, the LCS also defines the systems in which positions are maintained and the systems in which the market risk is measured. The first section also contains the product mandate that is split into two parts, the approved product list and the approved tenors and currencies list. The first list provides an overview of the ways in which all business units are allowed to trade in the different instruments, only internally with other business units as counterparty or also externally, with external counterparties. The second list provides an overview of all approved currencies and tenors. The second section of the LCS contains the trading limits that restrict the market risk that proprietary traders are allowed to take.


3 Trading limits

Market risk is the risk that the market value of the bank's trading positions is adversely affected by fluctuations in prices and/or interest rates. Banks are exposed to market risk due to the fact that traders in the financial markets departments trade at the bank's own risk and expense. The positions they take are called open trading positions. Since the credit crisis, however, banks have become more reserved about allowing their traders to hold trading positions. Open positions may result from proprietary trading activities but they may also be the result of a bank acting as market maker. Acting as a market maker means the bank is always prepared to act as counterparty for its clients. Generally, a bank closes a position that results from a client transaction directly in the market. Sometimes, however, this is not possible or advisable, for instance, in an illiquid market or in the case of a very large transaction. In such cases, the bank is left (temporarily) with an open position. To avoid this the bank may consider not to close the transaction with the client but, from a commercial viewpoint, this may not always be advisable. A trading limit indicates the maximum open position that a trader is permitted to hold. Trading limits may apply either for an entire department within the dealing room (trading desks) or for individual traders. The trading limit for a trading desk is determined by the same committee that is responsible for drawing up the LCS. The distribution of limits between individual traders at a specific trading desk is decided by the desk's departmental head. Junior traders are generally allowed only minor positions. A trader's limit is raised as his experience and profitability increases. Banks use two types of trading limits to manage market risk, nominal limits and value at risk (VaR) limits.


3.1 Nominal limits Nominal limits impose a limit to the size of a trading position regardless of market developments. The following are examples of nominal limits positions limit: sets an unconditional limit on the market value of a position; Greek limit: sets a limit to the value of an option portfolio measured by its Greek parameters (delta, gamma, rho, vega); Basis point value limit (bpv): sets a limit to the market value of an interest bearing portfolio measured by its bpv, i.e the change in price as a result of a change in interest rates of one base point; credit spread sensitivity limit: sets a limit to the market value of a bond portfolio measured by its change in price as a result of a change in the credit spread of the issuer of one base point; slope risk limit: sets a limit to the market value of an interest bearing portfolio measured by the change in this value as a result of a pre-defined change in the slope of the yield curve; event risk limit (stress test limit): sets a limit to the market value of a position as a result of a pre-defined market disruption.

Event risk limit In order to set an event risk limit. the market risk management department must design so-called stress tests. With a stress test, it draws up a future 'disaster scenario' in order to be able to assess the risk associated with future extreme market movements. This scenario could be an actual historical scenario such as 'nine eleven' (when the twin towers came down in New York). The disadvantage with this method, however, is that events from the past will most probably not occur again in the same way in the future. Market risk management will therefore also usually create its own imaginary disaster scenarios. For example, it will assume a 10% change in the currency exchange rates or an interest rate change of 100 basis points. Market risk management will then calculate the possible losses for the traders resulting from these imaginary disaster scenarios. Finally, for each trading position, market risk management sets a maximum loss that would be incurred if the event scenario was actually to happen and thus a corresponding nominal limit for the position.


3.2 Value at risk limit The value at risk (VaR) method specifies a loss amount that will not be exceeded with a certain probability during the coming trading day. This loss amount is also called the value at risk of the position. The starting point for the VaR method is the market value of a trade portfolio at the moment of measurement. Each day, market risk management defines a 'worst case scenario' for the market variables that determine the value of each position based on historical daily market movements. It then uses this scenario to calculate the possible value change of the position after one trading day, the result is the value at risk of the position. To approach the market risk of individual trading positions, many banks use the historical VaR method. With this method the worst case scenario is determined by listing the changes in the relevant market variables over a specific historical period, for example the last 250 trading days, and then selecting a specific unfavourable price change from this sample. Which scenario is chosen as the 'worst case scenario' depends on the level of probability required. For instance, market risk management will take the sixth worst scenario from the previous 250 trading days as the worst case scenario where the probability is 98% (five price movements, that is 2% of 250, are then worse). A simplified example of the historical VaR method is presented below. Example On 15 June 2009, in the front office system of a share trader, the VaR scenario for the Heineken share is determined based on the following 250 recent daily price movements. First, the system sorts the 250 values and calculates the probability percentage for each single scenario.




248 -3%







Price change -4% -3.5% Probability

-2.7% -2.5% -1.7% -1.5% -1.4%

+3% +3.5% 0.8% 0.4%

100% 99.6% 99.2% 98.8% 98.4% 98% 97.6% 97.2%


The table shows that the probability percentage for scenario 250 is 100%: based on these specific 250 values, theoretically, it is 100% certain that the price of the Heineken share will not drop by more than 4%. If this market risk manager, for instance, uses a probability of 97,5%, he chooses, conservatively, observation 244 as worst-case scenario (97.6%), i.e. a price decrease of 1.5%. If the share trader holds a long position of 100,000 Heineken shares at a current market price of EUR 20, his value at risk can easily be calculated as follows: Value at risk = 1.5% x EUR 2,000,000 = EUR 30,000 If a VaR-limit of EUR 22,500 is imposed for the trader in the above example, he would have to decrease the value of his position by selling shares in order to reduce his exposure. The maximum allowed market value of his position now is EUR 1,500,000 or 75,000 shares. With this position, the VaR would equal the VaR limit: 1.5% x EUR 1,500,000 = EUR 22,500. Each day the oldest observation is removed from the data set of daily market movements and replaced by the price movement during the last trading day. This means that the worst case scenario and thus the trader's allowed position may change every day. If, for the next trading day with the 97.5% scenario, there was a price decrease of 1.6% then the maximum allowed market value of the trader's position would be EUR 1,406,250 or 70,031 shares. The VaR method is based on historical data. The largest negative peaks, however, are not included: with the given probability percentage of 97.5%, 2.5% of the possible outcomes fall outside the scope of the analysis. Thus, the VaR method may provide a fair picture of the risks under normal market conditions but does not provide information about the extent of the possible losses that fall outside the selected probability interval, i.e. the danger area. Market risk managers, therefore, also use stress tests to estimate the risk under extreme market conditions.

Back testing Each day, risk managers try to 'predict' the maximum loss of a trading position with a certain probability by using the value at risk method. The results of the value at risk analyses are frequently tested to see whether these 'forecasts' are reliable.


These tests are referred to as back tests. In these tests, the VaR forecasts for a given historical period, e.g. 250 days, are compared with the hypothetical P&L. This is the actual result for the next trading day where trades that are closed on the day of observation are excluded. Back tests investigate the number of times that the hypothetical P&L was actually worse than the calculated value at risk (the prediction) during a specific period. If a risk manager uses a probability percentage of 98%, the actual hypothetical loss during the period of investigation may not exceed the calculated VaR value on more than 2% of the days. If the actual number of times that the VaR was exceeded is higher or lower than expected, the VaR method used has not produced the correct results and should be adapted.



Chapter 4

Client acceptance and credit risk

Banks only wish to do business with clients that do not pose unacceptable legal or financial risks. Before entering into transactions, banks therefore conduct thorough client investigations. The investigation of the legal liability of a client is called customer due diligence (CDD). Banks also examine the creditworthiness of their counterparts to assess the counterpart risk. Based on these assessments, they will decide if and to what extent they would like to do business. During the client relationship, banks closely monitor the creditworthiness of their counterparties. To mitigate their counterpart risk, they ask collateral or enter into netting agreements.

1 Customer due diligence

Banks are at risk of becoming involved in money laundering or the funding of terrorism. If a bank accepts money that it knows, or could reasonably be expected to know, has been criminally acquired, it may be charged with handling stolen goods or money laundering. Involvement in the funding of terrorism is lawfully forbidden. In order to avoid involvement in money laundering and the funding of terrorism, banks conduct client investigations. The customer due diligence (CDD) policy of a bank consist of three parts: 1. client acceptance, 2. client identification and verification, and 3. the monitoring and reviewing of clients, their accounts and the transactions they close.


1.1 Client acceptance Banks are legally required to divide all their clients into categories based on risk levels with regard to money laundering and terrorism financing. The client's characteristics and the products or services he uses determine the category in which he is placed. The client's country of origin plays a particularly important role in this respect. An important criterion, for instance, may be the fact that the client is the citizen of a country on which the banks home country has imposed economic sanctions, such as Iran. In Europe, for instance, institutions are required by the Sanctions Act 1997 to establish whether or not a client appears on the EU sanctions list as part of their acceptance procedure. Another criterion is whether or not the client's country of origin is an FATF member. FATF stands for Financial Actions Task Force. This organization makes recommendations for legislation and issues guidelines for anti-laundering programmes and programmes aimed at combating the funding of terrorism. The various risk categories are subject to different acceptance procedures: the higher the risk, the stricter the procedures.

1.2 Identification and verification Banks are required to identify all of their clients and to verify their identities. They are also required to investigate clients' backgrounds. Money launderers tend to avail themselves of a wide range of strategies in order to conceal the true origins of their money or value documents. In order to have a clear understanding of a client, a financial enterprise must therefore include in its investigation the identification of the ultimate stakeholder of a transaction or money transfer. Depending on the risk category in which a client is classified, a financial enterprise may have to verify more data regarding the authorized persons or entities.

1.3 Reporting In most countries, banks must report all transactions that may reasonably point towards money laundering to a special government-appointed organization. They are also required to install their own internal hotline for breaches. The compliance department is responsible for this task, in consultation with the security department. Employees can use the hotline to report transactions they believe may be criminal. After conducting an internal investigation, the compliance officer or the securities department can forward the issue to the government-appointed organization.


2 Counterparty limits, types of credit risk and risk mitigating measures

Banks also base the decision about whether to enter into transactions with a specific counterparty on their assessment of the clients creditworthiness. In order to make this assessment, a bank collects as much relevant information as possible including data about the business, for instance sales, profits and cash flow statements, trends in the sector in which the enterprise operates and the quality of the management. Based on this data, an account manager or a specialized department will draw up a proposal to be assessed by a credit committee. Based on this assessment, the committee determines the types of transactions that may be arranged with the counterparty and the maximum amount of risk the bank is willing to take, the credit limit. This limit is then entered into a special credit limit system. If the counterparty is another financial institution this whole process takes place within the financial markets department. When a bank concludes a transaction with a counterparty this is entered in the credit limit system. The available space under the credit limit is reduced by the amount of the credit risk that the transaction carries.

2.1 Types of credit risk In the financial markets department, the several types of credit risk are distinguished.

Lending risk Lending risk is the risk of a borrower defaulting on interest and redemption obligations. Lending risk exists from the moment that a credit agreement is entered into or an interest-bearing security is purchased and ceases to exist at the moment the credit or interest-bearing security is paid back.

Investment risk Investment risk comprises the credit default risk that is associated with a bank's investment portfolio.

Money market risk Money market risk arises when a bank places short term deposits with a counterparty in order to manage excess liquidity and the counterparty may not be able to return the amount.


Pre-settlement risk Pre-settlement risk or replacement risk is the risk of a counterparty defaulting on a derivatives contract. Contract parties are exposed to pre-settlement risk from the moment a derivatives contract is signed until the expiry date of the contract. If a counterparty goes bankrupt within the contract period, the bank must close a new transaction in order to replace the existing contract (replacement). The loss the bank may incur in this process is called replacement cost. Example A bank has closed an FX forward contract EUR/USD with a client, selling one million US dollars. The term of the contract is three months. The forward price is EUR/USD 1.5350. After two months, the client goes bankrupt. The one-month EUR/USD forward rate at that moment is 1.5600. The administrator of the bankrupt counterparty arranges the termination of the contract. The bank must therefore conclude a new FX forward contract to replace the old one. Let us compare the amounts in euros that the bank would have received according to the original FX forward contract with those it will receive according to the new FX forward contract: Amount in euros according to original contract: 1,000,000/1.5350 = EUR 651,465.80. Amount in euros according to replacement contract: 1,000,000/1.5600 = EUR 641,025.64. Thus the bank loses 10,440.16 euros on the value date. For derivatives, the exposure at default is measured by taking the market value of a contract as the starting point. If a counterparty goes bankrupt, a financial enterprise misses out on all future cash flows including the part of any next interest coupon that is already booked as accrued interest. The exposure calculated in this way is called current exposure at default. Based on the volatility, the banks then make an assessment of the possible future changes in this market value over the remaining term of the contract. This assessment is then used to adjust the exposure at default with a so-called add-on for potential future exposure.

Settlement risk The risk of a counterparty defaulting on the settlement of a transaction is called settlement risk or delivery risk. Banks are exposed to this risk, for instance, when dealing with FX spot transactions and cash security transactions. This has to do with the fact that the two counter transfers involved in these types of transactions are often performed separately at separate institutions.


2.2 Risk mitigating measures Banks undertake a number of measures to reduce their credit risk. One of the most commonly known is the demand for collateral. For transactions in financial markets, the collateral generally takes the form of a sum of money or securities. Another measure is the cancelling out of claims and liabilities arising from different contracts with the same counterparty. This is called contractual netting. With the intervention of a central counterparty such as LCH.Clearnet, it is possible to net contracts with various counterparties simultaneously.

Collateral A common way of reducing counterparty risk is to demand collateral. Collateral is a pledge that provides security against default by the counterparty. Whether a financial institution asks for collateral may depend on the creditworthiness of the counterparty. There are however also parties such as clearing institutions and governments that always demand collateral, regardless of the counterparty's creditworthiness. Since the start of the credit crisis, it has also become more common for banks to demand collateral for all derivative transactions. The most important forms of collateral are cash collateral, i.e. a sum of money, and securities. The collateral is entered into a separate collateral system linked to the counterparty limit system. Entering the value of the collateral into the counterparty limit system decreases the use of the counterparty limit. Cash collateral Collateral in the form of cash is used for derivative transactions and securities lending transactions where the cash represents a pledge for the borrowed securities. The settlement of cash collateral usually takes place daily based on fluctuations in the value of the covered contract over the previous trading day. Cash collateral for derivatives is sometimes called margin and the daily telephone calls or e-mails to the counterparty asking them to transfer cash are referred to as margin calls. Cash collateral is quite common among financial institutions. When concluding derivative transactions with non-financial institutions nowadays, however, banks ask cash collateral more frequently than before the credit crisis. When demanding collateral, financial institutions usually apply a threshold, that means that the counterparty is not required to deposit collateral until the market value of a contract exceeds a specific pre-agreed limit value. From this moment onwards, the margin is settled on a daily basis. Since the credit crisis, the thresholds have, in many cases, been abolished.


Even when banks demand 100% cash collateral for derivatives in the form of margins, they will impose a charge of a certain amount on the counterparty limit at the beginning of the transaction. This charge is known as add-on for potential future exposure. There are two reasons for this. First, there is the risk that the counterparty may go bankrupt and ceases to deposit margins that may result in the event of further fluctuations in the value of the contract during the time until the contract is legally terminated. The second reason is related to the replacement risk. Once it is clear that a counterparty is defaulting on its obligations, the bank is required to enter into an identical transaction in the market to replace the first one and the chance exists that, for some reason, the bank is not able to close this transaction at the prevailing market price. If this is the case, the value of the collateral will not be sufficient to compensate fully for the loss. The add-on for potential future exposure can be compared to the initial margin used in exchange transactions. Collateral in the form of securities In repurchase agreements and sell/buy back transactions, securities are used as collateral. Financial institutions generally only accept securities issued by a creditworthy party. They often use ratings for this purpose. In addition, they prefer securities whose value does not fluctuate too much, i.e. low volatility securities. This has to do with the chance of under-coverage during the contract period. The saleability of the securities in the event of a counterparty default is another factor that they take into consideration. The securities therefore have to be traded in a liquid market. Furthermore, financial institutions only accept securities for which they can easily assess the value themselves and that can easily be registered by their custodian. The risk of under-coverage exists since depreciation can cause the value of the collateral to drop below the volume of the exposure with the counterparty. In order to limit this risk, financial institutions may apply a haircut. For example, if 90% of the value of the collateral applies then there is a 10% haircut. The applied haircut percentage is based on the volatility of the collateral.


Example A pension fund closes a securities lending transaction with the hedge fund Centaurus. The pension fund transfers 1,000,000 Royal Dutch shares to Centaurus with the agreement that they will return the shares after one month. The market price of Royal Dutch is EUR 30 making the value of the loaned shares: 1,000,000 x EUR 30 = EUR 30,000,000. The pension fund only accepts Dutch state bonds as collateral and applies a haircut of 2%. The value of the collateral must therefore be 100/98 * EUR 30,000,000 = EUR 30,612,245. If the price of the Dutch state bonds is 100.37, Centaurus must provide EUR 30,612,245 / EUR 1,003.70 = 30,500 bonds as collateral.

Contractual netting/close-out netting Another way of reducing exposure at default is contractual netting also known as close-out netting. Contractual netting is an agreement between two parties to net the positive and negative values of all of their contracts should one of the two go bankrupt leaving just a single net exposure. Contractual netting is often included in master agreements such as an ISDA or an IFXCO agreement. The contractual netting agreement is recorded in the counterparty limit system. Example A bank has closed an interest rate swap and an FX forward contract with one and the same counterparty. The interest rate swap has a positive market value of EUR 500,000. The FX forward contract has a negative market value of EUR 300,000. Without contractual netting, the counterparty's bankruptcy would mean that the bank would have to fulfil its FX forward contract obligations while the counterparty would have the interest rate swap terminated. The bank would thus lose 500,000 euros. With contractual netting, the market values of the two contracts are set off against each other and the bank's loss in this case would only be 200,000 euros. Sometimes two parties agree to cancel all existing contracts and replace them with a new one. This is known as netting by novation.


Contractual netting by clearing houses / multilateral netting For exchange transactions, a clearing house always acts as a central counterparty. In the contract between the member and the clearing institution, a contractual netting agreement is automatically included. Banks also increasingly make use of the services of central counterparties for derivatives transactions. One clearing house that handles the clearing of derivatives is LCH.Clearnet. The system they use for this is Swapclear. When banks are connected to Swapclear, all bilateral contracts between two members are converted into two separate contracts each between one member and LCH.Clearnet. Because of the bilateral contractual netting clause with LCH.Clearnet, all contracts of a specific member with the various other members are now netted simultaneously. As a consequence, the credit exposure is significantly reduced. Another advantage is that the daily settlement of the collateral takes place exclusively with the central counterparty instead of with each counterparty separately.


Chapter 5

P&L measurement

The managers of the various trading desks need daily information about the risk and the results of their traders. At some banks, supplying this information is the responsibility of a special department called middle office. At other banks, it is part of the product control department's responsibilities. All banks keep these departments separate from the front office financial markets department.

1 The responsibilities of the P&L unit

The P&L measurement is carried out by a special department within the financial markets division. Sometimes it is part of the responsibilities of the product control department, with other banks it may be carried out by the middle office. The following components are taken into account in the daily P&L update: fluctuations in the value of the financial instruments; provisions; interest costs and revenues; broker fees. The department that is responsible for measuring the daily P&L should comply with several control measures. First, the P&L should be signed-off by the traders each day. Second, every unusual movement in the P&L figures needs to be explained. In this respect, the results for all closed deals should be checked. For any deal with a major negative or positive result, the price has almost certainly been entered incorrectly. This check is known as off-market price testing. In these cases, the trader in question must be contacted immediately to find out what went wrong. Finally, adequate information about other factors that could have had a material impact on the P&L should be collected, for example, late booked trades.


2 Fluctuations in the value of the financial instruments

The market value of financial instruments is calculated on a real-time basis in the front office systems. The pricing models which are used in these systems are verified and approved by the market risk department. Once each day, usually at the end of the trading day, the value is fixed for the daily results measurement. In order to determine the value of exchange traded instruments, the closing price on the exchange where the instrument is traded is used. For OTC instruments, the bank calculates the value itself based on self-compiled yield curves and exchange rate data. Every bank has its own policy regarding the screens from where it imports interest rate and exchange rate data and regarding the moment at which the values are fixed.

Independent price verification and curve policy The accuracy of the valuation of financial instruments depends on the quality of the valuation models used and the accuracy of the imported market data used for the daily fixing. This data is therefore subjected to a strict examination. The task of checking and approving this data belongs to the product control department and is known as independent price verification (IPV). The traders themselves must also give their approval for the imported data but product control has the final say in the event of any dispute. Sometimes there is no clear or reliable market data available. Clear data is absent, for instance, in the case of volatilities for which there is no benchmark. Reliable data may be unavailable for illiquid instruments which was the case for the securitized mortgage portfolios during the credit crisis. In these situations, traders are initially authorized to use their own data. However, the product control department regularly, at least once per month, checks the market data used by the traders. The product control department maintains its own data set for this purpose. The interest curves that are used for the valuation of interest bearing instruments are constructed by a special unit of the market risk department. This activity is called curve policy.


3 Provisions

Some financial instruments are so complex that it is virtually impossible to determine their exact value. In these cases, banks make a provision for possible inaccuracies in the valuation. These provisions are referred to as model reserves. The valuation of financial instruments is based on mid-market prices. These prices/exchange rates are the exact average of the bid and ask prices. Long positions, however, should in principle be based on bid prices, and short positions on ask prices. This is because a trader can only close a long position by selling the values he holds in position. As a market user, he will only be able to sell at bid prices. And a trader with a short position has to buy the values he holds in position in order to close his position. As market user he has to pay the ask price in the market. To lessen the negative influence of this on the accuracy of the results, banks also make provisions. In order to establish the size of the provision, the department responsible for calculating the P&L periodically receives data regarding the prevailing spreads in the market from the market risk management department. All provisions are subtracted from the results of the traders. If a trader closes his position and the released price in fact turns out to differ negatively from the last fixing, the relevant provisions will be activated and the traders result will not be negatively influenced.

4 Interest costs and revenues

For some traders, it is evident that a part of their result is determined by interest costs or revenues. This applies to those trading interest rate instruments such as fixed-income instruments or interest rate swaps. For example, if a bond trader has a long position on Government bonds, he is entitled to the coupon revenues. The opposite applies for a bond trader with a short position. He has sold a bond that he did not possess and will have to buy it back in the future. He will then have to pay the clean price on the purchase date plus the interest accrued up until that moment. When opening the short position, he has received the accrued interest up to the sale date. In this case, the accrued interest during the time the position was held is booked as a negative contributor to the trader's result, i.e. interest costs.


Interest costs and revenues do not just affect traders in interest rate instruments. They contribute to the trading result of anyone trading in financial instruments because going long on a financial instrument - such as a share - requires a trader to borrow money. The P&L department books interest costs for this purpose every day. This is also known as cost of carry. If a trader goes short e.g. on a security, he can use the revenues from the initial sales transaction to generate interest revenues. These interest revenues will contribute positively to his result. Interest is thus booked twice for bond traders: on the one hand as coupon interest and on the other as cost of carry. To calculate the cost of carry, normally the benchmark for the overnight interest rate, for example, EONIA, SONIA or fed funds is used.

5 Broker fees

If a trader uses the services of a broker, he has to pay a broker fee. Most banks have drawn up standard agreements with brokers, describing how the broker's fee should be calculated. Different calculation methods are used for currency transactions and derivatives.

Fee per million calculation The fee per million calculation is a method whereby the broker fee is expressed as a fixed amount for each million in nominal value, the rate. For instance, the rate may be 2 US dollars per million. This method is frequently used for FX transactions. The total fee charged by a broker for a transaction is calculated by multiplying the nominal amount of a transaction (stated in millions) with the rate, as in the following formula: Fee = nominal amount / 1,000,000 x rate The rate depends on the maturity of the FX contract and the currency involved. Figure 5.1 shows how the rate is influenced by the maturity of the contract and by the market liquidity of the traded currency pair. In order to determine the rate, one must always look at the column of the least liquid currency of a currency pair.


