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Management

of Operational

Risk in Foreign Exchange


The Foreign Exchange Committee
November 2004
2 FOREIGN EXCHANGE COMMITTEE
Table of Contents
Introduction .....................................5 Best Practice no. 15: Be Diligent When
The FX Marketplace ..........................................5 Confirming Structured or Nonstandard Trades..23
The Changing Marketplace...............................5 Best Practice no. 16: Be Diligent When
The History of This Document .........................6 Confirming by Telephone.............................24
What Is Operational Risk? ................................6 Best Practice no. 17: Institute Controls
What Are “Best Practices”?................................7 for Trades Transacted through Electronic
How to Use This Document.............................8 Trading Platforms ..........................................24
Future Trends.....................................................8 Best Practice no. 18: Verify Expected
Figure 1 —The FX Process Flow..........................9 Settlement Instructions.................................25
Definitions of Key Terms...................................9 Best Practice no. 19: Confirm All Netted
Transactions...................................................25
Pre-Trade Preparation Best Practice no. 20: Confirm All Internal
and Documentation .........................10 Transactions...................................................25
Process Description ........................................10 Best Practice no. 21: Confirm All Block
Best Practice no. 1: Know Your Customer .........11 Trades and Split Allocations .........................26
Best Practice no. 2: Determine Best Practice no. 22: Review Third-Party Advices ...26
Documentation Requirements......................11 Best Practice no. 23: Automate the
Best Practice no. 3: Use Master Netting Confirmation Matching Process ...................27
Agreements....................................................12 Best Practice no. 24: Establish Exception
Best Practice no. 4: Agree upon Trading Processing and Escalation Procedures.........28
and Operational Practices.............................13
Best Practice no. 5: Agree upon and Document Netting ...........................................29
Special Arrangements ...................................14 Process Description ........................................29
Best Practice no. 25: Use Online
Trade Capture .................................15 Settlement Netting Systems .........................29
Process Description .........................................15 Best Practice no. 26: Confirm Bilateral Net
Best Practice no. 6: Enter Trades Amounts........................................................30
in a Timely Manner .......................................16 Best Practice no. 27: Employ Timely
Best Practice no. 7: Use Straight-Through Cutoffs for Netting ........................................30
Processing......................................................16 Best Practice no. 28: Establish Consistency
Best Practice no. 8: Use Real-Time Credit between Operational Practices
Monitoring .....................................................17 and Documentation.....................................30
Best Practice no. 9: Use Standing
Settlement Instructions..................................17 Settlement ......................................31
Best Practice no. 10: Operations Should Be Process Description .........................................31
Responsible for Settlement Instructions ......18 Best Practice no. 29: Use Real-Time Nostro
Best Practice no. 11: Review Amendments .......18 Balance Projections ......................................32
Best Practice no. 12: Closely Monitor Best Practice no. 30: Use Electronic
Off-Market and Deep-in-the-Money Messages for Expected Receipts ..................32
Option Transactions ......................................19 Best Practice no. 31: Use Automated
Cancellation and Amendment Facilities ......33
Confirmation...................................20 Best Practice no. 32: Implement Timely
Process Description........................................20 Payment Cutoffs ............................................33
Best Practice no. 13: Confirm and Affirm Best Practice no. 33: Report Payment
Trades in a Timely Manner ...........................22 Failures to Credit Officers .............................33
Best Practice no. 14: Be Diligent When
Confirming by Nonsecure Means ................22

MANAGEMENT OF OPERATIONAL RISK IN FOREIGN EXCHANGE 3


Best Practice no. 34: Understand the Settlement Best Practice no. 51: Identify Procedures for
Process and Settlement Exposure ................34 Introducing New Products, New Customer
Best Practice no. 35: Prepare for Crisis Types, or New Trading Strategies .................43
Situations Outside Your Organization .........34 Best Practice no. 52: Ensure Proper
Model Sign-off and Implementation ...........44
Nostro Reconciliation......................35 Best Practice no. 53: Control System Access ...44
Process Description ........................................35 Best Practice no. 54: Establish Strong
Best Practice no. 36: Perform Timely Independent Audit/Risk Control Groups....44
Nostro Account Reconciliation....................36 Best Practice no. 55: Use Internal and External
Best Practice no. 37: Automate Nostro Operational Performance Measures............45
Reconciliations .............................................36 Best Practice no. 56: Ensure That Service
Best Practice no. 38: Identify Nonreceipt Outsourcing Conforms to Industry
of Payments...................................................36 Standards and Best Practices........................45
Best Practice no. 39: Establish Operational Best Practice no. 57: Implement Globally
Standards for Nostro Account Users............37 Consistent Processing Standards..................45
Accounting/Financial Control ...........37 Best Practice no. 58: Maintain Records
Process Description ........................................37 of Deal Execution and Confirmations .........46
Best Practice no. 40: Conduct Daily General Best Practice no. 59: Maintain Procedures
Ledger Reconciliation...................................38 for Retaining Transaction Records ...............46
Best Practice no. 41: Conduct Daily Best Practice no. 60: Develop and Test
Position and P&L Reconciliation..................38 Contingency Plans ........................................47
Best Practice no. 42: Conduct Daily Conclusion ......................................49
Position Valuation.........................................39
Best Practice no. 43: Review Trade Acknowledgments ...........................50
Prices for Off-Market Rates ..........................40
Best Practice no. 44: Use Straight-Through Works Consulted .............................51
Processing of Rates and Prices.....................40 Best Practices Map
Unique Features of Foreign to 1996 Version of Checklist ............52
Exchange Options and
Non-Deliverable Forwards .................40
Process Description........................................40
Best Practice no. 45: Establish Clear Policies
and Procedures for the Exercise of Options....41
Best Practice no. 46: Obtain Appropriate
Fixings for Nonstandard Transactions ...........41
Best Practice no. 47: Closely Monitor
Option Settlements .......................................41
General Best Practices .....................42
Process Description ........................................42
Best Practice no. 48: Ensure Segregation
of Duties........................................................42
Best Practice no. 49: Ensure That Staff
Understand Business and
Operational Roles.........................................42
Best Practice no. 50: Understand
Operational Risks..........................................43

4 FOREIGN EXCHANGE COMMITTEE


Management
of Operational

Risk in Foreign Exchange


Introduction
The FX Marketplace
The foreign exchange (FX) market is the largest and most liquid sector of the global
economy. According to the 2004 Triennial Survey conducted by the Bank for
International Settlements, FX turnover averages $1.9 trillion per day in the cash
exchange market and an additional $1.2 trillion per day in the over-the-counter
(OTC) FX and interest rate derivatives market.1 The FX market serves as the primary
mechanism for making payments across borders, transferring funds, and determining
exchange rates between different national currencies.

The Changing Marketplace


Over the last decade, the FX market has become more diverse as well as much larger.
Although in the past, commercial banks dominated the market, today participants
also include commercial as well as investment banks, FX dealers and brokerage
companies, multinational corporations, money managers, commodity trading
advisors, insurance companies, governments, central banks, pension and hedge
funds, investment companies, brokers/dealers, and other participants in the inter-
dealer market. In addition, the size of the FX market has grown as the economy has
continued to globalize. The value of transactions that are settled globally each day
has risen exponentially—from $1 billion in 1974 to $1.9 trillion in 2004.

The increased complexity of the market and higher trade volumes have
necessitated constant changes in trading procedures, trade capture systems,
operational procedures, and risk management tools. A number of changes have also

5
affected the FX market more broadly over the The History of This Document
last few years. Those changes include In 1995, the Foreign Exchange Committee (the

 introduction of the euro, Committee) recognized the need for a check-


list of best practices that could aid industry
 increased consolidation of both FX dealers leaders as they develop internal guidelines
and procedures to foster improvement in the
and nostro banks, resulting in market-
place consolidation, quality of risk management. The original version

 consolidation of FX processing in global of Management of Operational Risk in Foreign


Exchange was published in 1996 by the
or regional processing centers, Committee’s Operations Managers Working
 outsourcing of back office functions, Group to serve as a resource for firms as they

 introduction of CLS Bank in order to


periodically evaluate their policies and proce-
dures to manage operational risks properly.
substantially reduce FX settlement risk, This update, written in 2003 by the working
 increased focus on crisis management and group listed at the end of this document, takes
into account market practices that have
contingency planning in the wake of several
currency crises and the destruction of the evolved since the paper’s original publication
World Trade Center in New York City, and supercedes previous recommendations

 increased focus on “know your customer”


by the Committee on operational issues.

anti-money-laundering efforts and other In addition to this document, the


regulatory requirements to limit access by Committee has often offered recommen-
terrorists to worldwide clearing systems, dations on specific issues related to
 increasing use of web portals for FX trans- operational risk. Although the best practices
here are directed at FX dealers primarily, the
actions,

 expansion of prime brokerage, and


Committee has also offered guidance to other
market participants. Such guidance is

 regulatory focus on capital allocations for mentioned periodically in the best practices
here and may also be found at the Committee’s
operational risk.
website, <www.newyorkfed.org/fxc/>.
Developments like these make it crucial
that operations, operational technology, and What Is Operational Risk?
settlement risk management keep pace with Operational risk is the risk of direct or indirect
the changing FX market. loss resulting from inadequate or failed inter-
nal procedures, people, and systems, or from
external events.2 For the purposes of this

1 Bankfor International Settlements, Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity 2004 (Basel: BIS, 2004).
2 Bankfor International Settlements, Basel Committee on Banking Supervision, Operational Risk Supporting Documentation to the New Basel
Capital Accord (Basel: BIS, 2002), p. 2.