Figure 5.1 Broker rates for FX forward and FX swaps



Non Major


=< 1 week 1 week < 1 month 1 month < 3 months

0,15 1,00 2,00

0,35 2,00 4,00

1,50 7,50 13,00

Example The rate for an FX forward contract in EUR/NOK with a nominal value of 10 million euros and a term of two weeks is 2 euros. The broker fee for this transaction is 10 x EUR 2 = EUR 20. The rate for an FX swap EUR/CSK (Czech crown) with a nominal of EUR 30 million and term of 1 week is 1.50 euros. The broker fee for this transaction is: 30 x EUR 1.50 = EUR 45.

Flat calculation Flat calculation is a method in which the broker rate is expressed as an interest rate percentage, for instance 0.2 basis points (= 0.002%). This method is often used for interest rate derivatives. The broker fee is determined by means of the general equation used for calculating interest amounts: Fee = nominal x rate x days / 360 In this method, too, the rate depends on the currency being traded. The term of the contract is already taken into account in the formula itself.


Figure 5.2 Broker rates for interest rates derivatives (IRS, OIS, FRA)



Non Major


=< 1 month 1 month < 1 year >= 1 year

0,125 bp 0,1 bp 0,1 bp

0,2 bp 0,15 bp 0,15 bp

0,35 bp 0,35 bp 0,35 bp

Example The rate for an OIS (overnight index swap) in USD with a nominal value of USD 40 million and term of six months (183 days) is 0.1 bp. First the nominal value in euros must be calculated, on the basis of the EUR/USD exchange rate valid on the value date: EUR/USD = 1.3333. The nominal amount in euros is thus EUR 30 million. The broker fee for this transaction is: USD 30 million x 0.00001 x 183/360 = EUR 152.50. The brokerage control department is responsible for checking the invoices sent by brokers. At some banks, this department is part of the back office department. At other banks, this activity takes place at a middle office unit. The first thing the brokerage control unit does is to check whether a broker appears on the list of brokers with whom dealers are allowed to do business. Then it checks the amounts charged by the brokers. In a separate reconciliation system all broker invoices are compared with the amounts calculated by the bank. In the case of deviations, the brokerage control department will contact the broker in question.


Chapter 6

Deal capture, confirmations and settlement instructions

Transactions in financial instruments are processed according to a fixed procedure. This procedure involves the following consecutive activities: concluding the transaction, authorization, entering the transaction data, verification, confirmation and providing settlement instructions. The departments performing these operations functions are sometimes called Operations or Service Centres. In this book, the universal term back office is used. The processing of transactions normally takes place in various computer systems, such as a dealing system, front office system, back office system or confirmation-matching system. Financial institutions strive to maximize automation when it comes to exchanging information between these systems. This is referred to as straight-through processing. At different stages of processing, financial institutions will send information to other parties. In order to do so, they often use SWIFTNet. SWIFTNet is a computer network used exclusively for sending financial messages.

1 Closing transactions and capturing transaction data

Transactions in financial instruments are concluded by telephone, via dealing systems or via electronic brokers. Traders are only allowed to close transactions if they are properly authorized. Authorization means that the legality of a transaction is ensured. A transaction is authorized if the front office employee is entitled to trade in the instrument concluded; only concludes trades in amounts for which he has approval; remains within his trading limits; does not exceed the counterparty limit.


Often a front office employee will enter the transaction data into his or her front office system prior to concluding a transaction in order to check whether the transaction will be authorized. The trade limit is checked in the front office system. The counterparty limit is checked in a separate counterparty limit system, which is linked to the front office system. These checks are referred to as pretrade compliance. It is also important that the front office employee checks the counterparty's authorization. There is no problem if he has his regular contact person on the line, but if this person is sick or on leave, the front office employee must check whether his replacement is also authorized to close transactions. All telephone conversations made by front office staff are recorded on tape. This tape is used to provide evidence in case of disputes.

1.1 Transaction data Once a transaction has been agreed, the transaction data are entered into the front office system. If the transaction is concluded by telephone, the data are entered manually. If the transaction is concluded via a dealing system, the transaction information is fed into the front office system by means of an interface. A trader can then keep track of the market value and the risk associated with his position in the front office system. If no pre-trade compliance was carried out and it turns out following authorization that the front office employee has exceeded his trade limit, he must, in principle, offset the transaction, unless the line manager approves the transaction afterwards. If the counterparty limit turns out to have been exceeded, the necessary action depends on the nature of the counterparty. If, for instance, the counterparty is an asset manager or an enterprise, the client advisor must request post hoc permission for this transaction from the account manager. Usually, the account manager will grant this permission so that the transaction does not have to be offset. If, on the other hand, the counterparty is a bank, the deal most likely should be offset.


The following data must typically be entered into the front office system: the name of the counterparty; the type name of the financial instrument and, in the case of a security, also the ISIN code (international securities identification number); whether it is a purchase or sale; the currency, often referred to by means of a 3-letter ISO code, e.g. EUR or USD; the notional amount or amounts (in the case of FX transactions); the term of the contract; price, FX rate or interest rate; the daycount convention in the case of an interest instrument; the reference of the variable interest (e.g. EURIBOR or LIBOR), in the case of an instrument with a variable interest; the trade date and time; the name of the trader; the settlement date; the settlement instructions. Banks try to register data in such a way that these do not have to be entered again and again with every transaction. These fixed data are called static data. Examples of the static data of clients are personal data and account numbers. Static data are also entered for each new financial instrument, such as the interest calculation of the instrument and the currencies the instrument will be traded in. The use of static data reduces the risk of entry errors. Static data are entered into the relevant systems by a separate department within the back office department.

1.2 Master agreements Many financial instruments are traded over-the-counter. This means that the two parties do not have the comfort of the standard regulations of a central counterparty. To overcome this disadvantage, banks often use master agreements with over-the-counter transactions. These are agreements that set out all the agreements and conditions pertaining to all transactions concluded by an organization with one and the same counterparty within a certain instrument. For each


new transaction with this counterparty, the bank can then refer to the master agreement, while only specific transaction details are dealt with in a separate contract. Here are some examples of master agreements: ISDA Agreement (International Swap Dealers Association) Agreement: for interest rate derivatives, credit derivatives, equity derivatives and sometimes also for some FX derivatives like FX forwards; GMSLA Agreement (General Master Securities Lending Agreement): for securities lending transactions; GMRA Agreement (General Master Repurchase Agreement): for repurchase agreements (repos); IFEMA (International Foreign Exchange Master Agreement): for currency transactions. The most frequently used master agreements is the ISDA Agreement, made up by The International Swaps and Derivatives Association (ISDA). The ISDA agreement consists of a master agreement, a supporting schedule, individual transaction confirmations and a credit support annex.

The ISDA Master Agreement The master agreement is the principal document in an ISDA transaction that contains the standard terms and conditions that apply to all individual transactions agreed to between the counterparties. Examples of standard terms are provisions governing events of default, termination events and law.

The ISDA Schedule The schedule to the master agreement amends and supplements that agreement by customizing some standard terms and conditions. The schedule is far more likely to be subject to negotiations and modifications between the counterparties. The ISDA schedule may contain articles on the following issues: joint and several liability between parent-subsidiary groups; cross-default provisions, stating that any default by the customer in the payment of any other debt obligation (regardless of whether such obligation is owed to the bank) constitutes a default under the ISDA master agreement; netting agreements. ISDA schedules also typically describe the set-off rights of the parties against each other with respect to payments that may be required under the ISDA master agreement. The ISDA schedule typically gives a bank the right to set off against amounts held by the customer in deposit accounts for any payment owed to it by the customer; the duty to deliver documents like annual/quarterly reports or a list of authorized staff.


Confirmations For each individual transaction that is closed under an ISDA Agreement, a separate confirmation has to be made up that contains the trade details of this transaction. The general terms contained in the master agreement, as well as the more specifically negotiated provisions contained in the schedule, will still apply unless the parties to the confirmation explicitly agree otherwise. It is important that the back office or middle office monitors each new transaction confirmation to ensure that it has not introduced new or unexpected terms or modifications to the master agreement.

Credit Support Annex (CSA) Nowadays, collateral requirements play an important role in the negotiations of an ISDA agreement. The agreements on these requirements are stated in the credit support annex (CSA). In a CSA, parties must agree on the following issues regarding collateral: what type of collateral they accept, for instance cash or securities and, in the latter case, which securities are eligible; the frequency of the reconciliation of the transactions; the frequency of the margin calls; the possibility of extra margins calls; threshold and/or minimum transfer amount; who is responsible for establishing the value of mutual receivables and payables: the calculation agent.

2 Verification

Once a deal has been authorized, the data are sent from the front office system to the back office system, where they are checked for completeness. This is called verification. Verification is important because front office employees are often exclusively occupied with concluding transactions and may therefore pay less attention to entering transaction data. Also, they may not always see the value of verifying details regarding the processing of a transaction. This explains why they sometimes make mistakes in entering transaction data. For simple financial instruments such as deposits, securities and currency transactions, verification nowadays is for the most part automatically performed in the back office system. For more complex instruments, such as interest rate derivatives and special investment products, verification is still frequently performed manually by specialized back office employees. In the latter case, the


back office has to try to pinpoint possible errors, so as to ensure that the transaction can be processed smoothly. In this context, a back office employee may ask the follo-wing questions: Do the settlement instructions appear to be correct? Is there anything about the transaction that seems unusual, for example: a client concluding an unusual transaction; a client buying a certain currency it usually sells; the use of a broker not normally used? Is the agreed price in accordance with the current market level? This last check is called a reasonability check. If the price appears to deviate from what is normal, a back office employee must go to the dealer to check whether the price is in fact correct. With more and more transactions being processed by STP, a reasonability check by a back office is not always possible. Besides that, a reasonability check requires a considerable amount of knowledge. This is why daily checks for offmarket pricing are performed by the product control department.

3 Confirmation

Confirmation refers to the reconciling of the contract details of a transaction with the counterparty. Confirmation must take place quickly, so that possible errors can be corrected at an early stage. The confirmation procedure followed depends on the type of transaction. Here are several common methods of confirmation: 1. An exchange transaction between a member and the exchange is immediately confirmed electronically by the exchanges trading system. 2. In the case of a transaction between two banks, the two parties send each other a SWIFT message. These SWIFT messages are automatically created by the banks' back office systems. Examples of SWIFT confirmation messages are MT 300 for currency transactions (Figure 6.1), MT 320 for deposits and MT 340 for FRAs. If a transaction has been arranged through a broker, the broker will send an additional SWIFT message of confirmation to both contract parties. 3. A transaction between a bank and a client (investor, asset manager, institutional investor or enterprise) is usually confirmed by a fax or an e-mail sent by the bank to the client. These fax messages or e-mails are created in separate systems fed by the back office systems.


4. Financial instruments concluded by Markit wire (Swapswire) are confirmed electronically and directly. Markit wire can be used for interest rate derivatives and for credit derivatives. In most countries, banks are legally required to send their counterparty a confirmation. This rule also applies when a client concludes a transaction via the bank's auto-dealing system. The confirmation message automatically generated by this system does not count as a formal confirmation.
Figure 6.1 SWIFT MT300 confirmation message of an FX forward transaction between ING and UBS

Type of information Message header

SWIFT format

Relevance of the information

Reference code SWIFT-code of sender SWIFT-code of receiver Message text Trade date Value date Exchange rate Receiving agent

WCHZ0A1234INGB2a Code used to reconcile the confirmations INGBNL2A WXHZH80A ING Bank is the sender of the message UBS is the receiver

20090522 20090824 1.3222 BOFAUS3N

Trade date 22 may 2009 Settlement date 24 august 2009 FX forward rate ING wants to receive the US dollars on its account with Bank of America UBS wants to receive the euros on its account with Deutsche Bank

Currency, amount bought USD 13,222,000

Currency, amount sold Receiving agent

EUR 10,000,000 DEUTDEFF


Matching of confirmations The way in which counterparties must act with regard to confirmations is usually laid down in an agreement. In the case of a transaction between a bank and a client, e.g. the bank sends a confirmation to which the client must then respond. Banks often expect their clients to respond directly by e-mail or fax. If a client does not respond immediately - at least in the case of FX and money market transactions - the bank will contact the client immediately by telephone to confirm the transaction. This telephone conversation is stored in a separate computer system that is sometimes referred to as conversation checker. In some cases, however, a confirmation is considered accepted if the client has not responded by the end of the day. In the case of a transaction between two banks, it is common for both parties to send each other a confirmation. Banks use separate systems to match these confirmations. Some banks use an internal matching system. Others use external systems such as SNA, which is operated by SWIFT. These matching systems send an electronic status update of each confirmation to the back office system. If the confirmations match, the matching systems label the deal as such. If a confirmation is missing or does not correspond with that of the counterparty, it is marked with the status 'unmatched' and placed in a queue in the back office system. If a confirmation doesnt match, this may have to do with the transaction's settlement instructions or with the actual transaction data. If there is a difference in the settlement instructions, the back office must contact the counterparty's back office. If a comparison of the settlement instructions brings to light a mistake, the back office of the party responsible for the mistake must correct the information in its own back office system. A confirmation of this correction is then sent to the counterparty, after which the transaction can be given the status matched' and be processed further. If there is a mismatch of transaction data, the back office employees of both parties must contact their front offices as quickly as possible. If on inspection by the front office the data turn out to have been entered incorrectly, the front office must cancel the original transaction in the front office system. For this, the permission of the line manager is required. The transaction must then be reentered correctly, following which the back office sends a new confirmation to the counterparty. The error will then have been corrected administratively, although significant costs may have been incurred. Example A salesperson concludes a transaction with a corporate client. The salesperson incorrectly understands that the client wishes to sell 12.5 million US dollars to the bank. The exchange rate quoted by the spot dealer is EUR/USD 1.2500. The client accepts and the salesperson immediately


passes the transaction on to the spot dealer, who immediately closes his position by selling 12.5 million US dollars at a market rate of EUR/USD 1.2500. The salesperson enters the transaction into the front office system as a purchase of US dollars. As this information corresponds with the information provided orally by the salesperson, the spot dealer has no reason to assume anything is wrong. After the client has returned the confirmation, however, it turns out he wanted to buy rather than sell US dollars. Therefore, the transaction data in the confirmations do not match. The back office employee inquires with the salesperson, who concludes that he has indeed entered an incorrect deal. The salesperson now has to cancel the original transaction and must enter the correct transaction at the original exchange rate: the bank sells 12.5 million US dollars at an exchange rate of EUR/USD 1.2500. The original transaction is also cancelled in the trader's position overview. After the salesperson has re-entered the transaction, the spot dealer now has sold an amount of 12.5 million US dollars at an exchange rate of 1.2500 twice, without a purchase to counter the sales. The spot dealer thus finds himself in a short position in dollars with a volume of 25 million US dollars, for which he received 20 million euros. In order to close the short position, the spot dealer must sell USD 25 million immediately. If at that moment the exchange rate e.g. is EUR/USD 1.2400, he will have to pay the following sum: 25 million/1.2400 = EUR 20,161,290.32. As a result of the mistake made by the salesperson, the spot dealer therefore incurs a loss of 161,290.32 euros. He will recover this amount from the sales desk. In the above example, the bank's own salesperson made a mistake. If the salesperson turns out to have entered the transaction data correctly, the counterparty is responsible for the above scenario. In some cases, the front office employee of the bank and the counterparty may both be convinced that they have registered the deal correctly. If this is the case, they must re-contact one another in order to establish what precisely was agreed upon. If this contact does not result in a solution, they must listen to the telephone tape that was made of their conversation as quickly as possible to find out who is right.


4 Settlement instructions

Settlement is the final transfer of money and/or securities following transactions in financial instruments. Settlements take place at banks, central banks, custodians and central securities depositories or at specialized settlement institutes, such as the CLS bank. The date on which a settlement occurs is called the settlement date or value date. In order to make a withdrawal from its own account and in favour of another account, a party must issue an order to the institution at which it holds its account. This order is called a settlement instruction. Banks send settlement instructions via SWIFTNet. Clients of banks enter settlement instructions into the payment systems of a bank or the custodian at which they hold their securities accounts. Settlement instructions are usually drawn up automatically in a back office system. They are sent by a separate payment department or a specialized group within the back office, but only after a transaction has been confirmed by both parties and given the status 'matched' by the matching system. As banks manage accounts themselves, there may be cases in which a bank merely has to send an internal settlement instruction in order to settle a transaction. If, for example, a bank salesperson offers a short-term loan to an enterprise with an account at the same bank, the back office merely has to send an internal settlement instruction to the department managing the bank's accounts, requesting that the enterprise's account is credited and the internal financial markets/money market account is debited. Settlement instructions must always be sent to the settlement institution before a certain time to ensure that the amount is transferred to the recipient's account on the required value date and the receiver is able to invest the money in the money market. If this is the case, it is called good settlement value in jargon. The final time by which settlement instructions can be sent and still result in good settlement value is called the cut-off time. The cut-off time for transfers in euros processed through TARGET, for instance, is 17:30 hours, for transfers processed through Euro1 it is 16:00 hours.

4.1 Shadow accounts Financial institutions have an internal shadow account for every nostro account that they hold. All transfers that must take place on the external account are also processed on the shadow account. To this end, the back office system sends an internal settlement instruction to the system in which the shadow account is managed. For instance, if a bank has to pay a US dollar amount, it will send an external settlement instruction to the dollar correspondent bank to debit the US


dollar nostro account and an internal settlement instruction to its own accounting system to debit the shadow account of the USD nostro account. If the bank in a later stage receives a transfer statement from the correspondent bank (MT910), it can compare this with the position movement in its shadow administration. This check is called Nostro reconciliation and is usually performed by a separate department in the back office, operations control, or by the finance department.

4.2 Standard settlement instructions (SSI) If a front office employee concludes a lot of transactions with one particular client, it is inefficient to enter all client and settlement data for each separate transaction. For this reason, it is common practice to make an agreement with the client as to which accounts are normally to be used for processing the transactions. Instructions that relate to this common practice are normally referred to as standard settlement instructions, or SSIs. SSIs are part of a client's static data. Whenever a front office employee concludes a transaction with a client without further notice, he may assume it is to be processed in accordance with the SSI. If the client wishes the transfer to be directed through a different account, he must explicitly indicate this. Back office employees must always be alert for abnormal settlement instructions. If they suspect something is wrong, they must check with the front office of with the counterparties back office whether the settlement instructions are correct. If the beneficiary is a third party, alertness is even more vital, as this may indicate the possibility of fraud.

4.3 Settlement risk The risk of an incoming transfer not being processed, or being processed too late, is called settlement risk. The risk of an outgoing transfer not being processed, or being processed too late, however, is an example of operational risk. In securities or currency transactions, settlement risk can be avoided by making the transfers interdependent. This is the case whenever a currency transaction is settled through the CLS bank (payment versus payment) and whenever a securities transaction is processed in accordance with the DVP condition (delivery versus payment).


Another way of reducing settlement risk is to make use of payment netting. Payment netting reduces counter payments following from multiple transactions due on the same date in a single currency to a single net payment. Example A bank concludes a receiver's interest rate swap on 13/7/2009 with a principal of 100 million euros. The fixed interest rate is 3% (30/360) and the variable interest coupon is based on a six-month EURIBOR. In their ISDA Agreement, the parties have agreed that the fixed coupon payment will be netted with a variable coupon payment if they happen to coincide on the same value date. On 13/1/2010 the six-month EURIBOR for the coupon period 15/1/2010 - 15/7/2010 is fixed at 2% (actual/ 360, 181 days). The coupon payments on 15/7/2010 are: Fixed interest coupon first year: EUR 100 mio x 0.03 x 360/360 = EUR 3,000,000 Floating interest coupon 15/1/2010 - 15/7/2010: EUR 100 mio x 0.02 x 181/360 = EUR 1,005,555.55 As a result of the netting agreement, on 15/7/2010, the bank receives the net amount of EUR 1,994,444.45 from the counterparty. Erroneous settlements often occur during weekends or bank holidays. In order to avoid such errors, the back office must consistently maintain a bank holiday calendar for all relevant currencies. Whenever a new bank holiday is introduced, it must be entered into this database. If the settlement of a previously concluded transaction happens to occur on such a date, according to the model code of the ACI, the following rules apply: the modified following convention is used; the shift applies to both currencies in an FX transaction; the price is not modified.


5 Event calendar

For some financial instruments, transfers not only take place directly after the conclusion of a transaction, but may also take place in the course of the contract period. These transfers are scheduled in an event calendar, a list of events requiring action on the part of the back office during the contract period. The list is drawn up in the back office system. The actions listed in an events calendar may also pertain to refixing coupon interest rates, periodically assessing whether the collateral volume needs adapting, distributing or collecting dividend payments or performing early redemptions. The table below shows an event calendar of an interest rate swap.
Figure 6.2 Event calendar of a receivers interest rate swap in US dollars closed on 13 july 2009

Date 13/1/2010 15/1/2010 13/7/2010 15/7/2010 13/1/2011 17/1/2011 13/7/2011 15/7/2011

Event Fixing of the 6 months LIBOR for the coupon period: 15/1/2010 - 15/7/2010 Pay the floating coupon for the coupon period: 15/7/2009 - 15/1/2010 Fixing of the 6 months LIBOR for the coupon period 15/7/2010 - 17/1/2011 Receive the net amount of the fixed coupon for the 1st year and the floating coupon for the coupon period 15/1/2010 - 15/7/2010 Fixing of the 6 months LIBOR for the coupon period 17/1/2011 - 15/7/2011 Pay of the floating coupon for the coupon period 15/7/2010 - 17/1/2011 Fixing of the 6 months LIBOR for the coupon period 15/7/2010 - 17/1/2012 Receive the net amount of the fixed coupon for the 2nd year and the floating coupon for the coupon period 17/1/2011 - 15/7/2011 Fixing of the 6 months LIBOR for the coupon period 17/1/2012 - 17/7/2012 Pay the floating coupon for the coupon period: 15/7/2011 - 17/1/2012 Receive the net amount for the fixed coupon of the 3rd year and the floating coupon for the coupon period 17/1/2012- 17/7/2012

13/1/2012 17/1/2012 17/7/2012


6 Diagrams of processing methods A number of back office work processes will be described in this paragraph. The various stages of processing an FX transaction and an OTC securities transaction will first be dealt with, and then the process of a structured product will be discussed.

Processing of FX and money market transactions

Figure 6.3 Processing of an FX/MM transaction with another bank as counterparty

Front office


CLS Bank SWIFT Portal Counterparty limit system EBS RD 3000 ICAP Bloomberg Brokers Telephone 2 1 FO system 3 BO system 6 Matching system 7




Swift Portal
Internal settl. interface 10

SWIFT Alliance


EBA ( <50.000) Correspond Bank

Account system

1. The transaction data are imported into the front office system from a deal system. 2. Compliance with the counterparty limit is checked by means of an interface with a counterparty limit system. 3. After authorization, the transaction data are imported into the back office system. 4. The back office system generates a SWIFT confirmation message MT300 (FX) or MT 320 (MM). The confirmation message goes to SWIFT through an internal portal/mailbox. 5. Once the counterparty has returned the confirmation, it is entered into the matching system and matched with the back office system's output.


6. After the matching system has matched the deals, they are given the status 'matched' in the back office system. 7. The matching system sends the matched confirmations to an archive system for storage. 8. The back office system sends an internal settlement instruction to the accounts system. 9. The back office system draws up a settlement instruction to debit a nostro account belonging to the bank at the ECB or at a non-euro correspondent bank, with reference to 'financial markets' which is sent to the correspondent bank. 10.Having performed the transfer, the correspondent bank sends a transfer statement, which is reconciled with the information in the account system.