6 FOREIGN EXCHANGE COMMITTEE


paper, we adopt this definition of operational Operational risk has another distinctive
risk put forth by the Bank for International quality. Unlike credit and market risk,
Settlements. However, while reputational risk operational risk is very difficult to quantify.
is not considered part of operational risk for Clearly, an institution can measure some of
Basel capital purposes, the importance of the losses associated with operational errors
reputational risk in foreign exchange is reflected or losses that result from the failure of the
in the best practices outlined in this document. operational process to catch errors made by
Operational risk for foreign exchange in sales and trading areas. Determining
particular involves problems with processing, expected losses, however, given the
product pricing, and valuation. These uncertainty surrounding those losses, is much
problems can result from a variety of causes, more complicated for operational risks than
including natural disasters, which can cause for other risk categories.
the loss of a primary trading site, or a change
in the financial details of the trade or
settlement instructions on a FX transaction. What Are “Best Practices”?
Operational risk may also emanate from poor This document offers a collection of practices
planning and procedures, inadequate that may mitigate some of the operational
systems, failure to properly supervise staff, risks that are specific to the FX industry. The
defective controls, fraud, and human error.3 implementation of these practices may also
help to reduce the level of risk in the FX market
Failure to adequately manage operational more generally. Finally, acceptance of these
risk, in turn, can decrease a firm’s profitability. practices may help reduce operational costs.
Incorrect settlement of FX transactions, for
When robust controls are in place, less time
example, can have direct costs in improper
and energy is needed to investigate and
payments and receipts. In addition, trade
address operational problems.
processing and settlement errors can lead to
indirect costs, such as compensation payments
The best practices in this document are
to counterparts for failed settlements or the
already used to varying degrees by the
development of large losses in a firm’s portfolio
as a result of managing the wrong position. working group members responsible for this
Furthermore, investigating problems and paper. Collectively, the working group feels
negotiating a resolution with a counterparty that these are practices toward which all
may carry additional costs. Failure to manage market participants should strive. Therefore,
operational risk may also harm a firm’s this compilation is meant to provide a
reputation and contribute to a loss of business. checklist for organizations new to the market,

3 ForeignExchange Committee, “Guidelines for the Management of FX Trading Activities,” in The Foreign Exchange Committee 2000 Annual
Report (New York: Federal Reserve Bank of New York, 2001), p. 69.

MANAGEMENT OF OPERATIONAL RISK IN FOREIGN EXCHANGE 7


but it is also designed to serve as a tool for FX process flow is outlined in Figure 1 below.
established market participants as they Each section of this paper provides a process
periodically review the integrity of their description of the steps involved in the trade
operating procedures. Each firm is phase discussed in that section, followed by a
encouraged to take into account its own list of best practices specific to that phase. The
unique characteristics, such as transaction paper concludes with a list of general best
volume and role in the market, as it makes use practices that apply more widely to the overall
of the recommendations. These best practices management of operational risk, including
are intended as goals, not binding rules. guidance for contingency planning.

The best practices listed here are This document concentrates on some of
recommendations that all parties engaging in the most common areas where operational
FX, regardless of the institution’s size or role in risk arises in the various stages of the FX
the marketplace, should consider adopting for process. Often operational errors result from
both internal (with the exception of practices a breakdown in the information flow in the
that are inapplicable such as credit sequential steps of the process. To avoid such
management and documentation) and problems, it is essential that market
external transactions. In addition, it is clear that participants clearly understand each of the
the larger the participant, the more important seven stages of FX trade and settlement, and
it is to implement the recommendations in the fully comprehend how each phase is related
most automated manner possible. Smaller to the larger process flow. A break in the
participants should make sure that they have process, especially in the feedback loop, may
appropriate controls in place for any best lead to a breakdown in the flow of
practice that proves too expensive to information, which in turn increases the
automate. Given the differences in the size of potential for financial loss. Proper
firms, it may be helpful to underscore that procedures, including those concerning
firms are not bound to integrate all of the escalation and notification, should be in
recommended practices in this document, place for management to deal with problems
but should use them as a benchmark for wherever they occur in the process flow.
examining their existing practices.
Future Trends
How to Use This Document It is important to acknowledge at the outset
This document is divided into sections based that the FX business is constantly evolving.
on the seven steps of the FX trade process flow Technology continues to advance, trading
1) pre-trade preparation, 2) trade capture, volume in emerging market currencies continues
3) confirmation, 4) netting, 5) settlement, to increase, new exotic structures are continually
6) nostro reconciliation, and 7) accounting/ introduced, and many institutions are region-
financial control processes. How each of these alizing their sales and trading and operations
seven phases integrates with the others in the areas by creating small satellite offices. Some

8 FOREIGN EXCHANGE COMMITTEE


Figure 1
The FX Process Flow
Accounting/Financial Control

Pre-Trade Trade Netting Nostro


Preparation Confirmation Settlement
Capture Reconciliation

Problem Investigation and Resolution

Management
Management and Exception Reports

of the major trends that will continue to affect


FX operational risk are as follows:
 New types of clients continue to enter the
FX market, which require development of
 Technology continues to advance rapidly, new operational procedures.
enabling traders and salespeople to execute All of these trends, and many others, will
many more transactions during periods of
continue to change the industry, eliminating
market volatility.
some risks and introducing new ones. It is
 Systems are becoming more standard- imperative that management thoroughly
ized, and will use new communication understands the operations cycle and best
formats (for example, XML protocol). practices surrounding operational risk

 Trading volume in emerging market


management to manage risks properly as the
FX marketplace continues to evolve.
currencies continues to grow as many
developing nations become more active
in international capital markets. This Definitions of Key Terms
increase in volume is coupled with new To clarify terms used in this document:
and problematic settlement procedures
for these currencies. Bank refers here to all market makers in FX,
 Traders and salespeople continue to whether commercial or investment banks.
develop new and more exotic types of
From a bank’s viewpoint all deals are
transactions, especially in FX derivative
products. These require special, often conducted with a counterparty, which can
manual, processing by operations groups be another bank, or a corporate, institutional,
until new transaction types can be included or retail client. The concepts in this document
in the main processing cycle. apply to all such market participants.

MANAGEMENT OF OPERATIONAL RISK IN FOREIGN EXCHANGE 9


Sales and trading refers to the front office. P&L refers to the profit and loss record of a
Trading employees execute customer orders portfolio or transaction.
and take positions; they may act as a market
maker, dealer, proprietary trader, intermediary, Prime brokerage describes an arrangement that
or end user. A bank may also have a sales force allows customers to conduct FX transactions (spot,
or marketing staff, which is part of the front forward, and options) in the name of a bank or
office. Salespersons receive price quotes from “prime broker.” In a typical prime brokerage
the bank’s trading staff and present market arrangement, the customer chooses one or two
opportunities to current and potential clients. prime brokers to service their account. The
prime broker’s responsibility is to set up docu-
Operations is used throughout this docu- mentation and procedures that allow the
ment when referring to the processing, settle- customer to conduct FX transactions directly
ment, back-office, or middle-office areas. with several counterparties, but in the name of
Specifically, operations provide support service the prime broker. These executing counter-
to sales and trading. parties recognize the prime broker as their legal
counterparty in such trades. The prime broker
Interdealer refers to trading between market enters into equal and opposite trades with the
makers. customer and executing counterparties. Specific
procedures are agreed upon among the cus-
Nostro bank, correspondent bank, agent
tomer, prime broker, and executing counter-
bank, and clearing bank are used inter-
parties to effectuate the trading and “give up”
changeably here. A bank may use the services
relationships. The prime broker typically
of one or more affiliated or unaffiliated nostro
charges the customer a fee for prime brokerage.
banks to make and receive payments, or it
may act as its own nostro bank. Banks gener-
ally use a different nostro bank for each cur- Pre-Trade Preparation
rency that they trade. and Documentation
Vanilla options refers to options that are Process Description
standard in the industry. In other words, vanil- The pre-trade preparation and documenta-
la options are European style and expire at tion process initiates the business relationship
an agreed date and time and have no fixing between two parties. During this process,
or averaging of the strike price. both parties’ needs and business practices
should be established. An understanding of
Nonvanilla options generally refer to options each counterparty’s trading characteristics and
that have a fixing or averaging component or level of technical sophistication should also
are part of a structured (combination) option develop. In summary, the pre-trade process
type, for example, average rate options. Any allows both parties to mutually agree on
currency option that is not vanilla is consid- procedures and practices to ensure that business
ered nonvanilla, ranging from American style is conducted in a safe and sound manner.
options to heavily structured options.