Processing of an OTC cash securities transaction

Figure 6.4 Processing of an OTC cash securities transaction with an asset manager



Confirmation system Counterparty limit system Letter Fax 1 Telephone FO system BO system 3 Cash man system 4 Payment system 5 Internal settl. interface


Euroclear Bank

ECB Corresp. bank

2b 2a 2a

SWIFT Alliance


ECB Corresp. bank

Account system

1. The BO system sends a confirmation, using a confirmation system for clients connected to this system and a fax/letter for other clients. This confirmation has no further purpose for the bank as far as the rest of the processing procedure is concerned. 2. a. The BO system generates settlement instructions for the custodians. These are SWIFT messages sent to SWIFT.



4. 5. 6. 7.

The custodian also receives instructions from the counterparty and gives the transaction a 'matched' status if the instructions correspond with each other and sends a message to that effect through SWIFT. The transaction thus is either confirmed or not. b. As far as securities in the custody of the back office itself are concerned (e.g. local Government bonds), the back office system sends a direct SWIFT message to Euroclear Bank's EUCLID system. Euroclear Bank returns status notifications through the EUCLID system. The BO system sends information about the deal to the cash management system. This report contains the money transfers resulting from securities transactions for each custodian. The cash management system calculates the amounts to be deposited into or withdrawn from the custodians' accounts (sweeping). The cash management system sends information on the required sweeping transactions to the payment system (or generates these orders itself). The payment system forwards this information to the system in which the shadow accounts are managed. The payment system generates an external settlement instruction to the correspondent bank payable to the custodian or vice versa. Correspondent banks and custodians return a transfer statement, confirming that the transfer has been concluded, which is reconciled with the information in the account system.

The processing of structured products Structured products are financial instruments consisting of various plain vanilla instruments offered to a client as a single instrument. Structured products cannot always be processed in one and the same back office system. If this is the case, the various instruments constituting the structured product are entered separately in the back office systems in which these instruments are normally entered, but under the same deal number, a 'structure ID'.


Figure 6.5 Processing of a structured deal

Decomposition of the structured deal / confirmations and settlement suppressed

BO system FX/MM

BO system Bonds

Structured Product Group

One confirmation and net settlement flows

BO system Derivatives

Without further action, each separate back office system would create a confirmation which would be sent to the counterparty and each separate instrument would generate its own cash flows. However, as it is neither desirable for a client to receive multiple confirmations for an instrument presented to him as a single instrument, nor for him to see several different cash flows on his account, both the confirmations and the cash flows of these joint instruments are suppressed in the separate back office systems. A dedicated department in the back office, the Structured Products Group, sends one manually created confirmation and processes only the net cash flows of a structured product on the client's account. Before the confirmation is sent, the structured product group contacts the front office to have the confirmation and the event calendar checked.



Chapter 7

Money settlement

Nearly all transactions in financial instruments lead to transfers of money. With most of these money transfers, more than one bank is involved simultaneously. This is because the accounts of the two parties that close a transaction are often not held with the same bank. Therefore, banks often need to transfer money to another bank or they receive a transfer of money from another bank. A bank can only transfer money to another bank if it has direct or indirect access to an account system that the other bank also has direct or indirect access to. Banks have direct access to the account system of the local central bank. Banks have indirect access to the account system of central banks in other countries because they hold accounts at correspondent banks. In order to effect a transfer in its own currency, a bank must send a settlement instruction to the local central bank. There are two ways to do this, via an RTGS system or a clearing institution. For the transfer of foreign currency amounts, a bank must send a settlement instruction to its correspondent bank.

1 Bank accounts

Accounts are held at banks by individuals, companies and asset managers, but also by foreign banks. Banks call these client accounts loro accounts. Banks keep track of the balances and mutations of such loro accounts in their own account system. Banks also hold accounts themselves. For the local currency, they hold an account with the central bank of the country for which they have a banking licence. All banks with a banking licence in euro countries, for instance, hold a euro account at the European Central Bank (ECB). These may also be subsidiary companies of banks outside the euro area if they are a separate European legal entity. Banks can use the euro account at the ECB to make transfers in euros to other banks with a 'euro' banking licence.


In order to execute transfers in a foreign currency, a bank must have an account in that currency. Because a legal entity can only have a banking licence in one country it can have an account with only one central bank. In order to execute payments in foreign currencies, banks open accounts with foreign banks that in turn hold an account with the central bank in the country where the foreign currency is the local currency. These banks are called correspondent banks or intermediary banks and the accounts are referred to by the bank that holds them as Nostro accounts. If a bank with a French banking licence wants to hold an account in US dollars, for instance, it opens a US dollar account at a bank with an American banking licence. Although banks may use subsidiaries for this purpose, they only choose do so if the subsidiary has access to the local clearing system. Most banks use more than one correspondent bank per currency. They do this because they do not use correspondent banks for the sole purpose of taking care of payments in foreign currencies. Banks also use correspondent banks to take care of documentary credits, for instance. Most banks also have a foreign currency account with one or more custodians that register their overseas securities ownership. The correspondent bank that executes the payment transactions is normally called the principal correspondent.

2 Money transfers in the local currency

If a bank needs to transfer money to a counterparty, e.g. resulting from a granted money market loan, there are two possibilities. The first is that the counterparty holds an account at this bank. The second is that the counterparty is a client of another bank. If the counterparty holds an account at the bank, the bank can credit the counterparty's account within its own account system and debit the financial markets division's internal account. If the counterparty holds an account at another bank, the bank must transfer money to that bank. In the case of euro transfers, a Spanish bank, for instance, must use its account with the European Central Bank for this purpose. The bank prepares a SWIFT settlement instruction and sends it to a system that takes care of the first step in the processing of the transfer. This system may be either a RTGS system or a clearing system.


2.1 RTGS systems An RTGS system is a computer system that processes money transfers on an individual basis. RTGS stands for real time gross settlement. An instruction that is entered into an RTGS system is immediately forwarded to a central bank's account system. The central bank in question checks whether the paying bank's balance is sufficient. If this is the case, the settlement instruction is irrevocable and final and the central bank executes the settlement instruction immediately. It debits the paying bank's account and credits the beneficiary bank's account. The RTGS system for transfers in euros is called TARGET2. TARGET2 can be accessed by all banks that have a banking licence in a euro country. Banks use SWIFT MT202 messages to access the TARGET2 system. The RTGS system for transfers in US dollars is Fed Wire, for transfers in Pound Sterling CHAPS and for Japanese yens BOJ-Net. Transfers that are sent to an RTGS system are processed individually and are thus more expensive than transfers that are processed via a clearing system. This why this system is almost exclusively used to transfer urgent and/or large payments, high value payments. Money transfers that custodians send to Euroclear resulting from securities transactions are also always processed by TARGET2. Figure 7.1 shows a transfer in euros from the French Banque Paribas to the Italian Banca di Roma using TARGET2.

Figure 7.1 Interbank RTGA transfer from Banque Paribas to Banco di Roma

SWIFT-message MT 202

Banque Paribas -/Banca di Roma+


Payment instruction MT 202 Account statement

Account statement

Banque Paribas

Banca di Roma


2.2 Clearing systems A clearing system is a computer system that processes large numbers of settlement instructions simultaneously. The institution that operates a clearing system, the clearing institution, acts as a central counterparty for the member banks. The clearing system first sorts the settlement instructions and than calculates the most efficient manner of settlement for each member bank. In order to achieve this, most clearing systems collect all settlement instructions daily and balance these at the end of the day until the net amount to be credited or debited per member bank is known. A clearing institution holds an account at the central bank. It sends collection instructions to the central bank for the debiting of net payers' accounts and the crediting of its own account. It also sends settlement instructions chargeable to its own account and payable to the net receivers' accounts. After the central bank has executed these instructions, the clearing institution's account balance is zero again. The most frequently used clearing system for transfers in euros is Euro1. Euro1 is operated by the European Banking Association (EBA). The settlement instructions that banks send through Euro1 are processed after the cut-off time of TARGET2, i.e. the value date is the next day. This is why the settlement instructions that are sent to Euro1 are mostly not urgent. Because the amounts transferred are often not large, they are also referred to as low value payments. Banks generally have settlement instructions in euros processed by a clearing system if the amount is less than EUR 150,000. In figure 7.2, the Spanish Banco Santander sends a payment instruction to the ECB using the Euro1 clearing system. The EBA processes this instruction together with the instructions it has received that same day from all other member banks. The Euro1 clearing system calculates the balance to be paid or received for each member bank based on all these settlement instructions. EBA subsequently sends settlement instructions to the ECB using TARGET2. Next, the ECB executes the settlement instructions. The EBA sends information about each individual transaction to the beneficiary's bank (notification message), the Anglo Irish Bank (AIB), in this case. AIB is not the final beneficiary in this example, however. This is Sean Cork.


Figure 7.2 Transfer from Banco Santander to Sean Cork through the Euro1 system

Banco Santander -/EBA + and -/AIB Group + TARGET2

Account statement

Settlement instruction

Account statement

Banco Santander
Settlement instruction MT103



AIB Group
Account statement

Sean Cork

3 Money transfers in foreign currencies

If a bank needs to transfer money to a foreign currency account held at another bank, it must send a settlement instruction to its correspondent bank in the country where the currency is the local currency. The correspondent bank in turn sends a settlement instruction to the central bank in order to transfer the amount to another local bank. In the case of a large amount, the correspondent bank uses an RTGS system to do this and in the case of a small amount it uses a clearing system. The bank to which the correspondent bank has the amount transferred can be either the final beneficiary or the beneficiary bank. In the latter case, the paying bank must send an additional settlement instruction to the beneficiary bank in order to have the final beneficiary's account credited.


Figure 7.3 Transfer of a US dollar amount from ING Bank to Porsche through correspondent banks


Federal Reserve USA / Fedwire



JP Morgan Chase


MT 910

ING Bank

MT 103

Deutsche Bank

Porsche GMBH

Figure 7.3 shows a transfer of US dollars instructed by the Dutch ING Bank and chargeable to its nostro account at Bank of America (BOA). The beneficiary is Porsche GMBH, that holds a US dollar account at Deutsche Bank. ING sends an MT202 message to BOA. This is a SWIFT message that is used for a transfer to an account held in the name of a bank, Deutsche Bank in this case. BOA in turn sends a settlement instruction to the Federal Reserve Bank via the Federal Reserve Bank RTGS system Fedwire, ordering it to debit its account and credit JP Morgan Chase's account. This message also states that Deutsche Bank is the beneficiary bank. The FED forwards this MT202 to JP Morgan Chase and they in turn send a transaction statement to Deutsche Bank (MT910). The transaction statement informs Deutsche Bank that its JP Morgan Chase nostro account has been credited. Figure 7.4 shows the content of the MT202 message.


Figure 7.4 MT 202 sent by ING to Bank of America

SWIFT format Message header

Relevance of the information

Reference code SWIFT code sender SWIFT code receiver

202998988 INGBNL2A BOFAUS3N ING sends the payment instruction BOA has to execute this instruction

Message text Reference code MT 103 394882 Reference to the corresponding MT 103 message BOA should know to which correspondent bank the money should be transferred BOA should know which bank is the ultimate beneficiarys bank

Name and BIC code of JP Morgan Chase correspondent bank of CHASUS33 beneficiarys bank Name and BIC-code of the beneficiarys bank Value date, currency code and amount Deutsche Bank Frankfurt DEUTDEFF

110325USD3,000,000 On 25 march 2011 an amount of USD 3,000,000 has to be transferred

If Deutsche Bank were to receive no further information, it would not know who the beneficiary is of the amount that has been credited to its JP Morgan Chase account. The money would then remain in an intermediary account at Deutsche Bank. This is why ING sends an MT103 message to Deutsche Bank. This is a settlement instruction with a non-bank entity as beneficiary, Porsche GMBH in this case. ING also states the MT103 reference code in the MT202 message that it sends to BOA and JP Morgan in turn mentions this code in its MT910 message to Deutsche Bank. This enables Deutsche Bank to recognize the incoming amount. Figure 7.5 shows the content of the MT103 message.


Figure 7.5 MT103 Message sent by ING to Deutsche Bank

SWIFT format Message header Reference code SWIFT-code sender SWIFT-code receiver 394882 INGBNL2A DEUTDEFF

Relevance of the information

ING sends the settlement instruction Deutsche Bank has to execute the settlement instruction

Message text Reference code MT 202 Value date, currency code and amount Debit/credit 202998988 Reference to the corresponding MT 202 message

110325USD3,000,000 On 25 march 2011 an amount of USD 3,000,000 has to be transferred Cred Deutsche Bank has to credit the account of one of its clients Deutsche Bank should know which of its own accounts will be credited

Name and BIC-code of JP Morgan Chase correspondent bank of CHASUS33 beneficiarys bank Name and BIC-code BOA New York correspondent bank of BOFAUS3N payers bank

In case its own account will not be credited, Deutsche Bank should be able to inform JP Morgan which bank should have transferred the money

Beneficiarys name and IBAN code

PorscheGMBH, Deutsche Bank should know which DEUTDEFF0123456 of its clients accounts it should 789 credit BEN Porsche GMBH has to pay the transfer fees

Agreement on who should bear the costs


The header of every SWIFT message contains a reference code and the name and SWIFT code of both the sender and receiver. The SWIFT code of a member bank always consists of an eight-character letter/digit combination. The first four characters are the financial institution's bank identification code (BIC). The next two characters are the country code (in accordance with the ISO standard). The last two characters represent the organizations place of business. For instance, the Swift code for Deutsche Bank in Frankfurt is DEUTDEFF, where FF stands for Frankfurt. An MT103 message text contains, among other information, the final beneficiary's account number. For euro payments, this is an IBAN number. An IBAN number consists of a two-letter country code, a two-digit control number that is derived from the other parts, the BIC code of the beneficiary's bank and finally the beneficiary's 10-digit account number. An MT103 message also says who has to pay the costs of the transfer. The codes OUR, BEN and SHA are used for this purpose. OUR means the party giving the instruction pays all costs, BEN means the beneficiary pays all costs and SHA means that the costs are shared.

4 Bank holidays

Interbank payment instructions can only be executed when the computer system of the interbank settlement institution, the central bank, is operational, i.e. not on weekends or bank holidays. Bank holidays are days - other than weekends - on which the central bank is closed in a certain country, meaning that the interbank payment system is not operational. The bank holidays in the euro area are called TARGET days. Figure 7.6 gives an overview of the bank holidays in the euro area, the United States and Great Britain.


Figure 7.6 Bank holidays in Europe, the US and the UK

TARGET days New Years Day Good Friday Easter Monday Labour Day Christmas Day Boxing Day

US Bank holidays New years Day Martin Luther King Day app. 15 January Washington Day app. 20 February Memorial Day app. 29 May Independence Day 4 July Labor Day app. 4 September Columbus Day app. 9 October Veterans Day 11 November Thanksgiving Day app. 23 November Christmas Day

UK Bank holidays New Years Day Good Friday Easter Monday Early May First Monday of May Spring Bank Holiday Last Monday of May Summer Bank Holiday Last Monday of August Christmas Day Boxing Day

In the case of a currency transaction, the central bank payment systems of the two currencies being traded need to be operational on the same day. In the case of currency transactions in Islamic or Jewish countries, the fact that their weekend is on Friday and Saturday needs to be taken into consideration. In special cases, the Islamic currency can be delivered on Sunday and the other currency can be delivered on Monday, for instance. This must be taken into consideration in the swap points, there is one less interest day for the Islamic currency in this case.


Chapter 8

Securities settlement

Securities ownership by investors and securities traders is registered by custodians. The securities ownership of these custodians is in turn registered by central securities depositories. These organizations are both also responsible for the settlement of securities transactions. They carry out the transfer of securities from the seller's to the buyer's securities account and often also the opposite transfer of the associated money amount. A clearing institution acts as the central counterparty for securities transactions that are concluded through an exchange. It closes many contracts with all members of the exchange every day. In order to allow the processing of the transactions to proceed as smoothly as possible, the clearing institution balances all transactions it has concluded with each individual exchange member at the end of each trading day. The settlement of all exchange executed transactions takes place via a securities account that the clearing institution holds at a central securities depository and a cash account that the clearing institution holds at the central bank. More and more, clearing houses also act as central counterparty for over-the-counter transactions.

1 Central securities depositories

A central securities depository (CSD) is an organization that registers the securities ownership of a limited number of parties and carries out settlement instructions between the securities accounts of these parties. Euroclear Netherlands, for instance, is the local central securities depository for most Dutch securities. Euroclear Netherlands is connected to a computer system in which instructions for all Euronext exchanges can be deposited: ESES. ESES stands for Euroclear Settlement of Euronext Zone Securities.


1.1 Account holders and responsibilities of a CSD The entities holding accounts at CSDs are custodians and clearing institutions (dealt with later in this chapter), issuers and other (usually foreign) CSDs. The custodians and other CSDs are a CSD's real clients. They hold a securities account at the CSD for each fund for which they, in turn, carry out the securities registration for the end investors. Clearing institutions hold securities accounts at a CSD for each of the funds they provide the clearing for. With the exception of issuing institutions and the clearing institution, every account holder also has a cash account at the CSD. CSDs register the securities ownership of both exchange traded securities and securities that are traded exclusively over-the-counter, such as commercial paper, certificates of deposit and medium-term notes. Although the securities registration takes place by means of balances on securities accounts, the issuing institutions still need to produce one physical document for each security they issue: a global note. The global note contains information on the characteristics of the security concerned and the maximum number of securities the issuer is allowed to issue.

1.2 The role of a CSD with the settlement of securities transactions CSDs carry out the transfer of the securities resulting from securities transactions. They also often carry out the transfer of the associated money amounts. In the case of an exchange transaction, the CSD receives the settlement instruction from the clearing institution. In the case of an OTC transaction, the trading partners each send a settlement instruction via the CSD computer system, directly or through their custodian.

Initial public offerings and seasoned issues New securities are created when initial public offerings take place. When asked by the bank that services the issue, the CSD stores a global note for these securities and requests an international securities identification number, the, ISIN code. It subsequently creates an account in name of the issuer in order to register the not yet issued securities. After the issue, the CSD creates a securities account for the new securities for each of the banks that have subscribed for the issue and have been allotted the new securities. The CSD subsequently transfers the securities from the issuers account to these new securities accounts. At the same time, the CSD debits the


cash accounts belonging to the subscribing parties and credits the cash account of the bank supervising the issue. The supervising bank, in turn, transfers the issue proceeds to the issuer's account within its own account system. In the case of a follow-up issue, also called seasoned issue, the global note is increased and the new securities are again transferred to the issuer's account. After the issue, these securities are again transferred to the securities accounts of the parties that have subscribed for the issue. Securities that have been reimbursed by an issuer are also registered on the issuers account.

Exchange transactions in already issued securities In the case of transactions in existent securities that are concluded through an exchange, the CSD receives settlement instructions from the clearing institution after every trading day. These instructions are sent directly from the clearing system to the CSD system. The instructions involve the CSD debiting the clearing institution's securities account for a specific number of securities and crediting another account holder's securities account, or vice versa. The settlement of transactions in securities executed on the exchange normally takes place three business days after the transactions have been concluded (t+3). During the three interim days, all parties involved can check the transaction details and settlement instructions in order to ensure that the settlement will be executed properly.

Over-the-counter transactions In the case of over-the-counter transactions between two professional parties, the two contract parties both independently enter a settlement instruction into the CSD computer system on the transaction date. Based on these instructions, the CSD transfers a number of securities directly from the one account holder to the other account holder on the settlement date and usually transfers an amount of money in the opposite direction. The settlement of over-the-counter transactions in securities normally takes place two business days after the transactions have been concluded (t+2).


1.3 Execution conditions Parties that conclude an OTC securities transaction can give two kinds of instructions on how the settlement should take place: delivery versus payment (DVP) and free of payment (FOP). In the case of DVP, a CSD may only transfer the security from a securities account if there are sufficient funds in the counterparty's cash account. If the balance of both parties is sufficient, the transfer of the securities and the money take place simultaneously. Therefore, parties that conclude transactions DVP do not run any settlement risk. Transactions that are concluded through an exchange are always processed DVP. In the case of FOP, the transfers of securities and the money take place independently. The CSD takes care of the transfer of the securities and the central bank independently takes care of the transfer of the money. Because the CSD and the central bank do not contact each other to check whether the opposite transfer actually takes place, there is a chance that the securities are transferred while the money is not, or vice versa. There is, therefore, settlement risk. This explains why these terms of delivery are not often used. Regardless of the execution conditions, the selling account holders must ensure sufficient balances in their securities accounts for all securities transactions. If this is not the case, they must temporarily borrow securities using a securities lending transaction. In the case of over-the-counter transactions that take place DVP, the account holders that have bought securities must also ensure sufficient funds in their CSD cash accounts. Because the CSD holds an account at the central bank, an account holder can transfer money to its CSD cash account through the central bank. Some account holders have a credit line at the CSD. This means that DVP settlement can also take place if the buying account holder has insufficient funds in its cash account, provided it remains within its credit limit. In the case of exchange transactions, an account holder that has bought securities must ensure it has sufficient funds at the central bank. This is important because the clearing institution, which is authorized to debit this account for the money that needs to be paid on account of the exchange transactions, otherwise doesnt transfer the securities.


1.4 Feedback on the status of settlement instructions The CSD shares information on the status of transfers related to OTC transactions with both contract parties. It uses SWIFT messages for this purpose. If both contract parties have deposited a settlement instruction at the CSD and the data corresponds, the CSD indicates this using the code matched (MATC). If one of the parties has not yet sent a settlement instruction or if there are differences between the settlement instructions, the CSD indicates this using the code unmatched (UNM). The CSD sends the party that has not yet sent a settlement instruction a message with the status advised (ADV). Other examples of codes that a CSD uses to indicate the status of a settlement instruction are given in figure 8.1.
Figure 8.1 Examples of SWIFT codes that indicate the status of a transaction


Meaning The balance in the own securities account is insufficient The balance in the counterparty's securities account is insufficient The balance in the own cash account is insufficient The settlement instruction has been executed

1.5 The role of CSDs with the registration of foreign securities Some CSDs carry out the securities registration for both domestic and foreign securities. These CSDs are called international central securities depositories (ICSD). Two examples of European ICSDs are Euroclear Bank and Clearstream. In order to be able to carry out the registration of foreign securities, an ICSD does not need to store the global note associated with these foreign securities themselves. Instead, the CSD can open an account for these securities with the CSD that does store the global note. This is customary in the case of foreign securities.


Figure 8.2 Accounts of an ICSD

CSD United States Global Notes VS Securities Citibank -Cocal Cola -Merck -Ford -Mc Donalds

Euroclear Bank SNS Securities -Coca Cola -McDonalds -Ford -McDonalds RBC Dexia -Coca Cola -Merck -Ford -McDonalds

Euroclear Netherlands -Heineken -Royal Dutch -DSL CSD VS -Coca Cola -Merck -Ford -McDonalds

EuroclearBank -Coca Cola -Merck -Ford -MCDonalds

BNY Mellon -Coca Cola -Merck -Ford -MCDonalds

Figure 8.2 shows parts of the securities accounts belonging to the Depository Fund Company (the CSD in the United States) and to Euroclear Bank. The left side of the Euroclear Banks balance shows the accounts is has at two other CSDs. Because Euroclear does not store the global notes for American shares, it has opened a securities account at the US CSD for funds such as Coca Cola, Merck, etc. The Euroclear Bank also holds an account at Euroclear Netherlands for Dutch shares. Euroclear Bank can now offer its own clients, for instance SNS Securities or RBC Dexia, securities accounts in US and Dutch securities.

2 Clearing institutions

Securities clearing institutions are organizations that provide various services to their members with respect to the processing of securities and derivatives transactions. Clearing consists of three activities. The first activity is that the clearing institution functions as a central counterparty. The second activity is that the clearing institution cancels out opposite transactions with one and the same counterparty. This is called netting. The third activity is that the clearing institution sends settlement instructions to the central securities depository and the central bank. In that respect, they are authorized to have clearing members' accounts debited.


LCH. Clearnet and EMCF are examples of European clearing institutions. LCH.CLearnet carries out the clearing for the London Stock Exchange (LSE), clears listed derivatives transactions for EDX London and clears swaps and repos that are concluded over-the-counter through Swapclear and Repoclear. European Multilateral Clearing Facility (EMCF) delivers clearing services for, amongst others, Chi-X Europe and NASDAQ.

2.1 Clearing members The parties that are affiliated with a clearing institution are called clearing members. Clearing members are custodians. A custodian that wants to become a clearing member must have a minimum amount of equity, the required arrangements with a bank, employees that know enough about the instruments that need to be cleared and access to computer systems that are fit for the purpose. Individual clearing members (ICM) may only process transactions of their own organization. General clearing members (GCM) may also process transactions for other exchange members such as small trading houses, securities firms, and banks that are not clearing members themselves.

2.2 The clearing process for cash transactions If an exchange's trading system has executed two orders against each other, a clearing institution functions as central counterparty (CCP). Two contracts are simultaneously concluded in this case. The selling exchange member sells the securities or derivatives to the clearing institution and the buying exchange member buys the securities or derivatives from the clearing institution. The clearing institution subsequently concludes new contracts that set out the delivery obligations resulting from both transactions. Clearing members are the counterparty in these contracts. They take over the settlement obligations from the exchange members. The clearing institution concludes many contracts related to the processing of exchange transactions with each of the clearing members every day. In most cases, opposite delivery obligations apply. After every trading day, the clearing


institution computer system balances the number of securities to be delivered and received and the associated purchase and sale amounts for every clearing member and every fund. Example On March 6th, Banque Paribas has completed 5,000 exchange transactions. Among the transactions were the following transactions in the French Danone share for three of its private clients:

purchase/sale sale sale purchase

Number 100 1000 500

Price 43.00 43.20 43.10

Total value EUR 4,300 EUR 43,200 EUR 21,550

pay/receive receive receive pay

balance sale


EUR 25,950

balance receive

Based on these transactions in the Danone share, Banque Paribas must deliver 600 Danone shares to the clearing institution, the clearing institution must, in turn, transfer an amount of 25,950 euros to Banque Paribas. The clearing institution carries out a calculation like the one in the above example for every fund. This results in an overview of how many of each fund traded in, each clearing member must deliver or receive from the clearing institution. The clearing institution subsequently balances all money amounts per clearing member resulting from the purchase or sale of each individual fund. Example The clearing institution has calculated the following net purchase and sale data for Banque Paribas. Based on this information, the clearing institution calculates how much Banque Paribas must pay or receive on balance.


Netted transactions per fund for Banque Paribas

Danone AXA

sale sale

600 10,000 20,000 5,000

EUR 25,950 EUR 90,000 EUR 300,000 EUR 80,000 EUR 104,050

receive receive pay receive pay

Credit Agricole purchase France Telecom sale

Banque Paribas must pay the clearing institution an amount of 104,050 euros on balance. After the completion of a clearing round, the clearing institution sends information on the net payable and receivable amounts and the securities to be received or delivered on balance, as well as a transaction overview for all individual transactions on the trading day concerned to the clearing members. The clearing members compare this information to the transaction information they have received from their brokers and traders and any other exchange member for whom they provide the clearing of exchange transactions. The clearing institution also sends settlement instructions to the CSD and the central bank. The settlement instruction to the CSD is an order to execute all securities transfers generated by the clearing process. The settlement instruction to the central bank is an order to execute all money transfers generated by the clearing process.

2.3 Risk management Clearing institutions run the risk of a clearing member not fulfilling its obligations. However, the clearing institution must deliver to one clearing member regardless of whether the other clearing member delivers. The clearing institution must also purchase from the one clearing member regardless of whether the other clearing member purchases from it. If a clearing member does not meet a securities delivery obligation, the most extreme consequence is that the clearing institution must buy shares from a third party in order to meet its own delivery obligation. A clearing house can use a buy-in procedure for this purpose.


Buy-in procedure If a clearing member does not have sufficient securities in its account on the settlement date, the clearing institution immediately fines the clearing member and temporarily suspends its own delivery obligation in that fund. If the clearing member has still not met its obligations after seven days, the clearing institution can start a buy-in procedure. The European clearing institution LCH.Clearnet, for instance, does this on the eighth business day. A buy-in procedure entails the clearing institution organizing a purchase auction, which is announced publicly and to which anyone can subscribe. The clearing institution then selects the best sale offer, however bad it may be. Example A clearing member of LCH.Clearnet has concluded an exchange transaction in which it has sold 100,000 Lloyds Group shares on February 15, at a price of 70 British Pounds. On February 15, it becomes apparent that the clearing member cannot fulfil its delivery obligation. On February 25, the securities have still yet to be transferred to the clearing member's CSD securities account and so LCH.Clearnet starts a buyin procedure. The lowest sale offer in the auction is 75 British pounds. LCH.Clearnet accepts this offer and buys 100,000 Lloyds Group shares for an amount of 7,500,000 British pounds. As LCH.Clearnet will receive 7,000,000 British pounds from the original opposite transaction, it loses an amount of 500,000 British pounds. If a buying clearing member fails to meet its obligations, the clearing institution can start a sell-out procedure. This means that the clearing institution sells the securities it has bought after at least seven days. The sell-out procedure is identical to the buy-in procedure. The clearing institution must sell the securities to a third party in order to be able to meet its own purchase obligation. If the price has fallen in the mean time, the clearing institution suffers a loss resulting from this procedure. The clearing institution recovers any losses resulting from buy-in or sell-out procedures as much as possible from the clearing member in default. Every clearing member must deposit an amount of money when concluding a transaction in shares or bonds to offset any possible losses resulting from the counterparty risk. This is called an initial margin. The initial margin is based on the volatility of the underlying asset and the market liquidity in the underlying asset.


As an extra security precaution, clearing institutions can force all clearing members to deposit money in a guarantee depot, the clearing fund. If the initial margin of the defaulting member is not sufficient to cover the loss, the clearing institution will withdraw money from this depot. The other clearing members then each are held responsible for part of the loss.

2.4 The tasks of clearing institutions with derivatives Clearing institutions that work for derivatives markets are responsible for the processing of option premiums, the settlement of futures at maturity and the (interim) execution of options. The clearing institution also functions as central counterparty for derivatives transactions and requires collateral on a daily basis to protect itself against counterparty risk.

Activities related to options and futures contracts Clearing institutions that process options and futures calculate the net sums to be paid and received per clearing member after every trading day. The cash flows that a clearing institution includes in this process have to do with option premiums, money transfers resulting from collateral obligations (margins) and the settlement of options and futures. The net amounts are transferred the next day. If options are executed, the clearing institution plays an important role in the process of appointing the writer of an option who has to fulfil his obligation. This process is called assignment. If an options holder wants to make use of his execution right, he must order his broker to do so. The broker passes this order on to its custodian, who in turn uses an exercise note to pass it on to the clearing institution. As central counterparty, the clearing institution is the entity responsible for fulfilling the obligation first. Because the clearing institution is only an intermediary from an economic point of view, it appoints a clearing member that must fulfil the option obligation. The appointed clearing member in turn appoints one or more brokers by way of another random selection procedure. And the broker in turn appoints one or more clients. Both the broker of the executing option buyer and the broker of the appointed option seller subsequently issue an order to the stock market for the underlying transaction, so that it can be executed.


Derivatives transactions margins Like with securities transactions, the clearing institution runs a counterparty risk in the case of futures and purchased options. This is why it demands an amount of money as collateral in the case of these transactions. This money amount is called a margin. There are two kinds of margin in the case of futures, the initial margin and the variation margin. Clearing members must impose the margin obligations on their own account holders, too. The initial margin is an amount of money that the clearing institution demands when concluding a futures (or option) contract. At the maturity date, the clearing institution returns the initial margin to the clearing member's cash account at the central bank. This also applies if the clearing member closes its position prior to maturity. As with cash transactions, the initial margin is based on the volatility of the underlying asset and the market liquidity in the underlying asset. Variation margin or margin call is the daily offsetting of the profits and losses of a futures contract. The closing price of a futures contract is determined at the end of each exchange day. If this closing price is higher than the closing price of the previous day, the clearing member that bought a future has made a profit. The clearing institution deposits an amount equal to this day profit into the clearing member's account at the central bank. If the closing price is lower than the previous day, the clearing institution instructs the central bank to debit the clearing institution's account at the central bank. Only the final day result is offset at the future contract's maturity. Together with the daily results that have been offset throughout the maturity period, this forms the total result of the futures transaction. Example A trader on the Chicago Board of Trade buys 10 Dow Jones Futures contracts on Monday at a price of 11.502. The underlying value of a Dow Jones Futures contract is 10 times the Dow Jones Index Average. On the trade date, the initial margin for these contracts is set at 13,000 US dollars per contract. The closing prices of the Dow Jones Futures contract throughout the week are as follows: Mon: 11.512, Tue:11.546, Wed: 11.532, Thu: 11.580, Fri: 11.623. The amounts debited and credited on behalf of the initial margin and variation margin are as follows:


day Monday Tuesday Wednesday Thursday Friday

initial margin -130,000

variation margin (11.512 - 11.502) * 10 = + 100 (11.546 - 11.512) * 10 = + 340 (11.532 - 11.546) * 10 = - 140 (11.580 - 11. 532) * 10 = + 480


(11.623 - 11.580) * 10 = + 430

If the trader sells the Dow Jones Futures on Friday at the closing price of 11.623, he makes a profit that consists of the net total of all payments and receipts on account of the variation margin: 100 + 340 - 140 + 480 + 430 = 1,210 US dollars. This amount has been offset during the week via the central bank account of the bank at which the futures trader works. After the close out transaction, the clearing institution transfers the initial margin amount back to this account.

Swapclear and Repoclear The European clearing institution, LCH.Clearnet, also clears money transfers resulting from interest rate swaps and money market transactions that have been concluded over-the-counter. It has developed two systems for this purpose, Swapclear and Repoclear. Clearing members that make use of these systems must re-enter their over-the-counter transaction into these systems. Every original bilateral over-the-counter contract is then replaced by two separate contracts, with LCH.Clearnet being the counterparty. The cash flows resulting from interest rate derivatives are calculated in Swapclear and offset on a net basis. The same takes place in Repoclear for all money market transactions like repos and deposits without collateral. LCH.Clearnet finally sends settlement instructions chargeable to its own account and collection orders chargeable to the members' accounts at the central bank in order to have the net amounts transferred.


3 Custodians

A custodian is a company that registers securities and settles securities transactions on behalf of investment managers, investment funds, institutional investors, private investors and the financial markets divisions of banks. Custodians are often a separate division of a bank. In addition to a securities account, clients also hold cash accounts with custodians. Custodians in turn hold cash and securities accounts at Central Securities Depositories. Custodians can function as a clearing member, in which case they are sometimes called clearing custodians. The clients' securities accounts are not formally held at the custodians themselves but at a separate company. Although it is true that this company is usually connected to the bank to which the custodian belongs, it is always a separate legal entity. This arrangement has been chosen in order to ensure that clients' securities ownership is separate from the bank's personal claims and properties. Custodians are authorized to make changes to the securities accounts held at the separate company.

3.1 Local and global custodians A Dutch investor can hold a securities account at a Dutch custodian for all Dutch securities. This is because every Dutch custodian holds a securities account for all of these securities at Euroclear Netherlands. If an investor wants to have an American security registered, they can usually do this at a Dutch custodian, too. This is because Dutch custodians themselves hold securities accounts at several foreign CSDs or at an ISCD like Euroclear Bank. A custodian that offers securities accounts for securities that are registered at foreign CSDs is called a global custodian. A custodian that only registers local securities is called a local custodian. The advantage of a global custodian is that an investor that invests in multiple countries does not need to use a separate custodian for each security.


Figure 8.3 Accounts of a global custodian

CSD United States (DTC) Global Notes VS Securities Euroclear -Royal Dutch -Aegon -TomTom -Staatsobligaties Citibank -Coca Cola -Merck -Ford -Mc Donalds

Euroclear Netherlands Rabo Securities -Royal Dutch -Aegon -TomTom -Staatsobligaties -CocalCola -McDonalds BNY Mellon -Royal Dutch -Aegon -TomTom -DSL 05/37

BNY Mellon Euroclear NL -Royal Dutch -Aegon -TomTom -DSL 05/37 CSD VS -Coca Cola -Merck -Ford -McDonalds Robeco -Royal Dutch -Aegon -TomTom -Coca Cola -Merck -McDonalds

Global Notes NL Securities CSD VS -Coca Cola -Merck -Ford -McDonalds

BNY Mellon -Coca Cola -Merck -Ford -MCDonalds

Figure 8.3 shows how BNY Mellon holds accounts for Dutch securities at Euroclear Netherlands and accounts for American securities at DTC, the American CSD. As such, BNY Mellon is a global custodian that is able to offer securities accounts for domestic and foreign securities.

3.2 Role of custodians in the settlement of securities transactions Custodians are responsible for the settlement of securities transactions. A client that sells securities (DVP delivery condition) orders its custodian to debit its securities account on the transaction date and to credit the counterparty's securities account. The custodian first checks whether these securities are actually present in the client's account. If the counterparty has a securities account at another custodian, the custodian then immediately sends the CSD an instruction to have the securities transferred from its own account to the seller's custodian's securities account. If all goes well, the counterparty's custodian simultaneously sends an instruction to the CSD to have the money transferred. If the data in the two instructions match, the CSD sends both custodians a message with 'MATC' status. Both custodians forward this confirmation message to their clients. The seller and buyer now know that the processing of their transaction has gone well so far. The selling party's custodian must ensure that securities are in its CSD securities account on the settlement date. If all goes well, the counterparty's custodian, in turn, will have transferred money to its CSD cash account. After the CSD has checked both balances, it simultaneously effects the securities and money transfers. Next, the CSD sends an message to both custodians stating the


settlement is OK. The selling party's custodian subsequently debits the selling party's securities account and credits its cash account. Finally, the custodian sends a transfer statement to the seller. The buying party must ensure that the cash account it holds at its custodian has a positive balance on the settlement date. The custodian must subsequently transfer this money to its cash account at the CSD. After the custodian has received the CSD settlement 'OK' message, it debits the monetary amount from the client's account and credits the securities to its securities account. Finally, the custodian sends a transfer statement to its client. If the delivery condition had been FOP, the buying party's custodian would have needed to transfer the money directly through its central banks account to the seller's cash account at its custodian. The CSD would then transfer the securities to the buying party regardless of any payment. If both parties were to hold accounts at the same custodian, it would suffice for this custodian to carry out internal transfers of the money and securities between the seller and buyer's accounts within its own computer system.

Example An asset manager sells 10,000 Heineken shares to an ING Bank trader (broker) at a price of 30 euros. The asset manager's custodian is BNY Mellon and the ING Bank's custodian is BNP Paribas. Shortly after the transaction has been concluded, the asset manager instructs BNY Mellon to transfer the shares to the ING Bank account at BNP Paribas (DVP). BNY Mellon subsequently sends Euroclear Netherlands an instruction requesting it to debit its account for the Heineken shares on the settlement date and credit ING Banks Heineken account at BNP Paribas (DVP). The ING Bank also sends instructions to its custodian, BNP Paribas. BNP Paribas subsequently sends an instruction to Euroclear Netherlands (DVP) to transfer 300,000 euros to BNY Mellon on the settlement date. Euroclear Netherlands immediately sends a message to both custodians containing the instruction status, which is MATC in this case. On the settlement date, ING transfers an amount of 300,000 euros to the cash account at BNP Paribas, which in turn has the ECB transfer it to its Euroclear Netherlands (1) cash account. If the securities account of BNY mellon has a sufficient balance, Euroclear Netherlands simultaneously


(DVP!) transfers the securities from BNY Mellon's account to BNP Paribas' account and transfers the money from BNP Paribas to BNY Mellon (2a and 2b). Once the settlement is given the OK status, BNY Mellon (3a) and BNP Paribas (3b) adjust their clients' cash accounts and Heineken securities accounts balances in their own administrations.

Euroclear Netherlands Fortis Securities -Royal Dutch -Aegon -TomTom DSL


BNY Mellon


Global Notes NL Securities

Euroclear NL -Royal Dutch -Aegon -TomTom -DSL -Heieneken

Asset Manager -Royal Dutch -Aegon -Heineken -/- 10,000 (3a) -euro acc. + 300,000 (3a)

Asset Manager

BNY Mellon instruction -Royal Dutch -Aegon -TomTom -Heineken -/- 10,000 (2a) -euro acc. + 300,000 (2b) BNP Paribas -Royal Dutch -Aegon -TomTom -Heineken +10,000 (2a) -euro acc. + 300,000 (1) -/- 300,000 (2b) BNP Paribas Euroclear NL -Royal Dutch -Aegon -TomTom -DSL -Heineken instruction


ING Bank -Royal Dutch -Aegon -TomTom -Heineken + 10,000 (3b) -euro account + 300,000 (1) -/- 300,000 (3b)

ING Bank

3.3 The role of custodians with tri-parti repos With tri-party repurchase agreements, a custodian takes over the collateral management activities of both contract parties. The custodian performs the administration and calculates and executes all necessary margin payments. The custodian is also responsible for the settlement of coupon payments. In case of a coupon payment, the custodian will debit the money accounts of parties that on balance have received collateral and transfers the coupon amounts to the parties that on balance have pledged collateral.


4 Overview of the process of an exchange traded transaction

Figure 8.4 gives a global overview of the information flows related to the closing and processing of an exchange transaction.
Figure 8.4 Closing and processing of exchange transactions

Closing of Securities transactions

Processing of Securities transactions


Clearing House

Bank / Broker

Clearing Member

Central Securities Depository


7 1


Central Bank

1. A client gives an order to the broker. 2. The broker, who is a member of the exchange, puts the order through to the exchange. 3. The exchange sends information about each separate trade to the clearing institution. 4. The clearing institution sends information about each separate trade and about the total net settlement flows to the clearing members. 5. The clearing institution sends settlement instructions to the CSD (a) and to the central bank (b). 6. After the settlement has taken place, the CSD sends account statements to the clearing member. 7. The custodian sends an account statement to its client.


Chapter 9

Nostro reconciliation

The back office department of a bank's financial markets division usually has a special department that is responsible for the most important checks with regard to processing transactions in financial instruments. This department is usually called operations control. The most important task of operations control is to perform various reconciliations. In addition to this, operations control investigates the causes of incorrectly performed settlements and imposes interest claims on the internal or external parties responsible for the mistakes.

1 Reconciliation

Reconciliation is checking data for accuracy and completeness by comparing two different sources. In the context of transactions in financial instruments, reconciliation usually means checking whether the settlement of money has been performed adequately, in other words, whether the right amounts have been transferred to or from other parties. This is referred to as Nostro reconciliation. As the reconciliation of settlements of money is one of the most important controls for transactions in financial instruments, it is the responsibility of a separate department. With many banks, this responsibility is given to the operations control department that is part of the back office. Some banks even place the Nostro reconciliation activities outside the back office, within the finance department, for instance. The Nostro reconciliation involves comparing the movements on the accounts in a bank's own shadow administration with the transfer statements of the organization with which the settlement has taken place, a cor-respondent bank or custodian. Once the bank has received an account overview from the correspondent bank or the custodian in charge of the external account, the data are compared with those in the bank's own shadow administration. The reconciliation of money settlements is performed by means of a separate reconciliation system,


such as IntelliMatch. The reconciliation system reports on settlements 'by exception'. This means that a separate overview is drawn up of settlements that somehow differ from the settlements in the shadow administration. In addition to reconciling the money settlement, the operations control department may also perform a number of other reconciliation activities, such as 1. reconciliation between the front office and back office systems; 2. reconciliation between the securities back office system and the custodians' systems (custodian reconciliation); 3. internal deal reconciliation: check whether all internal transactions cancel each other out so that they are eliminated in the official reports.

2 Investigations

Reconciliation systems generate a list of transfer differences on the basis of a comparison of the shadow administration with the transfers reported by the external parties. The list contains four categories of differences. 1. The shadow Nostro account in the shadow administration has been credited and the Nostro account has not been credited. 2. The shadow Nostro account in the shadow administration has been debited and the Nostro account has not been debited. 3. The Nostro account has been debited, but this does not appear in the shadow administration. 4. A Nostro account has been credited, but this does not appear in the shadow administration. If the reconciliation brings to light a difference, a separate department is called in to identify the cause. This department is called investigations. The investigations department will try to find out which party is responsible for the mistake. Each of the above categories requires a different approach. The investigations department always first investigates the mistakes that could lead to interest claims from other banks. 1. The investigations department will contact the counterparty in order to find out whether it has actually transferred the amount. If the counterparty admits to having made the mistake and is not able to rectify this on the same value date, an interest claim will be drawn up. To this end, the investigations department will send the necessary information to the compensation department. If the counterparty indicates that it was not required to make a trans-


fer, the shadow transfer in the internal system is probably incorrect. Investigations must now find out which shadow transfer should have been made instead. 2. The investigations department will investigate whether a settlement instruction indeed has been sent to the correspondent bank. If this is the case, the investigations department will contact the correspondent bank in order to find out why the transfer has not yet been carried out. If the mistake lies with the correspondent bank, any possible interest claim filed by the counterparty will, in turn, be submitted to the correspondent bank. If the correspondent bank has not been sent a settlement instruction, there are two possible causes: a. The settlement instruction was never sent. After checking with the back office, Investigations will then immediately have a settlement instruction drawn up manually. b. A settlement instruction has been sent to the wrong account. In this case, the investigations department will ensure that a correct settlement instruction is sent after all. Following this, it will contact the bank to which the settlement instruction has mistakenly been sent, requesting for the transfer to be reversed as quickly as possible. In both cases, the investigations department must find out who is responsible, the front or back office. 3. In this scenario, the internal transfer may yet have to be made and the investigations department will have to find out whether it is on the way. Another possibility is that the reconciliation system has identified another open item in the shadow administration, in which another Nostro account has been debited in the same currency This means a settlement instruction has been sent to the wrong bank. This scenario is basically the same as that described under 2b. 4. Investigations will contact the bank that has sent the settlement instruction. This bank must see to it that the settlement instruction is cancelled. For the sake of reputation, erroneously received sums are returned as quickly as possible. If the counterparty maintains that it was definitely required to make a transfer, the shadow transfer was incorrect. Investigations must now find out which shadow transfer should have been made.


3 Compensation

If an error in the settlement is discovered too late, it cannot be rectified on the same value date. The result is that there is too little money on the beneficiary's account for one or more days and interest costs will be incurred. The beneficiary may submit an interest claim to recover these interest costs. The amount of the claim is calculated on the basis of a certain interest rate percentage of the transfer sum and the number of days by which the transfer is delayed. The interest rate used is money market benchmark e.g. EONIA, SONIA or fed funds. Claims on other banks are always submitted, claims on clients are sometimes not, depending on the circumstances. The department responsible for drawing up interest rate claims is sometimes referred to as Compensation. Example Dexia Bank sells 10 million Swiss francs to Fortis Bank with value date March 15. The Fortis Bank FX trader indicates that he wishes the Swiss francs to be delivered to his UBS account. The standard settlement instructions for Fortis Bank, however, state that Credit Suisse is the correspondent bank. The Dexia trader fails to pass on the irregular settlement instructions to the back office, so that on March 15 the Swiss francs amount is transferred to Credit Suisse in accordance with the standard instructions. On March 16, Fortis Bank Investigations contacts Dexia Bank Investigations about this mistake. Dexia Bank Investigations immediately has a settlement instruction sent to its Swiss francs correspondent bank in favour of UBS with Fortis Bank as final beneficiary. Next, Dexia Bank Investigations contacts Credit Suisse to request for the Swiss francs sum to be debited from the Fortis Bank account in favour of its own account at Credit Suisse. As a result of this error, Fortis Bank may claim that for the duration of one day its account with UBS showed an unduly overdraft. As a result, Fortis will probably submit a claim. Dexia Investigations will hold the FX trader responsible for the wrong settlement and will submit Fortis Bank's possible interest rate claim to the front office which will reduce the traders profit.