10 FOREIGN EXCHANGE COMMITTEE


In the pre-trade process, a bank develops response has been to develop laws and
an understanding of the inherent business regulations requiring institutions to establish
risks and risk mitigants of each of its counter- familiarity with each of their counterparties to
party relationships. The documentation and better identify and report suspicious activity.
agreements reflecting the relationship should
be identified and, if possible, executed At a minimum, information relating to
before trading. Thus, pre-trade preparation the identity of a counterparty and the
involves coordination with sales and trading counterparty’s activity should be gathered to
and operations as well as other support areas satisfy applicable laws and regulations for
such as systems, credit, legal, and compliance prudent business conduct. The reputation
to establish trade capture parameters and and legal risk to banks of not being vigilant in
requirements that should be in place prior to knowing their customers and complying with
trading. This process is especially important KYC laws and regulations can be severe. In
when the business requirements may be the United States, examples of laws and
unique and require additional controls. regulations that impose obligations of this sort
on banks are the Bank Secrecy Act, money
laundering regulations, U.S. Treasury, Office of
Best Practice no. 1: Foreign Assets Control (OFAC) regulations,
Know Your Customer
and the USA PATRIOT Act.
A bank should know the identity of its
counterparties, the activities they intend to
undertake with the bank, and why they are Best Practice no. 2:
undertaking those activities. Determine Documentation
Requirements
All firms should have strong Know Your A bank should determine its documentation
Customer (KYC) procedures for collecting requirements in advance of trading and know
information required to understand who the whether or not those requirements have been
customer is and why they are conducting met prior to trading.
business. KYC procedures have long been the
first line of defense for banks in setting A bank should execute transactions only if
appropriate credit limits, determining the it has the proper documentation in place. The
most appropriate documentation for the types of documentation that may be required
activities being contemplated, identifying include 1) master agreements (see Best
additional business opportunities, and Practice no. 3), 2) authorized signatory lists,
protecting against fraud. and 3) standard settlement instructions. Such
documents should be routinely checked
KYC procedures have, more recently, also before executing trades. An institution should
become the cornerstone for combating also establish a policy on whether or not it will
criminal activity. Illicit activity has become trade, and in what circumstances, without first
more sophisticated in the methods used to obtaining a master agreement (for example,
conceal and move proceeds. The global IFEMA, ICOM, FEOMA, or the ISDA Master)

MANAGEMENT OF OPERATIONAL RISK IN FOREIGN EXCHANGE 11


with a customer covering the transactions. It any missing master agreements. Such reports
should also be noted that electronic trading should classify data by age and be distributed
often requires special documentation. to management. Lastly, there should be
Specifically, customer and user identification escalation and support procedures in place
procedures, as well as security procedures, for dealing with missing documentation when
should be documented. normal efforts are not enough to obtain it.

This recommendation emphasizes the


Best Practice no. 3:
principles of awareness and information with
Use Master Netting Agreements
respect to documentation. In practice, it may If a bank elects to use a master agreement with a
be difficult to do business with a policy that counterparty, the master agreement should
requires documentation to be in place in contain legally enforceable provisions for
every instance. In many cases, the risks of not “closeout” netting and settlement netting.
having a particular piece of documentation
may be acceptable. Nonetheless, it is crucial “Closeout” and settlement netting
that all relevant personnel 1) know the policy provisions in master agreements permit a bank
of the institution on documentation, 2) know to decrease credit exposures, increase
business with existing counterparties, and
when the documentation is or is not in place,
decrease the need for credit support of
and 3) be able to produce reports regarding
counterparty obligations.4 Closeout netting
documentation status.
clauses provide for 1) appropriate events of
default, including default upon insolvency or
Representatives of the business, opera-
bankruptcy, 2) immediate closeout of all
tions, credit, legal, and compliance areas, for
covered transactions, and 3) the calculation of
example, need to establish the institution’s
a single net obligation from unrealized gains
policies and document their understanding of
and losses. Closeout provisions have the
these policies in writing. The institution added benefit of a positive balance sheet effect
should have adequate tracking systems under Financial Accounting Standards Board
(manual or other) to determine when policy (FASB) Interpretation 39, which allows the
requirements are satisfied or not. These netting of assets and liabilities in the unrealized
systems should be able to produce reports gains and losses account if netting is legally
necessary for proper contract monitoring. enforceable in the relevant jurisdiction.5

If the policy of the institution is to have a Closeout netting provisions help to protect a
master agreement in place, the institution bank in the event of a counterparty default.
should be able to produce a report displaying When a counterparty defaults, and a closeout

4 U.S. Comptroller of the Currency, Banking Circular 277 (Washington, D.C.: GPO, 1993), p. 22.
5 Financial Accounting Standards Board, FASB Interpretation No. 39: Offsetting of Amounts Related to Certain Contracts: An Interpretation of
APB Opinion No. 10 and FASB Statement No.105, (FASB, March 1992), and FASB Statement No. 105: Disclosure of Information about Financial
Instruments with Off-Balance-Sheet Risk and Financial Instruments with Concentrations of Credit Risk, (FASB, March 1990).

12 FOREIGN EXCHANGE COMMITTEE


netting agreement is not in place, the
bankruptcy trustee of the defaulting party may
 IFEMA Agreement covering spot and
forward currency transactions
demand payment on all contracts that
are in-the-money and refuse to pay on those  ICOM Agreement covering currency
where it is out-of-the-money. If the defaulting options
counterparty takes this action, the non-
defaulting party may be left with a larger-than-
 FEOMA Agreement covering spot and
forward currency transactions and currency
expected loss. A master agreement signed by options
both parties with enforceable closeout netting
provisions ensures that the counterparty These netting provisions should satisfy
remains responsible for all existing contracts relevant accounting and regulatory standards as
and not just those it chooses to endorse.6 long as legal opinions are able to conclude that
the agreements are legally enforceable in each
Settlement netting permits parties to settle jurisdiction in which they are applied. Banks
multiple trades with a counterparty with only should confer with local legal counsel in all
one payment instead of settling each trade relevant jurisdictions to ensure that netting
individually with separate payments. provisions are enforceable. To the extent that
Consequently, settlement netting decreases local counsel suggests that certain provisions of
operational risk to the bank in addition to a master netting agreement may be unenforce-
reducing settlement risk. To realize the able, the bank should ensure that other
settlement netting benefits, however, a bank’s provisions in the agreement could be enforced
operations function must commence settling nonetheless.
on a net basis. Therefore, it is essential that
operations receive a copy of the agreement
Best Practice no. 4:
or be notified of the terms of the executed
Agree upon Trading and Operational
agreement. Given the benefits of settlement Practices
netting, it is in a bank’s best interest to include Trading and operational practices should be
settlement netting in any master agreement established with all counterparties.
that it may enter into.
Most banks reach an understanding with all
The following master agreements have counterparties as to the type of business they
been developed as industry-standard forms. will be transacting and how they should
Each form includes provisions for settlement interact. Banks should include key
netting (included as an optional term) and operational practices such as providing timely
closeout netting: confirmation or affirmation, the use of
 ISDA Master Agreement standing settlement instructions (SSIs), and
timely notification of splits.