Chapter 10

Treasury systems

When capturing and completing transactions in financial instruments, banks make use of treasury systems that must offer all of the functions needed to close and process transactions. These systems must be capable of capturing trade details, creating confirmations and sending settlement instructions. Also, they must be able to exchange information with other systems at the bank, such as the accounting system and the ledger, and with external systems such as SWIFTNet and systems of data vendors such as Thomson Reuters and Bloomberg.

1 Front office and back office systems

A front office system is a system whereby transaction information is entered after a trader or salesman has entered into a transaction. Before a trader can complete a transaction, he needs information about current market prices and he must be able to check that no limits will be breached as a result of the transaction. The trader must enter information to this end in the front office system before concluding the deal. Once a transaction has been completed, the trader wants to keep track of his results and the extent of market risk of his position. The most important functions of front office systems are position keeping, valuation, calculating results and measuring market risk. Front office systems have interfaces with information systems of data vendors like Eikon, the combined information/trading system of Thomson Reuters, with a counterparty limit system, with electronic trading systems and with the back office system. If a financial institution makes use of multiple front office systems, these systems all interface with a central market risk system. In a front office system, the market risk of one or a limited number of activities is measured. In the central market risk system, the market risks are then combined. Correlations between the risk of the relevant trader and the market risk of the other trading positions of the bank are then taken into account.


A back office system is a computer system that generates information related to transaction processing. Back office systems serve the following functions: process confirmations; create payment instructions; create notification messages with regards to the fixing of interests rates, interest payments and dividend payment; create information needed for journal entries. When transactions are carried out through an exchange system or a system such as Marketwire, they are automatically confirmed by these external systems. The back office system then does not need to create an additional confirmation. Most back office systems have the option to identify the status of each transaction and generate queues of transactions in a particular phase of the settlement process, such as all transactions for which confirmation has been sent, but which have yet to be confirmed by the counterparty. All back office systems have an interface with the front office system, SWIFTNet or with another payment system and the accounting system (ledger). Most major banks use more than one front and back office system. For capturing simple instruments they use other systems than those used for complex derivatives. Some systems, however, are able to process all types of instruments.

2 Information exchange between systems

The exchange of information between computer systems within an organization takes place through interfaces. Banks also exchange information between one another, e.g. when sending confirmations or settlement instructions. A party that has concluded a transaction in a financial instrument that involves a payment obligation to the other party, for example, must instruct the institution where his account is held to debit the account in favour of the counterparty. If a party is connected to the computer system of the institution where his account is held, such a settlement instruction can be entered directly into that system. Nonbanks, for instance, usually have a direct link to the payment system of their bank or the computer system of their custodian. Banks are not usually linked directly to the computer systems of other financial institutions. Settlement instructions that financial institutions send to one another are therefore not directly exchanged via interfaces between their computer systems, but are often sent over a computer network that has been specifically developed for this purpose, SWIFTNet.


Back office systems are also sometimes linked to external reconciliation systems, such as TriResolve from TriOptima or clearing systems such as Swapclear and Repoclear from LCH.Clearnet.

3 Static data and standing files

Banks enter fixed information into their systems where possible in order to ensure that this information does not need to be re-entered with each new transaction. Such fixed data is known as static data. Static client data includes names, addresses, account numbers and standard settlement instructions (SSI). For each new financial instrument, static data is also entered such as the interest calculation method, currency type and ISIN code (international securities identification code). The use of static data reduces the risk of input errors. Static data is recorded by a separate unit within the back office department. Besides static data, a number of other matters must also be recorded such as which entries must take place in accounting for a particular transaction or a list of bank holidays. All fixed data is stored in standing data files, which are also known a standard data tables. Both, front office and back office systems are capable of holding static data. However, sometimes a separate data system is used for this purpose.
Figure 10.1 Examples of static data

File Client file

Information stored Name and adress SWIFT-code / BIC-code/ Account number (IBAN) Authorized personnel Location of head office

Deals file Currency file Holiday file Business code file Ratings file Trade or deal type file Accounting rules file

Data of closed deals ISO codes of all relevant currencies Bank holidays of all relevant currencies Internal and external branch code Rating categories of the different rating agencies and own rating categories List of codes to classify a transaction List of required journal entries


4 Capturing deals in the ledger

In order to capture the data of a transaction from a back office system in an accounting system (ledger), the transaction data must be converted into journal entries. Banks have established accounting entry rules for this purpose. These rules state which journal entries must be made during the term of a contract. Accounting entry rules are captured in a separate system or in a separate module in the back office system. This separate system or part of the back office system is known as a rules engine or accounting entry generator (AEG). The AEG is powered by (a different part of) the back office system and creates journal entries for all events based on transaction data. Figure 10.2 shows an example of an overview of journal entries that must be made related to a fixed-income instrument in a foreign currency.
Figure 10.2 Journal entries of a fixed-income security denominated in a foreign currency

Event Trade date buy Each day Each day Coupon date

Entry Deal capture buy Interest accrual Revaluation of FX-rate Interest settlement

Trade date sale / Redemption date Deal capture sale

Journal entries are sent to the ledger through an interface. Broker fees and operating costs are also included in this ledger. The financial markets ledger is, in turn, linked with the bank's general ledger. Information is also sent from the financial markets ledger to a system in which reports are processed for the central bank. Figure 10.3 gives an simplified overview of the total flow of information related to a transaction in a financial instrument.


Figure 10.3 Information flow through different treasury systems

Cost System

FO system

BO system


Financial Markets ledger

General ledger

Management Information systems

Central Bank reporting system

Central Bank

5 Computer systems requirements

Financial institutions today depend entirely on computer systems for their business operations. A financial enterprise must be certain that these systems meet a number of conditions. Firstly, computer systems must be adequately secured. Secondly, they must be able to reliably provide all the relevant data. Third, they must process all data correctly. Finally, the data provided by the computer systems must always be available (in time).

Access control and confidentiality Data should be confidential and only be accessible to authorized personnel, who are allowed to perform certain activities or to access certain information in a computer system. In order to ensure this, employees have to use an assigned log-in code and a password to access the parts of the system they need to perform their specific tasks. This procedure is called authorization. Organizations must make sure their employees do not know the passwords of their colleagues, so that they cannot use authorizations other than their own. If they are able to do so, the necessary separation of functions may be compromised. Also,


authorization mix-ups can make it more difficult to establish who is responsible for possible unlawful actions. It is important that the authorizations of employees are frequently monitored by a periodic scan of user rights. Example In 2008, the access control is said to be compromised at Socit Generale when Jrome Kerviel seemed to be able to use an authorization assigned to him at one of his previous functions. Therefore, he was able to conclude major futures transactions at the banks risk and expense. A periodic scan of user rights could have prevented this. Another measure taken by banks to ensure data confidentiality is to communicate with other financial institutions almost exclusively through the SWIFT network. This reduces the chance of messages being altered by unauthorized personnel or people outside the bank.

Integrity Integrity means the certainty that the computer systems process all relevant data correctly. A valuation system is an example of a system that is vulnerable to integrity. The range of structured products available, for instance, is incredible and they are sometimes very hard to value. Financial institutions even make provisions against erroneous calculations of the value of some instruments. The integrity of data of large financial institutions is also jeopardized by the fact that they usually consist of multiple business units with offices all over the world and the input provided by the various business units should be centralized at one point. Banks, for instance, often have more than one dealing room, requiring the position information of the traders to be brought together from the local systems in a central system via interfaces. If these interfaces are badly programmed, the information from the local systems fed into the central system may be incomplete or inaccurate. This means a bank may not have a clear view of its total position and its risk may be wrongly assessed.

Accuracy Computer systems often gather information from other systems and transpose it. A bank must be certain that the data provided by each supply system are accurate. Static data are a well-known example of data collected from other computer systems. If the static data have been entered incorrectly, all systems using those data will be affected. Errors in static client data, for instance, may result in an


incorrect confirmation being sent or an incorrect settlement of a transaction. These, in turn, may lead to damage claims and loss of credibility. Clients dislike administrative errors and will often deal with major or consecutive errors by temporarily terminating the relationship and moving to another bank.

Availability Systems must be continuously operational and therefore secured against viruses, power cuts and suchlike. Many financial institutions have backup systems to ensure that business will continue as usual if the actual systems malfunction. Many also have back up dealing rooms. In many countries, the regulators demand banks to have a business continuity plan (BCP) in place. A BCP is a logistical plan that outlines the measures an organization must take to recover in case of severe disruptions. Among other things, a BCP states which employees play a key role in restarting business activities and what these employees must do in the event of a disaster. A BCP also includes a disaster recovery plan (DRP), which outlines the IT measures necessary for recovery. This plan describes the most important applications and how they can be restarted as quickly as possible. A BCP also includes measures aimed at protecting static data and stored transaction data from destruction and/or misuse. Computer systems must also have sufficient spare capacity to be able to cope with increasing volumes and new product variations. When a new system is being bought or developed, the users should therefore have a major say. After all, they are the ones who can best assess future requirements. Conversely, IT staff should have a major say in the development of new product variations, as they will have to ensure that the systems can cope with the new product.



Chapter 11

Money market instruments and interest calculations

The money market is the market in which interest related financial transactions with a short term take place. Traders normally only consider transactions with a term shorter than one year as money market transactions. The most important function of the money market is to enable parties with temporary liquidity surpluses (lenders) to give short-term loans to parties with a shortage of money (borrowers). The lenders receive compensation, the money market interest. The traditional financial instruments on the money market are deposits, money market paper and repurchase agreements. The majority of money market instruments are concluded over-the-counter.

1 Deposit

A deposit is the placement of money by a party with another party for an agreed period of time and at an agreed interest rate. The party that lends the money has the advantage of a higher interest rate than the remuneration on his current account. The minimum maturity period for a deposit is one day (call deposit or overnight deposit). Common maturity periods are one, two and three weeks and one, two, three, six and twelve months. The majority of deposit transactions on the money market are usually interbank deposits. The settlement flows of a deposit consist of a transfer of the principal at the beginning of the period (t+2 where t stands for transaction date) and an opposite transfer of the principal plus the interest amount at maturity. A money market loan has the same characteristics as a deposit, it is a short-term loan to a company or lower government authority with a fixed maturity period and a fixed interest rate.


2 Calculation of interest amounts

Interest amounts are normally paid out in arrears and are calculated using the following equation: Interest amount = Principal x interest rate x daycount fraction. Because interest rates are always presented per annum, a correction factor is applied to bring the interest rate in line with the maturity period. This correction factor is called the daycount fraction. The equation to calculate the daycount fraction is:
number of days in coupon period (tenor) -. Daycount fraction = -----------------------------------------------------------------------------------------------year basis

2.1 The duration of the coupon period The start date of a coupon period is normally a fixed number of days later than the (re)fixing date of the interest rate. The first coupon period of a loan starts at the settlement date of this loan. That is, when the nominal amount is transferred from the lender to the borrower. With money market deposits, this is normally two working days after the closing of the loan agreement (t+2). With exchange traded bonds, normally after three working days (t+3). With an interest rate derivative the first coupon period normally starts on t+2. If the interest rate is refixed periodically during the term of a contract, the coupon period starts two working days after the fixing date. The end date of a coupon period is called the coupon date. On this date the coupon is paid. The coupon dates of regular periods (1, 2, 3 months etcetera) normally fall on the same day in the month as the start date. There are, however, exceptions to this rule. If the coupon date falls in a weekend or on a bank holiday, the coupon can not be paid on this date. This is because the central banks payment system is not operational on these days. The coupon date will then be adjusted to the previous or the next business day according to the convention agreed upon in the market or in the specific contract. The most used conventions are following and modified following. With the convention following, the coupon date will be postponed to the next business day. This is also the case with the convention modified following with one exception, however. If the adjusted coupon date would fall in the next month,


the coupon date is set on the previous business day. In the money market, normally, the modified following convention is used. This is also the case in ISDA agreements. Figure 11.1 shows the maturity dates of the regular periods for trading day 13 April 2009.
Figure 11.1 End dates of regular periods

period spot 1 month 2 months 3 months 4 months 5 months 6 months

date 15/4/2009 15/5/2009 15/6/2009 15/7/2009 17/8/2009 15/9/2009 15/10/2009

day Wed Fri Mon Wed Mon Tue Thu


15/8 is Sat

If the spot date falls on a month ultimo date, i.e the last trading day of a month, all regular dates will in principle be set on a month ultimo date too. Additionally, the modified following convention is applied. In this case, the convention is referred to as end-of-month convention (EOM). Figure 11.2 shows the maturity dates for several regular periods for trading day 28 April 2009.
Figure 11.2 EOM value dates

period spot 1 month 2 months 3 months 4 months 5 months 6 months

date 30/4/2009 29/5/2009 30/6/2009 31/7/2009 31/8/2009 30/9/2009 30/10/2009

day Thu Fri Tue Fri Mon Wed Fri


31/5 is sun note: 31st note: 31st 31/10 is sat


If the coupon date of a long term contract is adjusted, the question is whether the coupon term should be adjusted too. Again, two different conventions may be used: adjusted and unadjusted. Adjusted means that the number of the interest days is adjusted to the new coupon date. Unadjusted means that the number of interest days stays unchanged. The number of days in a coupon period is calculated by including the start date and excluding the end date. Example A deposit starts on 4 April and ends on 23 May. The number of interest days is 49: 27 in April and 22 in May.

2.2 Daycount conventions There are different methods to calculate daycount fractions. These are called daycount conventions. Which daycount convention applies depends on the type of interest instrument traded and on the country where this instrument is traded. There are two types of daycount conventions. They differ in the way that the number of days in a coupon period is calculated, the tenor. With the first type, the number of days in each month is set at 30. With the second type, the actual number of calendar days is calculated.

Daycount conventions 30/360 With daycount convention 30/360, the number of interest days is calculated by setting each whole month that falls within the coupon period at 30 days, in principle. The intervening ends of months dates are also set at 30. The year basis is always set at 360. Figure 11.3 shows some examples of calculations of the number of days according to the 30/360 convention.


Figure 11.3 Examples of the calculation of the number of days with daycount convention 30/360

Start date 1. 2. 3. 4. 5. 14-3-2009 14-2-2009 28-1-2009 14-2-2009 14-2-2008

End date 14-9-2009 14-4-2009 10-2-2009 5-3-2009 5-3-2008

# Days 30/360 180 60 12 21 21

1. There are two ways of calculating the number of interest days: a. from 14-3 to 14-9 are six whole calendar months: 6 x 30 = 180 days. b. Number of interest days in March: 30 - 13 = 17; Number of interest days April to August: 5 x 30 = 150; Number of interest days in September: 13; Total: 180 interest days. 2. Again there are two ways to calculate the number of interest days: a. from 14-2- tot 14-4 are two whole calendar months: 2 x 30 = 60 days. b. Number of interest days in February: 30 - 13 = 17; Number of interest days in March: 30; Number of interest days in April: 13; Total: 60 interest days. 3. Number of interest days in January: 30 - 27 = 3; Number of interest days in February: 9; Total: 12 interest days. 4. Number of interest days in February 30 - 13 = 17; Number of interest days in March: 4; Total: 21 interest days. 5. Number of interest days in February: 30 - 13 = 17; Number of interest days in March: 4; Total: 21 interest days.


There are a few alternative applications of the 30/360 daycount convention. These alternatives all have their own exceptions to the rule that the month ultimo is set at 30. The most frequently used 30/360 daycount convention is bond basis. With the bond basis convention, exceptions are made in the following cases: 1. if a coupon period starts or ends on 28 or 29 february; 2. if a coupon period ends on the 31st and at the same time doesnt start on the 30st or 31st. In these cases, the ultimo dates are not set at 30. Figure 11.4 shows examples of these exceptions.
Figure 11.4 Exceptions with daycount convention 30/360

Start date

End date

Start date acc. to bond basis 30-8-2009 28-2-2009 28-2-2009 13-3-2009

End date acc. to bond basis 28-2-2010 4-3-2009 31-3-2009 31-3-2009

# Days

1. 2. 3. 4.

31-8-2009 28-2-2009 28-2-2009 13-3-2009

28-2-2010 4-3-2009 31-3-2009 31-3-2009

178 6 33 18

1. Start date 31-8 is not an exception and will be set at 30; End date 28-2 is an exception and stays 28; Number of interest days: 5 x 30 + 28 = 178. 2. Start date 28-2 is an exception and stays 28; End date 4-3 stays 4; According to the general rule the intervening February month ultimo date will be set at 30; Number of interest days: 3 in February and 3 in March add up to 6. 3. a Start date 28-2 is an exception and stays 28; End date 31-3 is also an exception and stays 31; this is because the coupon period doesnt start at the 30st or 31st; Number of interest days: 3 in february and 30 in March add up to 33. b. From 28-2 tot 28-3 is 30 days (one whole month);


From 28-3 tot 31-3 is 3 days; Total number of interest days is 33. 4. Start date 13-3 is an exception and stays 13; End date 31-3 is also an exception and stays 31; this is because the coupon period doesnt start at the 30 or 31; Number of interest days is18. Apart from 30/360 bond basis there are two other alternative 30/360 daycount conventions: 30E/360 Eurobond and 30E/360 ISDA. With these alternatives only the ultimo date of February (28 or 29) is an exception. With 30E/360 eurobond, a start or end date of a coupon period that falls on the ultimo date of February is not set at 30. With 30E/360 ISDA this is only the case with the last coupon. If these exceptions apply, the start or end dates stay unchanged at the 28th or 29th.

Daycount conventions actual With daycount conventions actual the exact number of calendar days is calculated for a coupon period. The year basis, however, can differ. With daycount convention actual/360, for instance, the year is set at 360 days. This daycount convention is used on the money markets in the euro area, in the US, in Switzerland and on the Japanese money market. With the daycount convention actual/365, the year is set at 365 days. This is the case in the UK money market and, for instance, in Australia, New Zealand, Singapore and Hong Kong. Example A bank invests in a deposit with a principal of 20 million euros and an interest rate of 3.2%. The start date is 4 April and the end date is 23 May. In order to calculate the interest amount, first, the number of interest days must be calculated. In April, 30 - 3 = 27 days are included (the first three days of April do not count, April 4th does). In May 22 days are included (May 23rd does not count). The total number of interest days, therefore, is 27 + 22 = 49 days. The interest amount for this deposit is: EUR 20,000,000 x 3.2% x 49/360 = EUR 87,111.11 With the daycount convention actual/actual the number of days in the coupon period and the number of days in a year are both set at their actual number. In regular years the year is set at 365 and in leap years at 366. This daycount convention is used with most government bonds.


A deposit runs from 15 February 2008 (leap year) to 20. March. Figure 11.5 shows the daycount fractions according to the different daycount conventions.
Figure 11.5 Comparison of daycount fractions with different daycount conventions

Daycount convention actual/ 360 actual/actual actual/365 30/360

# Days in coupon period (29-14)+19=34 (29-14)+19=34 (29-14)+19=34 (30-14)+19 = 35

Year basis

Daycount fraction 34/360 34/366 34/365 35/360

360 366 365 360

Special cases of the actual/actual convention If part of a coupon falls in a leap year, with daycount convention actual/actual, the daycount fraction is calculated by splitting up the coupon period in one part that falls within the leap year and another part that falls within the regular year. The following equation is used in these cases:
dl dr - + --------. Daycount fraction = -------366 365

Where: dl= number of days in the leap year dr = number of days in the regular year Example A German Government bond with a nominal value of EUR 1,000 has a coupon of 4.5% with daycount convention actual/actual. The coupon date is 1 October. On 1 April 2008 an investor buys this bond. The daycount fraction for the expired period is:
92- -------91 Daycount fraction = -------+ - = 0, 25205 + 0, 24863 = 0, 50068 . 365 366

The accrued interest of this bond is EUR 1,000 x 0.50068 x 0.045 = EUR 22.53.


3 Repurchase agreement

Repurchase agreements (repos) are contracts for selling securities, containing an agreement that the securities will be bought back after a certain time period. Repos can be regarded as money loans for which the borrower gives securities as collateral. As opposed to a normal loan with securities as collateral, however, with a repo the money lender has legal ownership of the securities during its term. The party that lends the money and receives the securities as collateral calls this transaction a reverse repo. The maturity period of a repo is usually less than two weeks and is sometimes as short as a single day. Some repos are at notice, which means that the money lender can revoke the contract, with or without a certain prior period of notice. Repurchase agreements are widely used by central banks with the execution of their monetary policy. The refinancing transactions of the European Central Bank are repurchase agreements, for instance. The amount of money that is transferred at the beginning of a repo is called initial consideration. The initial consideration is related to the value of the collateral. It is the dirty price in the case of bonds, i.e. including accrued interest. The size of the amount at maturity is called maturity consideration. The maturity consideration equals the initial consideration plus a coupon that is based on the repo rate. Example The market value of a portfolio of bonds is EUR 50 million. The maturity period of the repo is seven days and the repo rate is 4.00%. The maturity consideration of this repo is EUR 50,000,000 x (1 + (7/360 x 0.04)) = EUR 50,038,888.89.

Sell/buy back A financial instrument that resembles a repurchase agreement is a sell/buy back. A sell/buy back also concerns a loan that is taken out with securities as collateral. Incidentally, the money lender calls a sell/buy back transaction a buy/sell back transaction.


In the case of a repo, an interest rate is determined as a payment for lending the principal and, in the case of a sell/buy back, a separate price is determined for the sale of the stocks at the beginning and for the purchase of the stocks at the end of the transaction. The difference between these two rates is the renumeration for borrowing the money. The main difference between a repo and a sell/buy back transaction, however, becomes apparent when there is a coupon payment over the collateral during the transaction period. In the case of a repo, the party that holds the collateral transfers the amount received by him directly to the party that has supplied the securities as collateral. In the case of a sell/buy back transaction, the coupon payment is included in the price for the second securities transaction.

4 Money market paper

Money market paper is a fixed-income security with a term shorter than two years that is issued through a lending programme. The nominal value or face value of money market paper is always a multiple of one million. It is thus only suitable for large investors.

Commercial paper Commercial paper is a type of money market paper that can be issued by all kinds of market parties. However, the issuing institutions are usually companies or local of regional government authorities. Commercial paper is issued on a zero-coupon basis. This means that the investor buys the security at a price that is equal to the present value of the commercial papers face value. At maturity, the investor receives the face value of the commercial paper. The investor's yield is determined by the difference between the buying price and the face value. The price of a commercial paper is, therefore, calculated by using the equation of the present value. The interest rate used in this equation is also referred to as yield.
Face value -. price (present value) = ----------------------------------------------------------------------------------------------------------( 1 + interest rate (yield) daycount fraction )


Example An investor wants to buy a commercial paper with a term of 91 days and a nominal value of EUR 100 million. The yield is 0.05. The price the investor has to pay is:
EUR 100 mio EUR100 mio - = ------------------------------- = EUR 98,751,887. price = -------------------------------------------1 + 0.05 91 360 1.102639

Treasury bills A Treasury bill is a money market paper issued by the American or British central government. At maturity, a Treasury bill is paid back at face value. The price of a Treasury bill at purchase is determined using the pure discount rate (PDR). This involves calculating an interest amount on the face value and subtracting it from the face value: Price = Face value -/- Face value x PDR x daycount fraction. Example A UK Treasury bill with a 91 days maturity period has a face value of GBP 50 million. The pure discount rate is 4.25%. The price of this Treasury bill is: GBP 50,000,000 -/- GBP 50,000,000 x 0.0425 x 91/365 = GBP 49,470,205.50.

Bank bills/bankers' acceptances A bank bill or banker's acceptance is a money market paper that is issued by a non-bank but guaranteed by a bank. The price of the bank bill is determined using the pure discount rate. At maturity, a bank bill is paid back at face value.

Certificate of deposit A certificate of deposit (CD) is a money market paper issued exclusively by banks. As opposed to the other forms of money market paper, CDs are sometimes issued at face value and, at the maturity date, the face value amount plus the interest payment is paid back. So, as with a deposit, a coupon is attached. If a CD is traded before maturity, the price is equal to the present value of the sum of the principal plus the interest payment. Other CDs, however, are issued at the present value and are repaid for the nominal amount and they resemble commercial paper.


Figure 11.6 gives an overview of the different types of money market papers.
Figure 11.6 Overview of money market papers


Issue Price


Maturity Consideration Face value Face value Face value Face value


Commercial paper Commercial paper US Treasury Bill Bank bill Certificate of deposit

Present value Yield (yield) Present value Pure discount (PDR) rate Present value Pure discount (PDR) rate Present value Pure discount (PDR) rate Face value

Miscellaneous Miscellaneous US/UK Federal Government Corporates Banks

Yield Face value + (present value) Coupon

5 Money market benchmarks

Every day a EURIBOR rate is determined on the money market by approximately 50 large banks, the panel banks, for specific periods up to one year as well as a rate for the day interest rate, the EONIA. The banks pass on these rates to the European Banking Federation (EBF). This is a European coordinating organization of national interest groups of banks. EURIBOR stands for euro interbank offered rate and EONIA stands for euro overnight index average. The EURIBOR rates and the EONIA rate are rates that banks charge each other for uncollateralized interbank deposits. Banks base themselves, in principle, on the current interest rates of the European Central Bank (ECB) and on the expectation about movements in the interest rates of the ECB during the coming year when determining the level of these rates. The EURIBOR rates and the EONIA rate well-known benchmarks for the money market. Because of the fact that during the credit crisis the interbank deposit market dried up, however, two other benchmarks gained importance on the money market: Eurepo, that is related to repuchase agreements and the overnight swap index (OSI) that is related to overnight index swaps. Both indices are determined in the same way as EURIBOR.


Chapter 12

Capital market instruments and corporate actions

Securities with a long-term or infinite maturity period are traded on the capital market. The capital market consists of two sub-markets, the equity capital market and the fixed-income capital market. The traditional instrument on the equity capital market is a share and on the fixed-income capital market they are fixed-income securities.


A share is a proof of co-ownership in a company. Companies are the only organizations that issue shares. As a co-owner, a shareholder shares in the company risk. In the worst case scenario, the company goes bankrupt and the shareholder loses his capital. This is why shares are called risk-bearing capital. In principle, a share has an undetermined term. It exists until the company is dissolved, taken over by another company or goes bankrupt. Many shares are listed on an exchange. These shares can also be traded through a multilateral trading facility (MTF), over-the-counter or through systematic internalization. Unlisted shareholdership is sporadically traded. This is referred to as private equity. Ownership of listed shares is registered using a balance on a securities account. End investors hold securities accounts with custodians for this purpose, and custodians in turn hold securities accounts with central securities depositories.

Return on shares The return on shares consists of two parts, the direct return in the form of a dividend and the indirect return in the form of share price changes. Dividend is a distribution to share holders taken from the net profit. If the company does not make a profit, it will not distribute dividends. But, on the other hand, that does not mean that a company that does make a profit always distributes dividends.


The management of the company proposes the dividend amount during the annual shareholders meeting. The shareholders vote on whether they agree with the proposal. If they do not give their approval, the management must modify the proposal.

Securities lending Securities lending is a financial instrument whereby a party agrees to temporarely lend securities to another party. The borrower gives the lender a renumeration and may provide collateral. This collateral may consist of a certain number of securities, a bank guarantee or a certain amount of money. In the latter case, a securities lending transaction is identical to a repurchase agreement. A common reason for a party to borrow securities in a securities lending transaction is in order to meet a delivery obligation resulting from taking a short position in securities. For instance, if a shares trader wants to profit from falling prices, he will take a short position by selling shares now with the intention of buying them back in the market at a lower price later on. The sale transaction gives him a delivery obligation. In order to meet this obligation, he can borrow the shares using a securities lending transaction. If the trader buys the shares in the market after some time has passed, be it with or without a profit, he can return them to the lender. The lender of the securities is often an institutional investor. In the case of cash collateral, the institutional investor has temporary access to an amount of money. The institutional investor gives the lender of the securities an interest payment in return. However, the interest rate that is used for this purpose is lower than the market interest rate. The profit for the institutional investor is that he can place the cash collateral on the money market at a higher rate of interest. In the case of other forms of collateral or no collateral, the lender receives a fee.

2 Fixed-income securities

Fixed-income securities are tradable debt notes issued by an organization in which it declares that it will repay a borrowed amount with interest to the person who owns the fixed-income security, the holder Fixed-income securities can be issued in various ways: through an exchange or directly to the investor (over-the-counter). In general, fixed-income securities that are listed on an exchange can be easily traded through the exchange or other public trading platforms or over-the-counter. The most well-known fixedincome securities that are traded through an exchange are bonds. Fixed-income


securities that are directly placed with investors are usually part of a lending programme. This means that an organization can issue fixed-income securities up to a certain maximum amount with relatively low administrative burden. Most issues through the programme are over-the-counter. A lending programme is also called a debt issuance programme (DIP) or note issuance facility (NIF). A commercial paper programme is one example of a lending programme. Issuing through a lending programme is also referred to as drawing. The drawing on a programme can be either on initiative of the issuer or on the initiative of the investor. The interest payment on a fixed-income security can take place periodically, using coupons, or once, at maturity. A fixed-income security contract specifies how much money the issuing organization must pay back to the owner of the fixed-income security. This is called the nominal value. The nominal value of a bond is usually EUR 1,000 and the nominal value of a medium term note (MTN) is a multiple of EUR 1 million. Most fixed-income securities in euros have an annual coupon. Most fixedincome securities in US dollars have a semi-annual coupon. The coupon rate is usually determined once at the time the fixed-income security is issued. Some fixed-income securities, however, have a floating coupon. These are floating rate notes, whereby the coupon rate is redetermined (fixed) every three or six months based on a reference interest rate such as EURIBOR or LIBOR. Some fixed-income securities do not pay out interim coupons. These are zero-coupon bonds. Zero-coupon bonds are issued at a price that is calculated as the present value of the nominal value and are repaid at the nominal value at the end of the term. The remuneration for the investor is included in the difference between the purchase price and the nominal value. As with listed shares, fixed-income securities are registered in securities accounts with custodians or central securities depositories. However, this applies to all fixed-income securities, listed fixed-income securities like bonds and unlisted fixed-income securities like commercial paper or medium term notes.


2.1 The yield of a fixed-income security The yield of a fixed-income security is the return that investors demand, based on the assumption that they will keep the bond until the end of the term. This is why it is also called yield to maturity. Investors consider the following factors when determining the yield on a fixed-income security: the general interest rate level on the capital market; the quality of the issuing entity; the liquidity of the bond.

The general interest rate level on the capital market The capital market interest rate is determined by the free interplay between supply and demand. The interest rate level on the capital market is largely determined by the expected inflation. When investors expect a higher rate of inflation, they demand higher compensation ('inflation compensation'). This is because inflation lowers the value of the amortization in real terms. A higher inflation (expectation) is therefore coupled with an increase in the capital market interest rate. Conversely, a lower inflation (expectation) leads to a decrease in the capital market interest rate. In addition to the inflation expectation, supply and demand factors also play a role. The capital market interest rate may fall due to an increase in the demand for fixed-income securities. This may be the case, for instance, when investors liquidate their share investments en masse, so that more money becomes available for fixed-income securities. A well-known benchmark on the capital market is the return on government loans. However, because of the fact that government bonds are not issued on a frequent regular basis, this benchmark is not often used nowadays. Instead, the interest rate swap (IRS) rate level is now often used as a benchmark. These are interbank rates, just like the Euribor rates. The benchmark that applies to IRS rates is the ISDAFIX Swap Rate, which is fixed daily based on quotes given by several dealers selected by ISDA, ICAP and Thomson Reuters. The ISDAFIX service provides average mid-market swap rates for seven major currencies at selected maturities on a daily basis. ISDAFIX rates are based on a mid-day and, in some markets, end-of-day polling of mid-market rates.


The quality of the issuing entity The quality or creditworthiness of the issuing organization indicates the likelihood of it being able to pay back the loan. The better the quality, the more certain the investor is that he will get his money back. An investor that buys a bond issued by a central government is usually almost certain that he will get his money back. The certainty of repayment is lower when it comes to bonds issued by companies. In order to compensate for this, investors demand higher coupon interest rates for securities that are less creditworthy. The difference in interest rate between the coupon that a certain institution must pay and that which the government must pay is called the risk premium or spread. In order to determine the creditworthiness of issuing institutions, many investors consult these parties' ratings. A rating is an assessment of an organizations creditworthiness, expressed as a letter or a combination of letters and digits. Rating agencies make a rough distinction between two categories: investment grade and high yielders. If a bond is qualified as Investment grade, it means that it is a reasonably safe investment. The categories of ratings used by Moody's and Standard & Poor's are shown in figure 12.1.
Figure 12.1 Overview of credit ratings

Investment Grade Highest quality High quality Upper medium grade Adequate payment capacity

Moodys Aaa Aa A Baaa3


High Yielders Predominantly speculative Speculative / low grade Poor quality / vulnerable to default Highest speculation Lowest quality / no interest being paid In bankruptcy

Moodys Ba B Caa Ca C



In addition to the quality of the issuing organization, the domicile also plays a role with regard to the creditworthiness of a client. Governments sometimes impose restrictions on the payment of interest and amortization of foreign debts. This is called political risk. The political risk is included in the rating of individual parties. If there is a political risk, an investor demands a higher coupon interest rate.

The liquidity of the bond Liquidity with respect to financial instruments means tradability. If bonds are not regularly traded, they are less appealing to investors and they will demand a higher yield. This is because investors need to wait and see if there is a counterparty that is interested and how much he is willing to pay should they want to sell these bonds. The liquidity of a bond is closely related to the number of bonds issued. Generally speaking, the liquidity increases as more bonds of a certain type are issued.

2.2 Clean and dirty price In the case of a transaction in a fixed-income security, the interest accrued up to the settlement date is sold with the security. The price of a bond thus consists of the exchange price, plus the coupon interest accrued up to the settlement date. The price without the accrued interest is called the clean price. The price including the accrued interest is called the dirty price. The interest amount is calculated by applying the interest rate, adjusted according to the daycount fraction, to the nominal value of the fixed-income security. The daycount convention for fixed-income securities varies. For most Government bonds, the actual/actual convention is used. For eurobonds 30/360 is common practice. Example A portfolio manager buys a French government bond (OAT) on an exchange at a price of 98.60 and an annual coupon interest rate of 5% (actual/actual), which is paid on July 15th. If the settlement date for this transaction is July 10th, 360 interest days will have passed since the last coupon payment. The daycount fraction in this case is thus 360/365 and the dirty price of the obligation is calculated as follows 98.60 + 100.00 x 360/365 x 0.05 = 98.60 + 4.932 = 103.532.


If the settlement date for this transaction would have been July 20th, five interest days would have passed since the last coupon payment. The daycount fraction in this case is thus 5/365 and the dirty price of the obligation is calculated as follows 98.60 + 100.00 x 5/365 x 0.05 = 98.60 + 0.068 = 98.668.

3 Special types of fixed-interest securities

A wide range of fixed-income securities are issued in the financial markets, each with its own features.

Floating rate notes A floating rate note (FRN) is a fixed-income security with an interest coupon that is reset periodically, usually after three or six months. The reference rate of an FRN is usually a money market benchmark such as LIBOR or EURIBOR.

Asset-backed securities and covered bonds Asset-backed securities are issued as a result of a securitization transaction. With securitization, the initiating party transfers a portion of its assets to a third party. This is often a legally independent entity created specifically for this purpose, known as a special purpose vehicle (SPV). The SPV obtains its funds by issuing debt securities in the form of bonds, medium-term notes or commercial papers. Securitization is not the actual sale of assets. If the bank, for example, were to securitize a loan portfolio, all contracts between the bank and the borrowers would have to be replaced by contracts between the SPV and the borrowers. In order to prevent this, credits are only transferred in an economic sense and not in a legal sense. This means that the bank has to arrange for all cash flows arising from the transferred portfolio to be forwarded to the SPV. The SPV can in turn use these cash flows to pay interest and installments for the fixed-interest securities it has issued. The cash flows of the acquired receivables thereby serve as a kind of collateral for payment obligations resulting from securities issued by the SPV. These interest-bearing securities are therefore called asset-backed securities (ABS) or collateralized debt obligations (CDOs). Apart from the duty to channel all cash flows of the securitized portfolio to the SPV, the bank has no obligations towards the SPV.


A variation on asset-backed securities are covered bonds. These are bonds issued by a bank whereby a specific credit portfolio serves as collateral in the event of the banks bankruptcy.

Callable/putable bonds Callable notes are fixed-income securities that can be redeemed prematurely by the issuer. The issuer only makes use of this option if the current interest rate is lower than the coupon rate. This is not a favourable option for investors as they have to invest their funds at a lower rate. Loan terms and conditions, therefore, often state that callable bonds are redeemed at a price at or above 100 in the event of premature redemption. A putable note or bond is a fixed-income security that the holder is entitled to sell prematurely to the issuer under predetermined conditions.

Perpetuals Perpetuals are fixed-interest securities that do not need to be redeemed. Interest on most perpetuals is periodically reviewed, e.g. every 10 years, which means that the coupon is adjusted to prevalent market rates every 10 years. Investors are thereby given the assurance that interest yields will not vary from prevalent market rates for too long. Most perpetual bonds are callable and they can be redeemed prematurely at intervals as defined in the loan agreement.

Subordinated loans or junior loans Subordinated loans or junior loans are loans whereby interest payments and repayments are subordinated to other fixed-interest securities of the issuer. In the event of payment difficulties, the issuer must first settle obligations in respect of other loans before it is required to comply with loan interest payments and/or to repay a junior loan. Investors thereby run a greater risk of not getting their money back than with a regular fixed-income security. In return for this risk, they receive a higher interest rate.


Inflation-linked Bonds Inflation-linked bonds or index-linked bonds are fixed-interest securities whereby the nominal value is periodically adjusted for inflation. Interest is also calculated against the higher amount. In case of inflation, the investor receives a higher amount at settlement than the initial investment. Example A pension fund invests in a one-year index-linked bond with a nominal value of EUR 1,000.00 and a coupon yield of 1%, with the guarantee that the principal amount is indexed to inflation. With an inflation rate of 2.4%, the pension fund will be repaid the principal amount of EUR 1,024.00, plus 1% interest after one year (1% of EUR 1,024.00 = EUR 10.24). The total amount payable after one year is EUR 1,034.24.

Junk bonds Junk bonds or high-yielders are fixed-interest securities issued by companies with low credit ratings. Investors buy these fixed-interest securities because they offer a high return. A fixed-income security can also be downgraded to junk bond status during its lifetime. This happens when the creditworthiness of the issuer falls sharply during the lifetime of the fixed-income security. The fixed-income security is than referred to as a fallen angel. High-yield bonds or junk bonds have a lower credit rating than Baa3 or BBB-.

Convertible bonds Convertible bonds are bonds that can be exchanged by the holder during their lifetime for a pre-determined number of shares in the issuer. The holder of a convertible bond actually holds a combination of a bond and a call option on the issuers shares. The option premium is included in the interest rate, and this rate is, therefore, lower than the interest rate on a regular bond with the same maturity.

Zero coupon bonds Zero coupon bonds are fixed-interest securities that do not yield any interim coupons during their lifetime. Zero coupon bonds are redeemed at their face value. The issuing rate is calculated as the present value of the face value. Zero coupon bonds are popular among investors because they run no reinvestment risk, which is also why they are often used as a hedge for guarantee products.


4 The role of the bank with a securities issue

Companies that have large financial requirements can choose to issue shares or fixed-income securities themselves as an alternative to bank credit. The issues and syndicates department of the financial markets division supervises these issues. A bank that services an issue is called the arranger. The arranger assists the issuer, for instance, in determining the issue price and represents the issuing institution towards the regulatory bodies and investors. An arranger always acts as issuing and paying agent. The responsibility of an issuing and paying agent is to draw up a global note, deposit it with the central securities depository and apply for an ISIN code. The issuing agent is also responsible for compiling a prospectus, in the case of listed securities, or a bond indenture, in the case of unlisted fixed-income securities. Both documents contain the terms and conditions of security issued. A prospectus also reveals comprehensive information about the issuing institution. These documents must be approved by and deposited with the regulatory supervisor, such as the Financial Services Authority (FSA) in Great Britain. Finally, the issuing agent is responsible for distributing the terms and conditions of the issue among investors. Finally, the issuing and paying agent is responsible for drawing up the settlement instructions for the payments and the securities transfers related to the issue and the coupons or dividends. If a security is traded on an exchange, the arranger also acts as listing agent. In this role, the arranger applies to the exchange for a listing on behalf of the issuing institution. The listing agent is also responsible for the following tasks: reporting to and/or gaining approval for the listing from the supervisor; registering stocks with the clearing institution; placing a public announcement; publicizing the result of the issue in the media. In order to increase the placing power, the arranger often forms an issue syndicate. This is a group of banks that jointly execute an issue. The arranging bank is called the syndicate leader. Apart from the syndicate leader, there are a number of parties involved as dealer. They are allowed to buy the securities directly from the issuer and sell them to their own clients.


In case of a lending programme, the arranging bank draws up a base prospectus. This document contains information about the borrowing institution and the general terms and conditions that apply for all issues of fixed-income securities issued through the programme. The base prospectus serves as a master agreement for the fixed-income securities issued under the programme and can somehow be compared with e.g. an ISDA Agreement. A base prospectus must include the following information: scope of the programme; risks of the programme; type of fixed-income securities that may be issued as part of the programme; conditions under which the fixed-income securities may be issued; information on the issuing institution (annual report); who the dealers are; information on taxation. The drawing on a programme can be either on the initiative of the issuer or on the initiative of the investor. In the first case, the issuer contacts one or more dea-lers and orders them to find investors. In the second case, an investor asks a dealer to find out whether the issuer is interested in issuing new securities. In both cases, two contracts are closed simultaneously. In the first contract, the issuer sells the securities to the dealer. In the second contract, the dealer, in turn, sells the securities to the investor. These contracts contain the terms and conditions of the issue in question: the amount, the coupon rate, the frequency of interest payments, the maturity date, conditions of early redemption and so on. Bond indentures can somehow be compared with the confirmations of a contract that is closed under a ISDA agreement. If a listed bond is issued through a lending programme, however, still a comprehensive prospectus has to be drawn up. If the dealer is not also the arranger of the programme, both the dealer and the issuer send information about the deal to the arranger who applies for a ISIN code and takes care of the settlement, in its role of issuing and paying agent respectively.


5 Corporate actions

Corporate actions are events in the life of securities that take place on the initiative of the issuing institution and have a direct impact on the holders of the securities. Examples of corporate actions in relation to bonds are coupon payments and redemptions. The most common corporate action relating to stocks is the dividend payment. Corporate actions may have far-reaching consequences for shareholders, e.g. rights issues and takeovers. The actions required as a result of corporate actions are mainly carried out by central securities depositories, custodians and asset managers.

5.1 Reasons for corporate actions Issuers may have a number of reasons for initiating corporate actions, including in relation to shares: providing remuneration to the holder (dividends); raising additional capital from own shareholders (rights issue); enhancing the marketability of shares (stock split or reverse split); changing the structure of a company (acquisition); giving information to shareholders (notice of a shareholders' meeting); and in relation to bonds: providing remuneration to the holder (coupon interest); (early) redemption of debt; converting debt into equity (conversion of a convertible bond).

5.2 Corporate action categories Corporate actions can be classified into three categories: mandatory corporate actions, voluntary corporate actions and issuer notices. The extent of the impact on the holders depends on the category of a corporate action. Because the consequences of corporate actions in relation to equity can be great, they must in principle be approved by the general or a special general meeting of shareholders.

Mandatory corporate actions A mandatory corporate action is a corporate action performed for all security holders, without exception. Examples of mandatory corporate actions are dividends, coupon payments and stock splits.


Voluntary corporate action A voluntary corporate action is a corporate action whereby individual security holders may choose if they want to encounter direct consequences. An example of a voluntary corporate action is a takeover.

Issuer notices Issuer notices are messages from the company to security holders. Examples of issuer notices are announcements of a shareholders meeting, the distribution of the minutes of a shareholders' meeting, the notification of new coupon interest rates and the notification of a change in an ISIN code. Issuer notices do not need the approval of the shareholders. Some corporate actions consist of several related corporate actions, multi-stage corporate actions. One such example is a rights issue. A rights issue consists of two successive corporate actions, an issue of claims and the conversion of claims into shares.

5.3 Implementation of corporate actions With corporate actions the following parties are involved: issuer; central securities depository; custodian; asset manager or manager of a mutual fund; end investor. These parties each have specific responsibilities with regard to the flow of information concerning the corporate action. An issuer is obliged to publish information regarding a proposed corporate action. This can be done via financial newspapers, the screens of data vendors such as Thomson Reuters or Telekurs and the websites of issuers or stock exchanges. All parties affected by a corporate action are required to retrieve this information themselves. Custodians and investment managers, however, often undertake this task on behalf of their clients. Parties with a vested interest often check the accuracy of the information regarding a corporate action they have obtained from a particular source with another source. This is referred to as cleansing.

Implementation of a dividend payment When an issuer has declared a dividend, the corporate action takes place via a number of stages that are shown in figure 12.1.


Figure 12.1 Distribution of cash or securities related to a dividend payment


Mutual Fund


3. 1. 2.




Asset Manager




The following steps are shown: 1. The issuer's bank, in its capacity as paying agent, transfers the total dividend amount from the issuer's account to the central securities depositorys account with the central bank. 2. The CSD is responsible for distributing the total dividend amount received from the issuer among its account holders, i.e. the custodians. In this context, the CSD performs the following actions: a. gathering information on the dividend payment; b. determining the dividend to be received by each custodian; c. sending a message to the custodians entitled to dividends; d. paying out the dividends through cash accounts held by the custodians at the CSD. 3. Custodians are responsible for distributing the dividend amount that they have received among their clients In this context, they are responsible for the following actions: a. gathering information on the dividend payment; b. determining the dividend to be received by each client (asset manager, investment institution or end investor); c. sending messages to the clients that are entitled to the dividend; d. sending messages to the CSD regarding the total dividend amount to be received; e. checking the total dividend amount received from the CSD; f. transferring the dividend to the cash accounts of the securities holders. 4. Asset managers and managers of mutual funds can pay the dividends to the final investors depending on the mandate or the terms of the mutual fund.


Stock dividend A stock dividend is a dividend payment in shares. If a company declares a stock dividend, the issuer's bank instructs the CSD to create securities. These securities are called stock dividends and have a short duration. The stock dividends are then recorded on the accounts of the custodians, who in turn book them on their clients' accounts. On the payment date of the dividend, the balances on the stock dividend accounts are debited and the shares accounts are credited at a specified ratio.