6 Group of Thirty, Global Derivatives Study Group, Derivatives: Practices and Principles (Group of Thirty, 1993), p.16.

MANAGEMENT OF OPERATIONAL RISK IN FOREIGN EXCHANGE 13


The level of trading activity with fund Counterparties at times may request third-
managers and investment advisors has party payments to facilitate underlying
escalated in recent years. These clients transact commercial transactions. Third-party
in block or bulk trades, which are then split into payments are the transfer of funds in
smaller amounts and entered into specific settlement of a FX transaction to the account
client accounts managed by fund managers or of an entity other than that of the
investment advisors. Until a block or bulk trade counterparty to the transaction. However,
is properly allocated to the specific accounts of third-party payments raise important issues
each fund entity, inaccurate credit risk
that need to be closely considered by an
management information may exist.
organization engaged in such practices.
The understanding should clearly establish
Firms should recognize that third-party
confirmation and settlement procedures for
payments cause a significant increase in
all counterparties and delineate both the
operational risk. Since the identity and
bank and client’s obligations in the process
flow. A bank should strongly encourage clients entitlement of the third party is not known to
to confirm bulk trades as soon as possible after the bank, extreme care should be taken in
the trade is executed.7 In addition, a bank verifying payment instructions to third parties.
should request that fund managers provide Regulatory requirements such as the USA
them with the “split” information on the trade PATRIOT Act, OFAC, and the Bank Secrecy Act
date for all trade types (spot, forwards, swaps, should also be applied to third parties. Both
tom/next, etc.) regardless of maturity, so that the counterparty and bank management
the bank’s credit information can be updated should be aware of the risks involved with
as soon as possible. these transactions and should establish clear
procedures beforehand for validating both the
Best Practice no. 5: authenticity and correctness of such requests.
Agree upon and Document Special
Arrangements Prime brokerage arrangements may also
If, in the course of the documentation set-up and involve special occasions for misunderstanding
establishment of trade and operational the respective rights and obligations of the
practices, it becomes clear that a counterparty various parties. Such arrangements should be
requires special arrangements—such as third- evidenced by written agreements (prime
party payments or prime brokerage service— broker and dealer, prime broker and customer,
those arrangements should be agreed upon and dealer and customer) that have been reviewed
documented in advance of trading. and approved by legal counsel.

7 For further information, see Best Practice no. 21, Confirm All Block Trades and Split Allocations.

14 FOREIGN EXCHANGE COMMITTEE


Trade Capture appropriate settlement instructions are
captured so that the required confirmation
Process Description message can be issued. For interbank,
The trade capture function is the second institutional, and corporate counterparties
phase of the FX processing flow. Deals may be with Standard Settlement Instructions (SSIs)
transacted directly over a recorded phone on file, the deal is immediately moved to the
line, through a voice broker, via an electronic
confirmation process.
matching system (for example EBS and
Reuters), or through Internet based systems However, if SSIs are overwritten or not in
(for example, proprietary trading systems or place, operations staff must obtain
multidealer trading platforms). settlement instructions from the
counterparty or confirm the settlement
After the deal is executed, the trader, or
instructions received by sales and trading.
trader’s assistant, inputs trade data into the
For forward trades that are not settled until
front-office system or writes a ticket to be
sometime in the future, operations staff may
entered into a bank’s operations system.
contact the counterparty at a later date for
Deals done over electronic dealing systems
settlement instructions. The financial details
such as Reuters or EBS allow deal information
to flow electronically to the front-office of the deal, however, must be confirmed on
system. Trade information typically includes the trade date. If deals need to be amended,
trade date, time of trade, settlement date, changes should be implemented in a
counterparty, financial instrument traded, controlled manner involving both sales and
amount transacted, price or rate, and may trading and operations.
include settlement instructions.
Fund managers and investment advisors
The system used in the front-office frequently trade for more than one underlying
processes this information and can provide fund or counterparty at once. Typically, they
“real-time” position and profit and loss transact a single “block” or “bulk” trade, which
updates. Trade information captured in the they then “split” into a series of smaller trades
front office system flows to the credit system as they allocate the block trade to the
where settlement risk and mark-to-market underlying funds or counterparties.
(also referred to as pre-settlement) credit risk Operations staff needs to receive split
measures and limits are updated. information soon after trade execution to issue
confirmations for each of the split transactions.
Trade information from front-office
systems flows through to the operations Inaccurate or untimely trade capture can
system, where it is posted to sub-ledger have implications for P&L and risk management
accounts, and the general ledger is updated for a bank. If a bank does not capture the
as trades are processed. Operations staff correct transaction, then its positions and
should be responsible for ensuring that reported credit exposure will be incorrect.

MANAGEMENT OF OPERATIONAL RISK IN FOREIGN EXCHANGE 15


Best Practice no. 6: reputation of the bank. Further, if credit
Enter Trades in a Timely Manner positions are not properly updated, the bank
All trades, external and internal, should be may take on more risk to a counterparty,
entered immediately and be accessible for both industry, or country than would be prudent.
sales and trading and operations processing as
soon as they are executed. In addition, it is important to note that
internal trades should be subject to the same
It is crucial that all trades are entered degree of diligence as external trades in terms
immediately so that all systems and processes of timely entry because they carry the same
are provided with timely, updated risks (with the exception of credit risk).
information. No matter how sophisticated the
system, data may not be accurate if users enter
Best Practice no. 7:
it incorrectly or delay its entry. For that reason, Use Straight-Through Processing
it is important to ensure that the duties of trade When sales and trading and operations use
entry are appropriately segregated. Front-end separate systems, electronic feeds should auto-
systems that capture deal information may matically feed all deals, adjustments, and can-
interface with other systems that monitor and cellations from one system to the other. Ideally,
update the following: the transaction data should also be carried
 credit limit usage, straight-through for posting to the general

 intra-day P&L,
ledger, updating credit information, generating
money transfer instructions, and feeding nostro

 trader positions, reconciliation systems.

 confirmation processing records, To ensure timely processing by operations


and eliminate potential errors that can occur
 settlement instructions, and if trades are reentered into the operations

 general ledger activity. systems, straight-through processing should


exist between sales and trading and
operations. Such a link should move deals,
A bank’s ability to manage risk may be
adjustments, and cancellations to the
adversely affected if it does not have accurate
operations system as soon as sales and trading
transaction updates in each of the above
finalizes them. This transaction data—also
areas. Inaccuracies in each category not only passed straight through to other systems in
erode a bank’s profitability, but may also the institution—will further decrease potential
tarnish a bank’s reputation. In the event of a errors that can occur when information is
settlement error, for example, the bank must manually keyed into systems. This practice
pay compensation costs to the counterparty also improves the timeliness of the data.
and cover short cash positions. Moreover,
incorrect financial statements arising from Most brokered transactions are now
problems in general ledger data can harm the executed over automated broker systems.

16 FOREIGN EXCHANGE COMMITTEE


Therefore, straight-through processing links update a counterparty’s credit status when the
from these systems into sales and trading should counterparty deals with the bank on a global
also be implemented when volume warrants. aggregate basis. This requires straight-through
processing from the trade capture system to a
real-time credit system.
Best Practice no. 8:
Use Real-Time Credit Monitoring
Sales and trading should see the effects of a
Credit lines and usage information should be
deal on a counterparty’s credit status
updated as soon as deals are entered, and the
immediately, and that unit should know when
information should be accessible to sales and
a counterparty’s credit limit is close to being
trading and risk managers. A bank should
filled and be prevented from dealing with
establish real-time credit systems to calculate
counterparties who have reached or exceeded
and aggregate exposures globally across all
such limits. Sales and trading and credit
trading centers.
management should produce reports of credit
A bank should execute transactions only if line excesses and exceptions on a regular basis
credit lines have been approved and are for review. Exception reports should identify
available for a designated counterparty. No both counterparties involved and the sales and
trade should be finalized without confirming trading personnel executing the transactions.
the availability of sufficient credit. Electronic
Real-time credit systems also allow a bank’s
broker credit prescreening schemes are
credit managers to assess the credit exposure
preferable to the practice of brokers switching
to a counterparty throughout the life of a
counterparties. In the event of default by a
transaction. Credit officers are better able to
counterparty, a bank could lose the positive
manage crisis situations and to adjust limits as
market value of the positions it has with the
the creditworthiness of a counterparty
defaulting party or, if default occurs in the
changes. A real-time credit system ensures
middle of settlement, it could lose the entire
that any changes in the credit limit of a
principal of the deal.
counterparty are reflected in the sales and
A sales and trading area should be able to trading system immediately.8
quickly assess its institution’s credit exposure
to its counterparties globally. These Best Practice no. 9:
exposures should be communicated in real- Use Standing Settlement Instructions
time to the trading system. The system should Standing Settlement Instructions (SSIs) should be
take into account changes in static credit lines in place for all counterparties. Market
for electronic trading platforms that participants should issue new SSIs, as well as any
periodically may have to be updated or changes to SSIs, to each of their trading partners
revised. The system should also automatically in a secure manner. For banks, the preferable

8 U.S. Comptroller of the Currency, Banking Circular 277 (Washington, D.C.: GPO, 1993).

MANAGEMENT OF OPERATIONAL RISK IN FOREIGN EXCHANGE 17


method is through an authenticated medium SSIs should be in a SWIFT/ISO format to
such as SWIFT messages. facilitate reference data maintenance and to
eliminate the potential for errors in
SSIs allow for complete trade details to be translation. Any deal record with exceptions
entered quickly, so that the confirmation to an existing SSI should be processed using
process can begin as soon after trade execution the same procedures as for nonstandard
as possible. In general, when SSIs are in place, it settlement instructions.
is possible to take full advantage of straight-
through processing because operations may
not have to manually intervene in the Best Practice no. 10:
Operations Should Be Responsible
transaction during the settlement process. SSIs
for Settlement Instructions
also allow for payments to be formatted
Operations should be responsible for ensuring
properly and for readable SWIFT codes to be
that settlement instructions are collected and
issued. If SSIs are not established, operations
confirmed. If no SSIs are in place, operations
must contact the counterparty to obtain
should be responsible for obtaining and
settlement instructions and the deal record
verifying the instructions.
must subsequently be changed to reflect these
settlement instructions. The extra work involved Although SSIs are preferred, they are not
in inputting, formatting, and confirming settle- always available, and at times SSIs may not be
ment instructions increases the opportunity for appropriate for all trades. When SSIs are not
errors in settlement, making SSIs important for used, the settlement instructions may be
risk management and efficiency. recorded at the time that sales and trading
conducts the trade. These exception settlement
Institutions should update their records
instructions should be delivered by the close of
promptly when changes to SSIs are received
business on the trade date (if spot) or at least one
from their counterparties. When an institution
day prior to settlement (if forward). Nonstandard
changes its SSIs, it should give as much time as
settlement instructions should be exchanged
possible—a minimum of two weeks notice—to
electronically if possible and should be checked
its counterparties so that they can update
by operations when the trade is confirmed. By
their records before the date that the new SSIs
taking responsibility for settlement instructions,
become effective. A bank should periodically
operations serve the role of an independent
review the SSIs that it has on file.
control on sales and trading activity.
SSIs for forward transactions can change
between the time a deal is confirmed and the Best Practice no. 11:
time it finally settles. Consequently, a bank Review Amendments
should either reconfirm all settlement Amendments to transaction details should be
instructions for forward deals before conducted in a controlled manner that includes
settlement, or it should reconfirm all both sales and trading and operations in the
outstanding deals whenever SSIs are changed. process. Particular care should be taken for

18 FOREIGN EXCHANGE COMMITTEE


amendments to FX swap transactions after the outright is initially entered into the system,
settlement of the near leg. traders cover any resulting currency and
interest rate exposure by entering into
If incorrect information was captured in offsetting deals. The offsetting deals also need
deal entry, certain trades will need to be to be amended if the swap is entered
changed or canceled after they have been incorrectly, which may affect P&L. Because
released to operations. Mistakes occur when the near leg has settled, it cannot be changed
a trader or salesperson enters the wrong to reflect P&L differences. Thus, amendments
counterparty for a deal, an incorrect value to swaps should be made with care so that
date or rate, or makes other data errors. resulting positions and P&L are accurate.
Although either operations or sales and
trading staff can initiate amendments and Best Practice no. 12:
cancellations, both sales and trading and Closely Monitor Off-Market and Deep-
operations should be involved in the process in-the-Money Option Transactions
to maintain proper control. It is imperative, All dealer institutions that permit requests for
however, that the duties related to processing Historical Rate Roll-overs (HRRs) should have
amendments and cancellations are clearly written procedures to guide their use and should
segregated between operations and sales and detail the added controls required in the trading
trading. This segregation of duties is one of and reporting of off-market transactions.
the key control mechanisms of any institution. Operational responsibilities should be clearly
defined in regard to monitoring, reporting, and
The specific process for handling special confirmations, if any are needed. Such
amendments and cancellations will vary from special confirmations may be necessary to identify
firm to firm and is often dictated by system the market forward rate in effect when the HRR
constraints. However, if operations staff is was executed. The sale of deep-in-the-money
responsible for amending or canceling a deal, options warrants special attention and specific
it should obtain supporting documentation procedures applicable to sales and trading staff
and receive prior written authorization from (and, if necessary, senior management).
sales and trading before processing the
amendments or cancellations. Exception Historical rate rollovers involve the extension
reporting on amendments and cancellations of a forward foreign exchange contract by a
should be made available to sales and trading dealer on behalf of a customer at an off-market
and operations management regularly. The rate. As a general rule, all transactions are
criteria used for reporting and the frequency executed at current market rates. However, at
of distribution will vary by firm. times commercial considerations may dictate
otherwise. For more information, see The
Amendments to swap transactions may Foreign Exchange Committee Annual Report
present difficulties for a bank if the near leg 2000, “Guidelines for the Management of FX
has already settled. When the swap or Trading Activities,” p. 74, and The Foreign

MANAGEMENT OF OPERATIONAL RISK IN FOREIGN EXCHANGE 19


Exchange Committee Annual Report 1995, “Letter deliverable forwards [NDFs] and currency
on Historical Rate Rollovers.” option transactions), documents are pre-
pared and 1) exchanged and matched by both
The sale of deep-in-the-money options counterparties, in the case of most dealers, or
warrants special attention and specific 2) signed and returned in the case of certain
procedures applicable to sales and trading clients or counterparties.9 In either case, it is
staff (and, if necessary, senior management). the market practice to verbally confirm (on a
There may be legitimate reasons for the sale recorded line) the primary economic details of
of such options—for example, the “sell back” an NDF or exotic currency option transaction
of an option or the implied delta within a between the two counterparties on the day
separate derivatives product. However, it the transaction is executed. Notwithstanding
should also be recognized that the sale of the fact that trades are verbally confirmed, it is
deep-in-the-money options can be used to still important that a hardcopy confirmation is
exploit weaknesses in a counterparty's sent and that the means of such delivery is
revaluation or accounting process that could agreed between the parties.
create erroneous results. Procedures should
ensure an appropriate level of review—if Given the significance of the confirmation
necessary, by senior trading management or process, it is important that the process is
risk management outside the sales and handled independently of the trading room.
trading area—to guard against potential legal, In most institutions, the operations
reputational, and other risks. department performs this activity. Any
exceptions to sending confirmations to
clients should be reviewed and approved by
Confirmation compliance or legal personnel, and business
Process Description and operations management.
The transaction confirmation is legal evidence
Exchanging confirmations is essential for
of the terms of a FX or a currency derivative
mitigating risk in the FX markets. Therefore,
transaction. Therefore, the management of
outgoing confirmations should be dispatched
the confirmation process is an essential con-
to the counterparty at the earliest possible
trol. This process is handled in many ways
opportunity. It is also the responsibility of
within FX markets. For vanilla spot, forward
both counterparties to actively match and
FX, or currency option transactions, counter-
validate their own transaction records of
parties exchange electronic or paper confir-
incoming electronic or verbal confirmations
mations that identify transaction details and
with counterparties by the end of the
provide other relevant information. For struc-
business day on the trade date. For some non-
tured and nonstandard transactions (non-

9 Typically the price maker prepares the confirmation and the price taker signs the confirmation.

20 FOREIGN EXCHANGE COMMITTEE


vanilla trades, a same day confirmation may Foreign exchange trades are executed in
cover some specific financials, but a multiple ways, including by phone (direct),
complete long-form confirm may follow at a voice brokers, electronic dealing platforms,
later date with nonfinancial information. and electronic brokers. As an increasing
number of FX transactions are being executed
Confirmations should be transmitted in a through secure electronic platforms (for
secure manner whenever possible. In the example EBS, Reuters) or online electronic
most developed markets, confirmations are dealing platforms, some counterparties have
generally sent via electronic messages through chosen, on a bilateral basis, to eliminate
secure networks. In some instances, traditional confirmation messages with one
proprietary systems have been developed to another in lieu of electronic affirmation
provide access to confirmations to clients.
facilities offered by electronic trading systems.
However, a significant number of transaction
These facilities allow operations to review
confirmations are also sent via mail, e-mail,
trading system data and validate trade details.
and fax. It is important to note that when these
open communication methods are used there Market participants can affirm that the trade
is a greater risk of fraudulent correspondence. details reflected in the electronic trading
system correspond to their own internal books
A transaction confirmation should include
and records. It is important to note, however,
all relevant data that will allow the two
that such validation exercises are not
counterparties to accurately agree to the
equivalent to traditional confirmation
terms of a transaction. All relevant settlement
messaging because they do not confirm that
instructions for each transaction should be
trade details have been correctly entered into
clearly identified in each confirmation. All
the books and records of each counterparty.10
confirmations should either be subject to the
1998 FX and Currency Option Definitions issued Some transactions between banks are also
by the Foreign Exchange Committee, executed via voice brokers. These bilateral
Emerging Markets Traders Association transactions should be checked against the
(EMTA), and International Swaps and broker advice that is typically received on the
Derivatives Association (ISDA), or be subject trade date from the voice broker. Similarly, in
to other appropriate guidelines, and should the case of FX prime brokerage relationships,
reference a bilateral master agreement—if one these same procedures should be followed in
exists between the parties. a timely manner by all three participants. It is
important to note that broker confirmations
are not bilateral confirmations between the