Choice dividend A choice dividend is a dividend whereby the holder can opt for a dividend in cash or equity. Payment of choice dividends is a mandatory corporate action with an option element. Holders have the option to receive a specified amount in cash for each share held, or a stock dividend can be credited to a separate account. Once an issuer has announced a choice dividend, the custodian must communicate this to his clients. This message must state within which period the client's option must be exercised, when the ratio of the required dividend rights for newly issued shares will be established (if this has not yet taken place) and what the payment date is for the dividend. Once the issuer has determined the ratio between the dividend rights needed per new share to be issued, the custodian must inform his clients accordingly. The clients must then specify their preferences.

Rights issue A rights issue is an issue whereby current shareholders receive claims. These are newly issued securities with a short duration, which the holders can exchange in a certain ratio against shares, or which can be traded on the stock exchange. The rate at which current investors can purchase newly issued shares by submitting claims is usually lower than the prevalent market rate. Because of the selection option, a rights issue is considered to be a voluntary corporate action. Custodians must indicate to their clients how many claims are needed to purchase new shares and within which time frame they must respond. Once the clients have made their selections, the custodian must communicate to the CSD the total amount of claims that their clients want to be converted to shares. For each client that converts claims into shares, the custodian must debit the claims account and credit the equity account at a specified ratio.


Stock split With a stock split, existing shares are converted into multiple new shares. A stock split is a mandatory corporate action. The reverse also occurs when several existing shares are exchanged for a smaller number of new shares. This is called a reverse stock split. With a (reverse) stock split, custodians must adjust the number of shares on their clients' accounts. Example The Financial Times of 15 August 2007: 'Supermarket group Ahold implements a reverse stock split on 22 August 2007, following approval in June by the shareholders. Every five existing shares with a nominal value of 0.24 euro cents will be merged into four new shares with a nominal value of 0.30 euro cents.

Takeover In a takeover, a company buys the shares of another company. In many cases, this takes place in mutual consultation. The acquisition is then approved at a shareholders' meeting and the rate is established. However, individual shareholders must decide whether they are willing to sell their shares to the acquirer. Should they decide to do so, they must report their shares for the takeover. Custodians must send a message to their clients, stating the acquisition rate and the period within which clients must respond. Custodians must then confirm the total number of reported shares to the CSD. On the acquisition date, custodians must debit the securities accounts of clients who are cooperating in the takeover and credit their cash accounts.

Coupon payment A coupon payment is a periodic payment of interest at a fixed interest value. With coupon payments, it is not difficult to gather information as the dates on which the coupons are paid are fixed and the coupon interest rate is contractually determined. Coupons are always paid in full to the bearer of the fixed-interest security on the coupon date.


5.4 Pending transactions Problems can be encountered if certain transactions have been concluded, but have not been processed in the securities administration. These transactions are called pending transactions. Pending transactions have a bearing on two balances: the economic balance and the technical balance. The economic balance is the balance on which an investor runs a price risk and for which corporate actions are relevant. The technical balance is the balance that is actually on the account. The economic balance changes immediately with every transaction, but the technical balance is only adjusted on the settlement date. The moment at which the custodian decides who will be affected by a corporate action is called the record date. The cum date mostly serves as the record date for dividend payments. The cum date is the last day on which a share is traded including dividends. The economic balance is determined after the exchange has closed on the record date. In order to determine the economic balance, the custodian adjusts the technical balance for pending transactions. Example If an investor buys shares on or before the cum date, the purchasing price takes into account dividends yet to be received. The buyer is therefore entitled to that dividend. However, if settlement should fall after the record date, the shares are not updated on his account on the record date. The technical balance is therefore not updated and if the custodian were to look only at the technical balance, the buyer would not receive the dividend, despite having paid for it. The seller would, on the other hand, receive the dividend twice. With bonds, custodians do not take into account pending transactions, as bonds are always sold with accumulated interest up to the settlement date. If the settlement date is prior to the coupon date, the buyer receives the full interest coupon.



Chapter 13

FX instruments and settlement of FX transactions

The foreign exchange market (FX market) is the market on which different currencies are traded against one another. The rate at which this happens is called the exchange rate or FX rate. Various instruments are used on the FX market, including FX spot transactions, FX forwards, and FX swaps. All of these instruments are mostly traded over-the-counter. FX transactions are settled by two opposite money transfers in the currencies traded. In order to limit the settlement risk associated with these transactions, several international banks have jointly developed a system called the continuous linked settlement system (CLS system). The CLS system makes the opposite transfers in a FX transaction interdependent.

1 FX spot

With most FX transactions, the currencies are traded at the current market exchange rate and settlement takes place on a standard delivery date, usually two business days after the transaction date. These transactions are called FX spot transactions. The current market exchange rate is also sometimes called the FX spot rate. Example The UBS euro-dollar trader buys 10 million euros on May 12th 2009 from the Deutsche Bank euro-dollar trader at the FX spot rate of 1.3425. As a result, on May 14th 2009, UBS must transfer an amount of 13,425,000 US dollars to Deutsche Bank. Deutsche Bank, in turn, must transfer an amount of 10,000,000 euros to UBS.


For certain currency pairs, the settlement of spot transactions takes place after only one business day. This is the case, for instance, for currency transactions between US and Canadian dollars. Sometimes the value date for one currency is different from that of another currency. This may be the case, for instance, when a currency from an Islamic nation is traded for a currency in a Western country and the delivery date is near the weekend.

Exchange rates The exchange rate between two currencies is given using an FX quotation. An exchange rate expresses the value ratio between two currencies as a number. In the case of most exchange rates, one unit of a currency is expressed as a number of unit of another currency. The currency mentioned first in an FX quotation is the trade currency or base currency (the traded good) and the second currency is the price currency or quoted currency (the currency in which the price of the traded good is expressed). In FX quotations, currencies are expressed by their ISO-codes. ISO stands for International Standardization Organization. Figure 13.1 shows a table with the ISO-codes of some of the most important currencies.
Figure 13.1 ISO currency codes.

Currency Euro US dollar Pound sterling Japanese yen Canadian dollar Australian dollar Hong Kong dollar Singapore dollar Korean won Swiss franc Chinese yuan Russian Ruble


There are international conventions regarding which currency is the base currency and which is the price currency in an FX quotation. The euro is always quoted as the base currency against other currencies: EUR/USD, EUR/GBP, EUR/JPY, EUR/CHF etc.


The British pound and the other currencies of the Common Wealth are base currency in all exchange rate quotations except in the cases that the euro is the counter currency. The US dollar is the base currency in most exchange rate quotations with exception of euros, British pounds etcetera: USD/JPY; USD/CHF; USD/CNY, however, EUR/USD; GBP/USD; AUD/USD. Exchange rate quotations for which these rules are properly applied, are referred to as direct quoted rates. If these rules are not applied, for instance in case of GBP/EUR, the quotation is called an indirect quoted rate. If the EUR/USD exchange rate is 1.5000, this means that one euro is worth just as much as 1.5000 US dollars. The euro is the trade currency and the dollar is the quoted currency. If a company wants to buy 1,000,000 euros, it pays 1,000,000 x 1.5000 = 1,500,000 US dollars. It is a little more complex if a company wants to buy 1,000,000 US dollars for euros. The US dollar now looks like the traded good, but the exchange rate does not reflect this. In order to know how many euros the company must pay, the reciprocal of the exchange rate is used: 1,000,000 x 1/1.5000 = EUR 666,666.67.

2 FX forward

An FX forward, also known as an FX outright, is an FX instrument whereby two parties enter into a reciprocal obligation to exchange a certain amount of a currency at a certain time in the future for a predetermined amount in another currency. The rate used is called the forward rate. The forward rate is largely based on the spot exchange rate. Because settlement only takes place after some time in the case of an FX forward, the FX spot rate is corrected. The correction used is based on the difference in the interest rates for the two currencies involved and is represented using swap points. One swap point for EUR/USD, for instance, is equal to 0.0001. Swap points are the translation of a difference in interest rates between two currencies into the difference between the FX spot rate and the FX forward rate.


Example An ING Bank euro-dollar trader concludes an FX forward with the Deutsche Bank euro-dollar trader on May 12th, 2009 and buys 10,000,000 euros for US dollars with the delivery date being May 14th, 2010 (one year after the spot date). The EUR/USD cash rate is 1.3475 and the swap points amount to -/- 0.0130. The EUR/USD FX forward rate is thus 1.3345. On May 14th, 2010 ING Bank must transfer an amount of 13,345,000 US dollars to Deutsche Bank and Deutsche Bank must transfer an amount of 10,000,000 euros to ING Bank.

Theoretical calculation of an FX forward rate The FX forward rate can theoretically be calculated by calculating the future value of one unit of the trade currency and of the corresponding amount of units of the quoted currency, both on the forward delivery date. The future value in the quoted currency should then be divided by the future value in the trade currency. In figure 13.2 the FX forward rate is calculated for an FX forward contract EUR/USD with a term of 91 days. The FX spot rate EUR/USD is 1.2500, the three months euro interest rate is 2% and the three months US dollar interest rate is 1%.
Figure 13.2: Three months FX forward rate EUR/USD

1.0% / 91 days USD 1.2500 USD 1.25316

2.0% / 91 days EUR 1.0000 EUR 1.005056

FX spot rate 1.2500/1.0000 = 1.2500

FX forward rate 1.25316/1.05056 = 1.246856


The future value of 1.2500 USD (quoted currency) after three months is:
Future value of USD 1.2500 = 1.2500 ( 1 + 91 360 0.01 ) = USD 1.25316 .

The future value of one euro (base currency) after three months is:
Future value of EUR 1 = 1 ( 1 + 91 360 0.02 ) = EUR1.005056 .

The theoretical FX forward rate is calculated by dividing the future value in the quoted currency by the future value in the trade currency:
1.25316 - = 1.246856 . Forward FX rate = --------------------1.005056

The general theoretical formula to calculate an FX forward rate is:

Spot rate ( 1 + days year basis r q ) -. Forward FX rate = -----------------------------------------------------------------------------------------1 + days year basis r b

In this formula rq is the interest rate of the quoted currency and rb is the interest rate of the base currency, both for the corresponding term of the FX forward contract. In the above example, the FX forward rate is EUR/USD 1.2469 (rounded) where the FX spot rate is EUR/USD 1.2500. The difference between the FX forward rate and the FX spot rate is 0.0031, or 31 forward points. Here, the FX forward rate is lower then the FX spot rate. The euro now trades on a discount against the US dollar. If the euro interest rate would have been lower than the US dollar interest rate, the FX forward rate would have been higher than the FX spot rate. The euro would then be traded at a premium.

Value today and value tomorrow FX outrights In some cases market parties want the settlement of an FX transaction to take place at a point in time prior to the spot date, on the trading day itself (value today), for instance, or on the first subsequent business day (value tomorrow). Settlement value tomorrow is always possible, settlement value today is only possible if the systems used for the settlement of currency transactions, the payment systems of the central banks for the currencies involved, are still in operation. As with FX forward contracts, the FX spot rate is adjusted for the interest rate differential between the traded currencies.


3 FX swap

An FX swap is an OTC currency derivative with a short maturity period, whereby two parties enter into a reciprocal obligation to exchange a certain amount of two currencies on the spot date at the FX spot rate and to reverse this exchange at the FX forward rate, in the future. The exchange at the beginning of the maturity period is called the short leg, the exchange at the end of the maturity period is called the long leg. Example A bank sells a client one million euros for 1,250,000 US dollars with delivery after two business days (EUR/USD FX spot rate is 1.2500) and at the same time agrees to buy the euros back after one year at an FX forward rate of 1.2469, therefore receiving 1,246,900 US dollars. This contract is called a EUR/USD FX swap with a term of one year.

4 Settlement of FX transactions

An FX transaction is processed using two separate interbank transfers in the currencies concerned. If, for instance, a Dutch bank buys dollars from a Japanese bank for euros, the Dutch bank sends a settlement instruction for the euro amount to the ECB on the settlement day chargeable to its euro account and payable to the Japanese bank's euro correspondent bank with the Japanese bank as final beneficiary. The Japanese bank in turn sends a settlement instruction to its US correspondent bank, chargeable to its US dollar account and payable to the Dutch bank's US correspondent bank, with the Dutch bank as final beneficiary. Because the transfers in the two currencies do not take place within one and the same system, there is a risk that one party's transfer takes place without the other party's transfer taking place. This is called settlement risk. Because of the huge volume of FX transactions, banks have decided to limit this risk by founding a settlement institution for FX transactions: the CLS Bank.

4.1 The role of the CLS Bank The CLS Bank is a settlement institution that carries out transfers in the most important currencies resulting from the FX transactions of about 70 of the world's largest banks. In order to effect an FX transaction through the CLS bank, both transaction parties need to be registered with the CLS bank and both currencies need to be included in the CLS bank's currency assortment: euro, US


dollar, Japanese yen, Canadian dollar, Australian dollar, New Zealand dollar, Hong Kong dollar, Singapore dollar, Korean won, Danish crown, Swedish crown, Norwegian crown, Swiss franc, South African rand, Mexican peso, Israelian shekel. All participating banks hold an account at the CLS bank in each of the aforementioned currencies, in order to facilitate the processing of the FX transactions. The CLS bank in turn holds accounts at the central banks concerned. For instance, the CLS holds a US dollar account at the Federal Reserve Bank (FED), a Japanese yen account at The Bank of Japan and a euro account at the ECB. Banks can transfer amounts to the accounts they hold at the CLS bank using these accounts. These transfers are called 'pay-ins'. Example Barclays needs to deposit an amount in its CLS Bank US dollar account. In order to do this, it must instruct its correspondent bank JP Morgan Chase to transfer the US dollar amount to the CLS Bank's US dollar account at the FED in favour of Barclays CLS Bank US dollar account.

4.2 The settlement procedure of the CLS Bank The CLS Bank processes transfers in three phases. First, the receipt of instructions and pay-ins through the central banks, second, the internal settlement within the CLS Bank and finally the external settlement through the central banks. The interbank payment systems (TARGET2, Fedwire etc.) of all currencies involved are operational throughout these three phases.

Phase 1: the delivery of instructions and pay-ins All member banks send SWIFT messages of the FX transactions they have concluded to the CLS Bank (MT300 series). Based on all the transactions delivered, CLS Bank creates a pay-in schedule every day. This is an overview of the payment obligations in all currencies of the banks involved on account of the FX transactions they have concluded and that need to be settled on that day. The cut-off time for the notification of transactions that have to be processed on that same value date is 06:30 CET (Central European Time).

Phase 2: internal settlement within the CLS Bank The settlement of transactions subsequently takes place between 07:00 CET and 09:00 CET. For the Far East, this at the end of the afternoon and for the United States it is in the middle of the night. The CLS system processes the FX transactions on an order-to-order basis. This means that the CLS Bank processes each transaction separately, on a first in first out basis. The payment-versus-


payment principle (PVP) applies to each individual transaction. This means that the two cash flows resulting from a FX transaction take place simultaneously and that the CLS bank only debits a member's account if it is certain that another account belonging to the same member is simultaneously credited in another currency. The CLS Bank may also processes an FX transaction under certain circumstances if a bank does not have sufficient funds in a currency to be delivered. In such cases, the bank must have sufficient collateral in the form of balances in other currencies. However, the CLS Bank does not take the entire balance in other currencies into account, but subtracts a safety margin: the haircut. This is how the CLS Bank allows for possible changes in exchange rates during the day. In the case of a 15% haircut, the collateral value of a balance in another currency is equal to 85% of that balance. Example Socit Gnrale carries out an FX spot transaction with Deutsche Bank. It sells 100 million British pounds for 130 million US dollars. Settlement takes place at the CLS Bank. However, the balance on Socit Gnrale's British pound account at the CLS Bank is only GBP 75 million. The CLS Bank would therefore not carry out the transaction based on the GBP balance alone. However, Socit Gnrale has a credit balance of 100 million euros on its euro account. At a EUR/GBP exchange rate of 0.75, that is equivalent to GBP 75 million. The CLS Bank applies a 10% haircut. This means that the collateral value of the euro credit balance is equal to 90% x GBP 75 million = GBP 67.5 million. Because Socit Gnrale has sufficient collateral, the CLS Bank will execute the GBP/USD FX transaction. If a bank has sufficient collateral, the CLS Bank therefore also executes transactions that result in a debit position on an account in a certain currency. The advantage of this is that a bank does not need to transfer money immediately to the CLS Bank to make up the debit balance. That would not be efficient, because it is very possible that a debit balance on this account would be supplemented through the settlement of another transaction that is processed later in the day. This is why banks do not need to carry out pay-ins for each separate currency equal to the net amount to be transferred based on all the FX transactions they have deposited. Instead, they ensure that the account in their own currency has a surplus, in order to be able to provide the necessary collateral for possible


interim debit positions in other currencies. Settlements through the CLS bank therefore have considerably less impact on the liquidities of the members' banks than the traditional method of settlement. The CLS Bank does however impose a limit on the size of the debit balance of an account. If this limit is reached, the member bank must cover the deficit of the currency account concerned before the CLS Bank continues to process the transactions chargeable to this account. This applies regardless whether the bank concerned has sufficient collateral. A deficit can be covered in three ways: through an interim pay in to the CLS Bank, through an inside/outside swap (I/O swap) or through a today/tomorrow swap. An I/O swap is an intraday FX swap whereby one leg is completed within and the other leg is completed outside the CLS system. In order to remove a debit balance in euros, a member can conclude an I/O swap with another member in which the member buys euros within the CLS system for US dollars and sells the euros outside the CLS system for US dollars at the same rate. The second leg of the swap is settled outside the CLS bank, through the central banks' RTGS systems. A disadvantage of an I/O swap is that part of the settlement risk is being reintroduced to the parties. After all, the second leg of the swap takes place outside the CLS bank. A today/tomorrow swap is an FX swap that is settled entirely within the CLS bank. The settlement of the first leg takes place on the day the today/tomorrow swap is concluded. The settlement of the second leg takes place a day later. The advantage of a today/tomorrow swap over an I/O swap is that no settlement risk returns. The drawback of the today/tomorrow swap is that the liquidity position of both members in the two currencies is influenced for an entire day.

Phase 3: external settlement through the central banks During the final phase of the settlement process, the CLS Bank pays out the balances that are on the member banks' accounts after the internal settlement of all transactions has been completed. In order to do this, the CLS Bank instructs the central banks to debit its account there and credit the account of the member banks. These transfers are called pay-outs. The CLS bank only transfers amounts to a member after the member has covered any debit balances on its accounts. This is why the member banks still have the opportunity to make interim pay-ins during phase 3, too.


At the end of phase 3, all the accounts within the CLS bank have a zero balance. This also applies to all accounts that the CLS bank holds at the central banks. Phase 3 ends at 10:00 CET for the Asia and Pacific region and at 12:00 CET for the Europe region.


Chapter 14


Derivatives are instruments whereby the value is derived from the value of traditional instruments or the value of certain financial indicators. In every financial sub-market, derivatives are traded. In the money market, for instance, money market futures are traded. In the capital market fixed-income, amongst others, interest rate swaps are traded. And in the FX market, FX options are traded. Derivatives can be used to hedge interest or FX positions or to take open positions.

1 General features of derivatives

The instruments or indicators that the value of derivatives is derived from are called the underlying value. The underlying value is also sometimes called the reference value. The following can be agreed within a financial derivatives contract: to buy/deliver a certain financial security (possibly after an opposite initial trade) on a future date; to offset the difference between an interest rate or price that has been agreed upon in the contract and the actual interest rate or price at a certain time in the future, the fixing date; to swap the yields of two different financial instruments during a future time period; to conclude a certain transaction at a predetermined price or fixed-interest rate on a future date. The following must be recorded when concluding a derivatives contract. First, the size of the contract, which is expressed in a number of shares in the case of shares derivatives, a nominal amount in the case of interest rate derivatives and an amount of a certain currency in the case of currency derivatives. Second, the reference value, the reference value is the closing price on an exchange in the case of shares derivatives, an interest rate benchmark like EURIBOR in the case


of interest rate derivatives and an agreed exchange rate on a certain screen at a certain point in time in the case of FX derivatives. Third, who the buyer and seller are. With the exception of options, no physical selling or buying actually takes place when the derivatives contract is concluded. After all, derivatives refer to the entering into of future obligations. Even so, the terms buying and selling are used. A derivative buyer is generally the party that profits from an increase in the price/rate of the underlying value and a seller is the party that profits from a decrease. A contract price or rate should also be included in a derivatives contract. This is the price or rate that is compared to the reference value on the fixing dates or the price at which a future transaction shall be concluded as a result of the derivatives contract. Fixing dates and settlement dates must also be included in the contract. Fixing dates are the dates on which the contract price is compared to the reference value or the market price of the underlying value at that moment. Settlement dates are the dates on which the parties involved settle the calculated obligations.

2 Option

An option is a derivative for which one of the parties obtains the right to buy or deliver a certain asset; offset a difference between an interest rate or price that is fixed in the contract and the actual interest rate or price at a certain moment in the future; exchange the yields of two different financial instruments or enter into a certain transaction at a predetermined price or interest rate. The party who obtains this right is the buyer of the option. The buyer can demand that the other party, the seller, fulfils its side of the agreement. The seller, also referred to as writer, enters into a one-sided obligation without the right to demand that the buyer fulfils the opposite obligation. The selling of options is also called writing options. The predetermined rate or interest rate level at which the buyer can exercise his right is called the strike price. A right to buy the underlying value or receive an amount of money when the market price/rate of the underlying value is higher than the strike price is called a call option. A right to sell the underlying value or receive an amount of money when the market price/rate is lower than the strike price is called a put option. The date on which an option contract ends is called the expiry date.


Options can be based on a wide range of underlying values, varying from shares to CO2 emission rights. Options such as share options, interest rate instrument options and currency options are traded in just about every sub-market of the financial markets. Long-term share options are sometimes called warrants. Many financial instruments have options hidden in them. Such options are called embedded options. Some options, like share options, are traded on an exchange. Other options are traded over-the-counter, for instance the currency options that companies use for covering their currency risk. Just about all interest rate options are OTC options, too.

The settlement of options It is not possible to say in advance whether settlement will take place during the maturity period of an option or at maturity. For the purpose of option settlement, the price of the underlying instrument is compared to the exercise price. If the buyer wants to exercise the option, there are two possibilities. Either the difference between the market price and the exercise price is paid (cash settlement) or physical delivery takes place. This means that a transaction in the underlying value is created. Example An investor holds a call option General Electric with a strike of 14.00 US dollars and a contract amount of 10,000 shares. At the expiry date of the call option, the price of a the General Electric share is 15.00 US dollars. The investor now exercises his option by buying 10,000 General Electric shares at a price of 14.00 US dollars. An investor holds 1,000 put options on the FTSE 100 with a strike of 5,400. The FTSE option trades at GBP 10 per contract. At the expiry date of the put option, the FTSE is fixed at 5,200. The investor will exercise his option and will receive a cash settlement amount of 10,000 British pounds. The buyer of an exchange traded option can exercise his right at any time during the option maturity period. This means that the settlement can take place at any point in time during the option maturity period. Options to which this applies are called American-style options. Settlement of OTC currency options can only take place at the maturity date. This is called European style. Bermudan options are an intermediate form of options. They can only be exercised on a limited number of predetermined dates during the maturity period.


Part of the settlement of an option that always applies is the payment of a premium to the seller by the buyer. This premium is usually paid one business day after the signing of the contract.


A forward rate agreement (FRA) is an OTC interest rate derivative that is traded on the money market in which two parties enter into a reciprocal obligation to offset the difference between an interest rate agreed in the contract and the level of a reference interest rate - usually EURIBOR of LIBOR - once at a certain time in the future. The buyer of an FRA is the party that receives an amount of money from the other party if the reference interest rate on the fixing date is higher than the contract interest rate. The seller receives an amount of money from the buyer if the reference interest rate is lower than the contract interest rate at maturity. There are two kinds of maturity periods for FRAs: the contract maturity period and the underlying maturity period. The contract maturity period runs from the contract date to the fixing date. The underlying maturity period runs from the settlement date to maturity. The contract maturity period of a '6s vs. 9s' FRA, for instance, is six months and the underlying maturity period is three months. Example The relevant dates of a '6s vs. 9s' FRA contract that is closed on the 1st of March are: Contract date: March 1st; Fixing date: September 1st; Settlement date: September 3rd; Maturity date: December 3rd.