10 Forfurther guidance on electronic validation and affirmation, see Foreign Exchange Committee, “Supplementary Guidance on Electronic
Validations and Confirmation Messaging,” in The Foreign Exchange Committee 2001 Annual Report (New York: Federal Reserve Bank of
New York, 2002).

MANAGEMENT OF OPERATIONAL RISK IN FOREIGN EXCHANGE 21


principals of the trade and therefore do not through any other internal departments. Senior
carry the weight of a bilateral confirmation. operations management and compliance staff
must approve any exceptions.
When trades are not confirmed, exposure
to market risk arises. To mitigate this risk, Counterparties should either send out their
standard escalation procedures should be in own confirmations, or sign and return (affirm)
place to pursue and resolve all discrepancies incoming confirmations. Under no circum-
in a timely manner. Operations staff is stances should either party simply accept
responsible for reporting all unconfirmed receipt of the counterparty confirmation as
trades and unmatched incoming con- completion of the confirmation process.
firmations to sales and trading. When
necessary, the taped phone conversation or the Data included in the confirmation should
log from the electronic execution system can be contain the following: the counterparty to the
used to resolve the discrepancy. Once the FX transaction; the office through which they are
acting; the broker (if applicable); the transaction
problem has been identified, the counterparty
date; the value date; the amounts of the
with the error should correct the affected deal
currencies being bought and sold; the buying
in its system and issue a corrected confirmation.
and selling parties; and settlement instructions.

Best Practice no. 13: These procedures are meant as practices


Confirm and Affirm Trades for executions directly between two parties.
in a Timely Manner In the case of prime brokerage relationships,
Both parties should make every effort to send (in which one financial institution extends its
confirmations, or positively affirm trades, within credit to a third party dealing with the
two hours after execution and in no event later institution’s customer), confirmations should
than the end of the day. This guideline applies to be exchanged among the three parties in
trades executed with both external and internal addition to the fulfillment of other requirements
counterparties. Any exception to this rule should for exchanging information. Prime broker
be clearly documented and approved by relationships alter the control procedures
operations management and compliance staff. employed with direct dealing; therefore, the
prime broker should consider incorporating
Prompt confirmations are key to the orderly
processes to ensure that communication of
functioning of the marketplace because they
notice of execution is correct.
minimize market risk and minimize losses due
to settlement errors. In order for confirmations
to be timely and accurate, they should be Best Practice no. 14:
formatted based on trade data captured in the Be Diligent When Confirming
by Nonsecure Means
bank’s operations system. In order to ensure
A procedure should be in place to call back a
that confirmations are accurate, they should be
counterparty any time the confirmation process
generated and sent directly from the operations
occurs via nonsecure media.
system to the counterparty without passing

22 FOREIGN EXCHANGE COMMITTEE


Various communication media are Structured transactions, including non-
currently used for the confirmation process, deliverable forwards (NDFs), often contain
including fax, mail, and secure electronic unique features such as special pricing or
messaging such as SWIFT. Authenticated settlement conventions. Trade details may
electronic messaging is the most secure means also assign responsibilities to each
of transmitting confirmations. When other counterparty by identifying the calculation
communication media are used, various risks agent or the confirming party. Every feature of
are introduced, ranging from human error to the trade detail affects the valuation of the
possible fraudulent correspondence. When trade. Consequently, the price, price source,
employing open communication systems, calculation agent, and confirming party must
especially mail platforms, this risk increases. be carefully validated.
There is a direct correlation between the
openness of communication links and the Currently, the standard SWIFT confirmation
possibility of fraudulent actions. format cannot accommodate all the unique
features of structured trades. Confirmations
It is recommended that a bilateral supporting these transactions are often
agreement that includes a callback procedure manually prepared, transmitted by fax, and
be established when any unauthenticated manually matched against accounting
electronic message system is used. This records. Because of the complexity of these
procedure should include the callback to an trades, and the fact that they are often
authorized individual other than the manually confirmed, there is a significant risk
individual who sent the nonsecure that the confirmation process may fail to
confirmation. This conversation should be detect errors or omissions.
done on a recorded telephone line and
properly noted. Unlike standard trades, confirmations for
structured transactions are usually provided
by a calculation agent or jointly between two
Best Practice no. 15: calculation agents. It should be clear which of
Be Diligent When Confirming
the two counterparties is acting as calculation
Structured or Nonstandard Trades
agent (or joint calculation agent status should
Special care must be taken when confirming the
be indicated). Additionally, the roles and
details of structured transactions or nonstandard
responsibilities of the calculation agent or
trades that cannot be confirmed by a bank’s
joint agents should be specified. The
normal procedures or processes. Whenever
calculation agent may also have certain rights
possible, standard confirmation formats should
and obligations related to price observations
be used. These formats should identify the
and confirmations. These rights should be
calculation agent, special rights and respon-
clearly identified in the text of the
sibilities assigned to each counterparty, and
confirmation or in the trade contract.
special instructions on pricing sources, if any.

MANAGEMENT OF OPERATIONAL RISK IN FOREIGN EXCHANGE 23


Standardizing the confirmation process can execution, and in no event later than the end
substantially reduce the operational risk of the day. It is imperative that these
associated with this process. Every effort conversations are conducted over recorded
should be made to use the standard telephone lines. The confirmation conver-
confirmation formats outlined by the FX sation should also take place between
Committee, the Emerging Markets Traders appropriate individuals only. All relevant
Association (EMTA), and the International
information, financial details, and settlement
Swaps and Derivatives Association (ISDA). Not
instructions should be confirmed. Following
only should these formats be employed, but
the telephone confirmation, both parties
every confirmation should also clarify when
nonstandard price sources, disruption events, should record the date, time, telephone line,
expiration times, or any other nonstandard and the name of the individual with whom
elements of a trade are introduced. the trade was confirmed. In addition to the
telephone confirmation, both parties should
exchange and match a formal (mail, SWIFT, or
Best Practice no. 16:
Be Diligent When Confirming other electronic) confirmation or a callback
by Telephone procedure should follow.
Extra care is necessary when confirming trade
details by telephone. Phone confirmations Best Practice no. 17:
should be conducted over recorded lines between Institute Controls for Trades Transacted
appropriate individuals. Following the telephone through Electronic Trading Platforms
confirmation, both parties should exchange and If two parties bilaterally choose to validate trade
match a written or electronic confirmation via data against an electronic front-end trading system
fax, mail, SWIFT or secured electronic means in place of exchanging traditional confirmation
such as SWIFT. messages, both parties should ensure that trade
data flows straight through from the front-end
Not all trades can be fully confirmed
system to their respective operations systems. Strict
electronically; some structured trades are one
controls must be in place to ensure that the flow of
example. In addition, some counterparties do
data between the two systems is not changed and
not have the ability to confirm trades
that data is not deleted.
electronically on the trade date. In such
instances, the most common method of Issuing traditional confirmations is always
confirming transactions is by telephone. considered a best practice from a risk
However, telephone confirmations are the least perspective because they reflect the books
reliable method for confirming trades and prone and records of both counterparties. However,
to errors. When using this method, attention to firms with well-established controls and
detail and clarity must be emphasized. straight-through processing may consider a
bilateral agreement with a counterparty to
Operations should aim to complete phone
accept validation of trade data over a secure
confirmations within two hours from trade
electronic platform to constitute a legally

24 FOREIGN EXCHANGE COMMITTEE


binding confirmation, if the recorded trade Best Practice no. 19:
details are deemed sufficient to validate the Confirm All Netted Transactions11
trade terms. Only institutions that have direct All transactions, even those that will be netted,
feeds from dealing systems all the way should be confirmed individually.
through their operations systems, however,
should employ this exception process and Netting trades for settlement is an
consider this acceptable as an alternative to important operational function because it
traditional confirmations. allows a bank to reduce settlement risk and
operational cost. However, it is still necessary
to confirm all transactions individually. If
Best Practice no. 18: netted trades are not confirmed individually,
Verify Expected Settlement
trades may be mistakenly added or removed
Instructions
from the net agreement, which will be difficult
A bank should include its own settlement
to detect on settlement day. Incorrect netting
instructions as well as the settlement instructions
will distort credit and settlement risk. It may
of its counterparty on confirmations. Upon
also cause losses to a bank if it must pay gross
receipt of a confirmation, firms should
amounts instead of netted amounts or if it has
systematically check both parties’ settlements
to cover overdrafts resulting from incorrect
instructions and ensure that they coincide with
settlement. The confirmation of these deals
those agreed upon at trade capture.
should be performed as it would be in any
It is in the best interest of a bank to send its other transaction or with the aid of a netting
own settlement instructions to counterparties. service provider.
This step provides counterparties with written
confirmation of the settlement instructions Best Practice no. 20:
and can help reduce mistakes and the Confirm All Internal Transactions
possibility of fraud. Internal transactions should be subject to the
same procedures as those in place for external
Similarly, if a bank receives settlement clients. Internal counterparties should confirm or
instructions on an inbound confirmation, the affirm transactions as if they transacted a deal
bank should check that the instructions match with external counterparties.
the instructions included in the trade
agreement. It is best to discover and correct Quite often, operations and management
errors in settlement instructions before relax their control procedures when
payment instructions are issued in order to executing internal deals. In some cases,
reduce the incidence of error for both parties. confirmations are not sent to the internal
counterparty, and not affirmed by the
receiving internal counterparty. However,

11 Additional recommendations for netting trades can be found in Foreign Exchange Committee, “Guidelines for FX Settlement Netting,” in
The Foreign Exchange Committee 1996 Annual Report (New York: Federal Reserve Bank of New York, 1997).

MANAGEMENT OF OPERATIONAL RISK IN FOREIGN EXCHANGE 25


when confirmations are not properly issued Such fiduciaries combine several client trades
and affirmed, trade details are not verified, into larger block trades that are then allocated
and a greater probability of error results. to the fiduciary’s specific clients. Until a block is
properly allocated to the specific client,
A bank should recognize that deals done inaccurate credit risk management information
with internal counterparties are not immune may exist. Banks should use particular caution
from errors. Lack of confirmations will prevent when establishing practices for block trades.
the timely recognition of trade errors, thereby
increasing the risk of settlement mistakes or Although confirmations of block trade, by
incorrect funding. Consequently, a bank themselves, reduce a bank’s market risk,
should issue confirmations and should abide confirming only the block trade does not
by the standard confirmation process for all provide the essential customer data for the
internal counterparties to preserve controls firm’s credit and compliance systems. For a
and risk management procedures. bank to fully understand its counterparty risk,
all deals must be confirmed at the split
If multiple systems are used by an (counterparty) level.
institution, then the confirmation process
should be automated across those systems. In The recommended best practice is to send
institutions in which only one system is used these confirmations via electronic messages
across internal counterparties, a process through secure networks within four hours and
should be set up within that system to insure no later than the end of the day on the trade
that both sides of the transaction are properly date. A bank should require that fund managers
recorded and matched. provide them with the allocation information
on the trade date for all trade types regardless of
maturity, so that the bank’s credit information
Best Practice no. 21:
Confirm All Block Trades can be updated as soon as possible.
and Split Allocations
When block trades combine several split trades, Best Practice no. 22:
the full amount of the block trade should be Review Third-Party Advices
confirmed within two hours of the trade. All Banks should confirm trades conducted through
allocations for split trades should be confirmed a broker directly with one another. Review of
separately within four hours and no later than Reuter’s logs, EBS trade tickets, and voice broker
the end of the business day on the trade date. advices should not serve as the primary method
Sub-account allocations are necessary to of bilateral confirmation. These logs and advices
evaluate not only credit exposure but also should be treated as a third-party verification of
potential regulatory compliance.
trade information.
In recent years, the use of block (or bulk)
Bilateral confirmations are written statements
trades has increased as trading with fund
of all the essential economic terms of a
managers and investment advisors has grown.

26 FOREIGN EXCHANGE COMMITTEE


transaction. Reuters logs and EBS trade tickets Best Practice no. 23:
are effective ways for operations to review trade Automate the Confirmation
information captured in the operations system, Matching Process
and to verify that the economic terms, including Electronic confirmation matching and tracking
settlement instructions, of the trade were systems should be adopted as standard
operating procedures.12
properly captured in the risk and confirmation
systems of the firm. Electronic confirmation matching requires
that two parties agree to electronically match
However, Reuter’s logs, EBS trade tickets,
their confirmations through an in-house
and voice broker advices do not ensure that
proprietary system or a third-party vendor.
the counterparty has captured the correct
Electronic confirmation matching is the most
trade information in its operations systems.
reliable method of confirming transactions.
Therefore, institutions should not rely solely Such matching decreases market risk and
on an incoming broker advice. As the contract trade errors, minimizes settlement and
binds the two principals to the transaction, compensation payments, and reduces
direct and timely bilateral confirmations operational and overhead costs. Electronic
should be exchanged between the two confirmation matching allows a bank to
counterparties for every transaction. If a firm increase the volume of transactions
does not receive a bilateral confirmation from confirmed in a timely manner.
its counterparty, then it should review with its
legal counsel whether the counterparty is The confirmation process should be
bound to the terms and agreement of the additionally controlled by establishing an
deal as documented by the broker advice. automated confirmation tracking and follow-
up system. Such a system will decrease the
As stated in the process description that chances that deals are not settled properly
begins this section, institutions that have and help management track and escalate
direct feeds from secure electronic platforms nonconfirmation. Moreover, automating
(for example EBS, Reuters) and that in confirmation tracking and follow-up enables
addition pass straight through to the a bank to identify counterparties that do not
operations systems may consider bilaterally confirm on a regular basis so that they can be
agreeing to eliminate any further exchange of addressed. Finally, automation, as opposed to
confirmation on these transactions. a purely manual system, decreases potential
errors caused by human intervention (phone
and paper) and reduces operational costs.13

12 Foreign Exchange Committee, “Standardizing the Confirmation Process,” in The Foreign Exchange Committee 1995 Annual Report (New
York: Federal Reserve Bank of New York, 1996).
13 Foreign Exchange Committee, “Standardizing the Confirmation Process,” in The Foreign Exchange Committee 1995 Annual Report (New

York: Federal Reserve Bank of New York, 1996).

MANAGEMENT OF OPERATIONAL RISK IN FOREIGN EXCHANGE 27


Best Practice no. 24: practices regarding unconfirmed trades as
Establish Exception Processing outlined by the firm. Under no circumstances
and Escalation Procedures should a dispute be carried over for more than
Escalation procedures should be established to one day after the trade date, and if such a
resolve any unconfirmed or disputed deals. dispute should arise, it should be carried over
Periodic reports containing transactions that only with the approval of senior management.
have not been confirmed or affirmed, and
counterparties that do not confirm or affirm, Escalation procedures should also include
should be issued to sales and trading and senior notification to sales and trading so that they
management. know which counterparties do not comply with
best practices. Senior management should also
Exposure to market risk arises when trades be informed of unconfirmed deals so that they
are not confirmed. To mitigate this risk, can evaluate the level of operating risk being
standard escalation procedures should be in introduced by maintaining dealing relationships
place to pursue and resolve all discrepancies with noncompliant counterparties. Compen-
in a timely manner. Unconfirmed deals may sating controls—such as sending out periodic
indicate trade entry errors, such as a failure to statements with all outstanding forward trades—
enter the trade, or that a counterparty did not can be implemented, but it must be recognized
recognize a trade. Repeated problems may that such controls do not eliminate the risks
indicate that the counterparty does not inherent with unconfirmed trades.
execute operational procedures correctly,
which may signal the need to reevaluate the The segregation of duties between sales
trade relationship. and trading and operations can pose special
challenges when dealing with exceptions.
Internal procedures should be established Under no circumstances should operations
to monitor unconfirmed trades. When a concede control of unconfirmed trades to
confirmation is received from a counterparty, sales and trading. If confirmations are
and no record of the deal exists internally, received that operations does not recognize,
operations should immediately establish it is imperative that operations maintain
whether a deal has in fact been conducted by control of such confirmations until either a
contacting the appropriate person in sales and cancellation or amendment is received.
trading. Operations should then verify the When trades remain unconfirmed, escalation
trade information from a related source (for procedures should be strictly followed and
example, Reuters conversation or broker senior operations management should
confirmation) or by contacting the formally review any exceptions to policy.
counterparty directly. In either case,
operations needs to follow escalation

14 Banks may also conduct “novational netting,” which nets trades across all currency pairs. For example, a dollar-yen trade and a euro-dollar
trade may be netted for a single dollar payment.