The settlement of an FRA The amounts involved in the settlement of an FRA are calculated on the FRA contract fixing date. Settlement takes place on the corresponding spot date, which in most cases means two workings days later (t+2). The calculation of the FRA settlement amount takes place in three steps:


1. The reference interest rate is compared with the contract interest rate. 2. The difference in interest rates is calculated as an amount over the underlying maturity period and over the principal. 3. Because the settlement date is two days after the fixing date, in stead of at the maturity date of the underlying period of the FRA, the settlement amount is discounted against the money market reference rate that corresponds with the underlying period. Example Two parties have concluded a '4 vs. 7' FRA. Maturity is in four months and the reference interest rate is the three-month EURIBOR. The contract interest rate is 3.75%. The contract principal is EUR 5,000,000. On the fixing date, the three-month EURIBOR is fixed at 3.95%. This FRA is settled as follows: 1. The difference between the contract interest rate and the reference interest rate = 0.20%. 2. The interest amount over the underlying maturity period and over the principal amount of EUR 5,000,000 is calculated: EUR 5,000,000 x 91/360 x 0.20% = EUR 2,527.78. 3. This amount is discounted using the three-month EURIBOR rate of 3.95%. The present value formula is used to achieve this: Settlement amount/(1 + days /360 x interest rate). In this case, the settlement amount is: 2,527.78/(1 + 91/360 x 0.0395) = EUR 2,502.79. The seller has to pay EUR 2,502.79 to the buyer on the settlement date.

4 Financial future

A financial future is an exchange traded financial instrument whereby two parties enter into a reciprocal obligation to buy or deliver a certain financial security at a certain point in time in the future at a predetermined price (physical delivery) or to offset the difference between the price or interest rate that is agreed upon in the futures contract and the actual price or interest rate at that point in time (cash settlement). In Europe, financial futures are mainly traded on Euronext.liffe and Eurex, the derivatives daughter markets of NYSE Euronext and Deutsche Burse, respectively.


Bought futures contracts can be sold to the exchange and sold futures contracts can be bought back from the exchange at any time during their lifetime. This is referred to as closing the futures contract or offsetting it. If a party closes a futures contract, the original contract becomes void. The last date on which trading may take place is called the expiry date. Just before the expiry date of a future with physical settlement, the market parties usually close their futures in order to avoid physical delivery. Because financial futures are exclusively traded on stock exchanges, they have standardized conditions. In the case of most futures, only a limited number of series are traded. Contract sizes are also standardized. Parties that want to conclude a futures contract need only indicate how many contracts they would like to conclude. As with options, futures have a wide range of underlying values, varying from bonds to exotic fruits. As with securities, the registration of futures is done by custodians and central securities depositories.

4.1 Shares future and index future A shares future is an exchange listed forward contract whereby shares are delivered at maturity at a predetermined price. The contract size of a shares future on Euronext, for instance, is 100 shares. In addition to futures that have a specific share as the underlying value, there are also index futures. Index futures are futures that have a price index as the underlying value. An example of such is the Dutch FTI future. An FTI future is an exchange listed forward contract whereby the difference is offset at maturity between the actual Dutch AEX Index at maturity and the AEX Index agreed upon in the futures contract. The underlying value of an FTI future is 200 times the level of the Dutch AEX Index. Example The AEX Index closes at 375. A trader expects a rise of the AEX Index and buys an FTI contract at 375. When the trader later closes this contract at 382, he makes a profit of: (382 - 375) x 200 euros = 1,400 euros.


4.2 Bond future A bond future is a stock market listed forward contract whereby Government bonds must be delivered at a predetermined price at maturity. The underlying value of a European bond future, for instance, is a notional bond with a nominal value of 100,000 euros and a coupon interest rate that was determined at the moment the future was introduced, for example 6% in the case of Bund Futures. The most common bond futures in Europe are the Bund future, Bobl future and Schatz future. The underlying value for these futures is a notional German Government bond with ten, five and two-year maturity periods, respectively, and a 6% coupon. In addition to these bond futures, there is also the German Buxl future which has a notional bond as its underlying value with a 30-year maturity period and a 4% coupon. The prices of these bond futures are used as most important benchmark for the euro capital market interest rate.

4.3 Money market future A money market future (MM future) is a future with a short-term forward rate as underlying value. An MM future is comparable to an FRA. Like FRAs, MM futures have cash settlement. The price of a money market value is expressed as 100 -/- the forward yield over the underlying period of the MM future. The price will go up if the relevant forward rate decreases and will go down if the relevant forward rate increases. A party that wants to take profit from higher interest rates therefore has to sell MM futures. This is the opposite as with FRAs. MM futures are standardized. The underlying period is often three months and the contract amounts are shown in figure 14.1.
Figure 14.1 Overview of money market futures

contract Short Sterling Eurodollar Euribor EuroYen

contract volume value of one point Reference rate GBP 500,000 US 1,000,000 EUR 1,000,000 JPY 100,000,000 GBP 12.50 USD 25.00 EUR 25.00 JPY 1.250 GBP LIBOR USD LIBOR EURIBOR JPY LIBOR


The value of one point is the change in the contract value if the underlying interest rate changes with one basis point (0.01%) using the 30/360 daycount convention. The value of one point of an Short Sterling contract, for instance, can be calculated as follows: Value of one point = 500,000 Sterling x 0.0001 x 90/360 = 12.50 Sterling. The changes in the value of futures contracts are settled with the exchange on a daily basis. This process is called margining. Example On Monday, a money market trader buys 25 month Eurodollar contracts at a price of 97.47. During the first week the closing prices of this future are Mon: 97.54, Tue: 97.42, Wed: 97.48, Thu: 97.50, Fri: 97.58. The daily margin payments are as follows:


Price movement (points) +7 -12 +6 +2 +8

Margin call

Paid by

Monday Tuesday Wednesday Thursday Friday

+7 * 25* USD 25 = USD 4,375 +6 * 25 * USD 25 = USD 3,750 +2 * 25 * USD 25 = USD 1,250 +8 * 25 * USD 25 = USD 5,000

Exchange Exchange Exchange Exchange

-12 * 25 * USD 25 = -USD 7,500 MM trader

If the MM trader is able to sell the MM futures on Monday at the opening of the exchange at a price of 97.58, his result will be USD 6,875. Since the exchange has already paid this amount to the trader during the term of the contract, no additional settlement will take place. During the lifetime of a money market future, the price is determined by the free play of demand and supply. The fixing rate on the expiry date, however, is set by the exchange. For money futures that are traded on NYSE Liffe, for instance, this rate is called exchange delivery settlement price (EDSP). The EDSP is fixed at 11.00 a.m. and is calculated as 100 -/- the British Bankers Association Interest Settlement Rate (BBAISR), which is a mean of the quotes of 16 banks for the three months money market interest rate.


5 Interest rate swap

An interest rate swap (IRS) is an OTC interest rate derivative whereby two parties enter into a reciprocal obligation to exchange interest coupon payments in the same currency during an agreed period of time without exchanging principals. Interest rate swaps are used to change the interest rate conditions of a financial instrument, usually from fixed to variable or vice versa. For the party in an interest rate swap paying the fixed-interest rate coupon, the interest rate swap is a payer's swap. For the party in the interest rate swap receiving the fixed interest rate coupon, the same interest rate swap is a receiver's swap. Sometimes it is also referred to as the buying or selling of a swap. The general rule regarding buying and selling on the financial markets applies here too: a buyer benefits from an increase in a market variable and a seller benefits from a decrease. The buyer of a swap is therefore the one that pays the fixed interest. This party benefits from an increase in the interest rate. The interest rate swap maturity periods vary from one to fifty years. The principals differ greatly. The principal for most transactions is somewhere between 1 and 100 million euros. The reference for the variable interest rate obligation of a swap in euros is usually the three or six-month EURIBOR or LIBOR rate. Sometimes the price of a swap is referred to as the fixed-interest rate level of the interest rate swap. This fixed IRS rate is determined by supply and demand on the IRS market and usually follows the market interest rate for Government bonds with a spread. The fixed-interest rate usually applies for the entire duration of the interest rate swap. In some cases, both interest rates are floating. This is the case, for instance, for an interest rate swap in which a three-month EURIBOR is swapped for a one-year EURIBOR. A swap involving the swap of two variable interest rates is called a basis swap.

IRS settlement Both the fixed and floating interest coupons in an IRS are paid in arrears. The floating coupon is usually paid every quarter or semi-annually. The floating interest rate for the next coupon period is determined two business days before the expiration of the current floating coupon period. The fixed interest rate is


usually paid at the end of each year. The amount of the fixed coupon is often offset with the floating coupon that is due on the day that the fixed coupon is paid. This is called payment netting. Example The cash flows for a payer's IRS with a principal of 10,000,000 euros and a duration of three years, in which a three-year fixed-interest rate of 3.5% is swapped with a six-month EURIBOR rate are as follows. The first EURIBOR fixing is 2.1% and the first floating coupon period is 183 days.
Period Settlement amount Receive EUR 10,000,000 x 183/360 x 0.021 = EUR 106,166.EUR 350,000 -/EUR 10,000,000 x days/360 x 6m EURIBOR2nd fixing EUR 10,000,000 x days 360 x 6m EURIBOR3rd fixing EUR 350,000 -/EUR 10,000,000 x days/360 x 6m EURIBOR4th fixing EUR 10,000,000 x days/360 x 6m EURIBOR5th fixing EUR 350,000 -/EUR 10,000,000 x days/360 x 6m EURIBOR6th fixing Settlement amount Pay -

t=0 6m 1 yr

1.5 yr 2 yr

2.5 yr 3 yr


6 Overnight index swap

An overnight index swap (OIS) is an OTC interest rate derivative whereby two parties enter into a reciprocal obligation to swap interest rate flows for a short period of time in the same currency, without exchanging principals and whereby one of the interest rate coupons is based on an overnight rate. Overnight index swaps are used to change the interest rate conditions of a money market instrument. The maximum duration of an OIS is two years. The principals are always large (e.g. at least GBP 10 million). The reference value for the daily interest rate is, for example, the EONIA or SONIA (Euro and Sterling OverNight Index Average respectively).

OIS settlement The fixed interest is determined at the start of the contract period. The daily interest rates are determined at 18.00 hours daily. Settlement takes place based on payment netting. Therefore, there is only one cash flow at maturity. The table below shows when the settlement of overnight index swaps takes place on the different money markets.
Currency GBP, CHF Japan + EUR US Settlement date maturity date (M) M+1 M+2

The coupon for the fixed leg is calculated by using the following formula: principal x days/year basis x interest rate. The floating coupon is calculated on a compounded base using to the following formula: Interest amount floating leg = Principal x ((1+1/360 x r1) x (1+1/360 x r2) x (1+3*/360 x r3) x ......x ( 1+1/360 x rn) - 1). In this formula, n stands for the last fixing date.
* on Fridays, the EONIA is fixed for the whole weekend.


Example A trader closes an OIS swap denominated in euros with a term of one week and a principal of EUR 100 million. He is paying the fixed rate of 0.95%. During the week, the EONIA fixings are as follows:
day Monday Tuesday Wednesday Thursday Friday fixing 0.95 0.98 1.01 1.02 1.04

The interest amount of the floating leg is calculated as follows: EUR 100 mio x ((1+1/360 x 0.95) x (1+1/360 x 0.98) x (1+1/360 x 1.01) x (1+1/360 x 1.02) x (1+3*/360 x 1.04)-1) = EUR 19,668.07. The fixed coupon is = EUR 100 mio x 7/360 x 0.0095 = EUR 18,472.22 On the settlement date, the trader will receive the following netted amount: EUR 19,668.07 - EUR 18,472.22 = EUR 1,195.85.

* The Friday fixing is used for all days during the weekend.


7 Non-deliverable forward

A non-deliverable forward or NDF is an OTC instrument that is traded on the currency market whereby the difference between the contract exchange rate and the spot exchange rate on the fixing date is offset on the settlement date. A nondeliverable forward (NDF) is used to hedge currency risks in currencies without a market in ordinary FX forward contracts. This is the case, for instance, for a number of Asian currencies such the Chinese yuan, the Indian rupee, the Indonesian rupiah, the Korean won, the Philippines' peso and the Taiwanese dollar. You could say that an NDF is an FX forward contract with cash settlement instead of physical delivery. In theory, the rate for an NDF is determined in the same way as the FX forward rate for an ordinary FX forward contract. In practice, however, the rate for an NDF differs from the FX forward rate due to supply and demand factors.

NDF settlement The two currencies are not actually exchanged in the agreed exchange ratio on the expiry date of an NDF contract. Instead, the difference between the contract rate and the FX spot rate on the fixing date is paid out in the hard currency. In the case of an USD/TWD contract, for instance, the settlement takes place in US dollars. Example A Spanish importer concludes a three-month NDF in EUR/CNY and hedges against an increase in the Chinese yuan. The contract size is CNY 100 million and the contract rate is 9.45. On the contract fixing date, the EUR/CNY FX spot exchange rate is 9.25. The settlement amount is calculated as the difference between a notional purchase of CNY at the contract rate and a notional sale of CNY at the FX spot exchange rate on the fixing date: 'Purchase' CNY 100 million at 9.45: EUR 10,582,010.58 'Sale' CNY 100 million at 9.25: EUR 10,810,810.81 The balance the importer receives is an amount of EUR 228,800.23.


8 Contract for difference

A contract for difference (CFD), also called an equity swap, is a swap with an undetermined maturity period whereby the total return of a share is swapped against a money market benchmark. Contracts for difference are often concluded instead of shares futures for the purpose of protecting share portfolios from falling prices. The advantage of a CFD relative to a share future is that a contract for difference has an undetermined maturity period and, therefore, does not need to be concluded repeatedly. CFDs can be traded on an exchange or over-the-counter. Large American banks like Goldman Sachs and Merrill Lynch function mainly in the role of market maker in the over-the-counter market. It is common practice for the party that concludes a CFD on an exchange or with a market maker to have the unilateral right to terminate the CFD contract.

CFD settlement No settlement takes place when a CFD is entered into. During the term of the contract, the CFD buyer periodically pays a risk-free interest rate, including a mark-up, and receives any dividends on the underlying share that may be distributed. Also normally, during the term of the contract, changes in the value of the CFD contract due to changes in the price of the underlying share are settled on a daily basis. Figure 14.2 shows the settlement flows of an CFD with a contract amount of EUR 10,000,000 / 500,000 shares. Partly, buying a CFD produces the same cash flows as investing in the share. There are both interest costs incurred and dividends received. With an CFD, however, changes in the value of the position are settled on a daily basis while a share investor would only realize his total trade result at the moment he sells his shares.


9 Cap and floor

A cap is an OTC interest rate instrument whereby a party has the right to offset the difference between an agreed interest rate level (the strike interest rate of the cap) and a reference interest rate, usually the three or six-month EURIBOR or LIBOR rate, at several future moments, if this reference rate is higher than the exercise price. One could call the cap a call option on the EURIBOR/LIBOR. In effect, a cap consists of several consecutive options with the same exercise price: caplets, also called interest rate guarantees. The buyer of a cap receives a payment if the level of the EURIBOR is higher than the strike on an expiry date of one of the options. The level of the payment is calculated by expressing the difference between the reference interest rate and the strike as a percentage. This percentage is then applied to the agreed principal and offset over the underlying period of the option concerned. If the reference interest rate on an expiry date is lower than the strike, the option concerned generates no value, it expires worthless. The options with a later expiry date are not affected in such a case and remain intact. Because a cap is an option, the buyer must pay a premium. There are two ways to pay the cap premium: up-front (one payment when concluding the cap) or amortized (spread over the duration of the cap). Example A company has closed a cap with a strike of 4.00% and a term of five years to hedge against increases in interest rates. The contract amount is 10 million US dollars en the reference rate is three months USD-LIBOR. On 13 May, the reference rate is fixed for the underlying period 15 May 2010 - 15 August 2010 (92 days). The three months USD-LIBOR fixing is 4.14%. Because the caplet is in-the-money, on 15 August, the company will receive an amount of 10,000,000 x 0.0014 x 92/360 = 3,577.78 US dollars.


Floor A floor is an OTC interest rate instrument whereby a party has the right to offset the difference between an agreed interest rate level (the strike interest rate) and the reference interest rate, usually a three or six-month EURIBOR of LIBOR, at several future moments, if this reference rate is lower than the exercise price. One could call a floor a put option on the EURIBOR/LIBOR. A floor also consists of several consecutive options with one and the same exercise price. Floors can be used by investors that have long-term variable interest rate investments and want to protect themselves from decreases in interest rates.

10 Swaption

A swaption is an OTC interest rate instrument whereby a party has the right to enter into an interest rate swap at maturity at a predetermined interest rate. A payer's swaption gives the option buyer the right to pay the long interest rate in the underlying interest rate swap. If the swap interest rate in the market at the swaptions maturity is higher than the exercise price, the buyer exercises the option and thus engages the swap. He then pays a long interest rate that is lower than the current market interest rate. The buyer can also opt for cash settlement, in which case he requests the seller of the swaption to pay out the market value of the swap on the settlement date. A receiver's swaption gives the buyer the right to conclude an interest rate swap in which he will receive the long interest rate. Example On September 2010, a company expects that it will have a long-term financing need starting on 15 September 2011 and lasting for 10 years. To hedge against increases in interest rates, the company closes a payers swaption with a contract amount of 5 million British pounds. The strike of this swaption is 4.75%. The period of the underlying swap is 15 September 2011 - 15 September 2021. On 13 September 2011, the company closes a loan agreement with the bank for an amount of 5 million British pounds and a term of 10 years. The actual IRS rate than is 5.12%. Therefore, the company exercises the swaption and closes a ten year payers IRS with a fixed rate of 4.75% against six months GBP-LIBOR with a nominal of 5 million British pounds. If the interest rate condition of the loan is six months GBP-LIBOR flat, the company has now fixed its rate for the period 15 September 2011 15 September 2021 at a level of 4.75%.



A access control 93 accounting entry generator (EAG) 92 actual/360 103 add-on for potential future exposure (PFE) 28 American style option 139 arranger 118 Asset & Liability Committee (ALM) 4 asset-backed security (ABS) 115 assignment 77 authorization 39 B back office 7 back test 23 back office system 90 bank bill 107 bank holiday 65 banker's acceptance 107 base currency 128 base prospectus 119 basis point value limit 20 Bermudan option 139 bond basis 102 bond future 143 bond indenture 119 broker 14 brokerage control 38 business continuity plan 95 buyer of the option 138 buy-in procedure 76 C calculation agent 43 call option 138 cap 151 caplet 151 cash management 2 cash settlement 139 central counterparty 14 central securities depository (CSD) 67 certificate of deposit 107

choice dividend 123 clean price 114 cleansing 122 clearing custodian 80 clearing fund 77 clearing member 73 clearing system 60 client advisor 5 close-out netting 31 callable note 116 collateral 29 commercial paper 106 compensation 88 compliance officer 12 confirmation 44 contract for difference 150 contractual netting 31 convertible bond 117 corporate actions 120 correspondent bank 58 cost of carry 36 cost of fund 3 covered bond 116 credit committee 27 credit limit 27 credit spread sensitivity limit 20 cum date 125 curve policy 34 custodian reconciliation 86 customer due diligence 25 cut-off time 48 D daycount convention 100 daycount fraction 98 dealer 118 dealing room 6 dedicated control 12 delivery risk 28 delivery versus payment (DVP) 70 deposit 97 debt issuance programme (DIP) 111


dirty price 114 disaster recovery plan 95 dual control 12 duty of care 5 E EBS 15 embedded option 139 end-of-month (EOM) 99 EONIA 108 Eurepo 108 EURIBOR 108 equity swap 150 ESES 67 Euro1 60 European style option 139 event calendar 51 event risk limit 20 exchange 13 exchange rate 127 expiry date 139 exposure at default (EAD) 28 F fallen angel 117 FATF 26 finance department 10 financial future 141 fixed-income security 110 fixing date 138 floating rate note (FRN) 115 floor 152 following 98 foreign exchange market 127 forward rate agreement 140 free of payment (FOP) 70 front office 7 front office system 89 FTI future 142 fund manager 2 funds entrusted 3 FX forward 129 FX risk management 3 FX spot 127 FX swap 132

G general clearing member 73 global custodian 81 global note 68 good settlement value 48 Greek limit 20 H haircut 31 high yielders 113 hypothetical P&L 23 international central securities depository (ICSD) 71 internal control 11 independent price verification (IPV) 34 index futures 142 index-linked bond 117 individual clearing member 73 inflation-linked bond 117 initial consideration 105 initial margin 76 inside/outside swap 135 integrity 94 interbank funding 3 interest rate guarantee 151 interest rate risk management 4 interest rate swap 145 intermediary bank 58 Internal Audit Service 12 investigations 86 investment banking 1 investment grade 113 investment risk 27 ISDAFIX 112 international securities identification code (ISIN) 68 issue syndicate 118 issuer notice 121 J junior loan 116 junk bond 117 K key staff exposure 11


L lending programme 1191 lending risk 27 limit control sheet (LCS) 18 liquidity 114 local custodian 81 long leg of an FX swap 132 loro account 57 low value payment 60 M mandatory cash reserve 2 mandatory corporate action 121 margin 78 margin call 78 market risk 19 maturity consideration 105 merchant banking 1 model reserves 35 modified following 98 money market 97 money market future 143 money market loan 97 money market paper 106 money market risk 27 multilateral netting 32 multilateral trading facility (MTF) 14 N netting 14 netting by novation 31 new product approval process 17 note issuance facility (NIF) 111 nominal limit 20 nominal value of a bond 111 non deliverable forward 149 nostro account 58 nostro reconciliation 85 O off-market price testing 33 operational audit 12 operational risk 16 operations control 85 option 138

overnight swap index (OSI) 108 overnight index swap 147 over-the-counter market (OTC market) 14 P payer's swap 145 pay-in schedule 133 paying agent 118 payment-versus-payment principle 134 pending transactions 125 perpetual 116 physical delivery 139 plain vanillas 7 political risk 114 position 4 positions limit 20 post-trade transparency 13 pre-settlement risk 28 pre-trade compliance 40 private equity 109 proprietary trading 4 put option 139 putable note 116 Q quoted currency 128 R rating 113 reasonability check 44 receiver's swap 145 reconciliation 85 reference value 137 replacement risk 28 repo 105 repo at notice 105 repurchase agreement 105 Reuters dealing 3000 15 reverse repo 105 rights issue 123 risk premium 113 RTGS system 59


S sales 5 seasoned issue 69 securities lending 110 self-control 12 sell-out procedure 76 settlement 48 settlement date 48 settlement instruction 48 settlement risk 28 share 109 short leg 132 slope risk limit 20 SNA 46 special purpose vehicle 115 spread 113 standard data table 91 standard settlement instructions (SSI) 49 standing data files 91 static data 91 stock dividend 123 stock split 124 straight-through processing (STP) 39 strike price 138 structure ID 54 structured products group 55 subordinated loan 116 swap points130 swaption 152 systematic internalization 15 T tenor 100 threshold 29 today/tomorrow swap 135 trader 4 trading limit 19 trading system 13 transparency before the trade 14 Treasury bill 107 U underlying value 137

V value at risk limit 21 value date 48 value today 131 value tomorrow 131 variation margin 78 verification 43 voluntary corporate action 121 Y yield of a bond 112 yield of commercial paper 106

Z zero coupon bond 117