28 FOREIGN EXCHANGE COMMITTEE


Netting resolved between bank and counterparty
operations units. Operations generally confirms
Process Description netted amounts again on the day before
Bilateral settlement netting is the practice settlement date in addition to confirming the
of combining all trades between two transaction itself on the trade date (see the
counterparties due on a particular settlement confirmation section and Best Practice no. 19).
date and calculating a single net payment in
each currency. If, for example, a bank does The operational process of settlement
twenty-five trades in dollar-yen with the same netting should be supported by a legal
counterparty, all of which settle on the same agreement. Such an agreement may be a
day, bilateral settlement netting will enable the simple one-page document that only
bank to make only one or two netted payments supports settlement netting, or the settlement
instead of twenty-five.14 The establishment of netting provision may be included in a master
settlement netting agreements between agreement (see Best Practice no. 3)
counterparties may be used to reduce settle-
ment risk, operational risk, and operational costs. Best Practice no. 25:
Use Online Settlement
Multilateral settlement netting is the Netting Systems
practice of combining all trades between The use of an online settlement netting system is
multiple counterparties and calculating a encouraged to calculate net payments in each
single net payment in each currency. This currency. Online software for calculation of
practice is supported by CLS Bank (CLS). CLS netted payments should be used to ensure proper
Best Practices can be found on the website calculations.
<www.cls-services.com>.
Correct calculations of netted payments are
Netted payments are calculated for important to ensure accurate settlement
transactions done in the same currencies with amounts, enhance efficiency of operations, and
equal value dates. The bank and counterparty preserve client relationships. If, for example, a
continue to confirm all deals on a daily basis bank mistakenly expects a payment of
either directly or through a system that helps $2 million from a counterparty but receives
support settlement netting. These systems $1 million, it will initiate investigation
allow a bank to view netted amounts of trades procedures and possibly escalation procedures
on a screen. with the counterparty, thus possibly damaging
the relationship between institutions. Faulty
A summary of netted amounts by currencies netting calculations also create an inaccurate
and value date can also be monitored and assessment of a bank’s credit risk with the
individual netted trades can be reviewed counterparty.
subsequently. Trades that have been matched
and confirmed are typically identified as well. Because of these risks, a bank should use
Any disputes should be investigated and online (real-time) software to calculate netted

MANAGEMENT OF OPERATIONAL RISK IN FOREIGN EXCHANGE 29


payments. By using online software, both payment amount with each other at some
counterparties can enter deal information into predetermined cutoff time.
the trade capture system. The system will
confirm the transactions, and will calculate, on
Best Practice no. 27:
a currency-by-currency basis, the net amount Employ Timely Cutoffs for Netting
due to each counterparty. The two counter- A bank should adopt the latest cutoff time
parties to the transaction will be notified if possible for confirming netted trades. Credit
these amounts are not equal and the resulting system functions should be in place to accurately
discrepancy may be resolved immediately. reflect the effect of netting.
Using online netting systems also helps to To include all transactions done between
reduce settlement risk. Because online two counterparties and achieve the maximum
systems allow banks to quickly recognize and risk reduction, the net payment amounts
correct netting errors, currency exposures can should be confirmed at the latest possible
be managed more effectively. If a bank time. This measure will allow trades done for
conducts ten trades (within the same settlement on the trade date to be included in
currency) with a counterparty, it will only the net amount. As netting occurs and other
experience a currency exposure for two trades are done with the counterparty, credit
netted amounts (one for the amount it is systems should be updated. Credit systems
paying and one for the amount it is receiving) should be adapted to account for legally
and not for twenty different amounts. When enforceable netting agreements and should
additional trades are done, the resulting reflect changes in credit-line usage
exposure is added to the net exposure. appropriately. This allows sales and trading to
appropriately deal with counterparties based
Best Practice no. 26: on available credit and to gauge the risk
Confirm Bilateral Net Amounts associated with each deal. Deals that miss the
Final amounts should be confirmed bilaterally netting cutoff should be settled gross and
with the counterparty if they are not done reflected as such for credit purposes.
electronically.

Third-party electronic settlement netting Best Practice no. 28:


Establish Consistency between
systems inform both bilateral parties of the
Operational Practices
amount that they owe and can expect to and Documentation
receive at some predetermined cutoff time. Management should ensure that operating
However, if electronic settlement netting practices are consistent with credit policies and
systems are not used, then the calculations other documentation. Credit systems should not
performed by one party’s operations group reflect settlement netting benefits unless
may contain an error. To protect against an documentation exists to support settlement with
improper settlement of a net amount, counterparties on a net payment basis.
counterparties should confirm the net

30 FOREIGN EXCHANGE COMMITTEE


Sometimes operational practices do not Settlement occurs and payments are
follow documented policy. The trade capture exchanged on the value date of the
system may not indicate netting counter- transaction. For counterparties that are not
parties, for example, thus preventing the bank settled on a net basis, payment instructions
from realizing the benefits of netting. In another are sent to nostro banks for all the amounts
variance from policy, a bank might practice owed—as well as for expected receipts.
netting although a formal agreement has not Settlement instructions are sent one day
been established with the counterparty to do before settlement, or on the settlement date,
so. A bank that is caught in a legal dispute, depending on the currency’s settlement
however, will not be able to justify its practices requirements. Settlement instructions should
without legal and operational support. include the counterparty’s nostro agent’s
Additionally, a bank may be prevented from name and SWIFT address and account
effectively managing its risk position. numbers if applicable. Systems generate
predictions of expected movements in nostro
To this end, operations management
accounts to help manage liquidity and
should strive to establish procedures that are
reconcile actual cash movements against the
in line with operational goals and follow
nostro accounts.
documented procedures. Management
should be certain that operational proce- All payments are exchanged through the
dures ensure that netting is carried out aforementioned nostro accounts. These
between a bank and designated counter- accounts are denominated in the currency of
parties. Operations should also ensure that the country where they are located. When a
netted trades are reflected in trade capture bank enters into a contract to buy dollars and
systems and credit systems so that netting is sell yen, for example, it will credit its yen nostro
successfully executed. The operational account and debit its dollar nostro account.
procedures should include any necessary cut- The counterparty credits its dollar nostro
off times, standing settlement instructions account and debits its yen nostro account in
(SSIs), and an agreed method of confirmation Japan. Both banks initiate a money transfer to
and affirmation should be supported by each pay their respective counterparties; this is done
counterparty’s documentation policy. by a funds movement between the two banks
using the local payment system. The money
Settlement transfer is complete when both counterparties
have been paid the appropriate amounts.
Process Description
Settlement is the exchange of payments If settlement error occurs in the process, it is
between counterparties on the value date of typically quite costly. If a bank fails to make a
the transaction. The settlement of FX payment, it must compensate its counterparty,
transactions can involve the use of various thus generating additional expense.
secure international and domestic payment Settlement errors may also cause a bank’s cash
system networks. position to be different than expected.

MANAGEMENT OF OPERATIONAL RISK IN FOREIGN EXCHANGE 31


In addition, settlement risk—the risk that a Best Practice no. 29:
bank makes its payment but does not receive Use Real-Time Nostro Balance
the payment it expects—can cause a large Projections
loss. This risk arises in FX trading because Nostro balance projections should be made on a
payment and receipt of payment often do not real-time basis and should incorporate the latest
occur simultaneously. A properly managed trades, cancellations, and amendments.
settlement function reduces this risk.
Settlement risk is measured as the full amount A bank is exposed to risk when managing
of the currency purchased and is considered its nostro funds if expected cash positions
at risk from the time a payment instruction for vary greatly from actual cash positions. If more
the currency sold becomes irrevocable until cash is needed than the balance in an account,
the time the final receipt of the currency the bank will incur overdraft costs to fund the
purchased is confirmed.15 positions. Continual overdraft balances will
generate expenses for the bank and may cause
Sources of this risk include internal operational difficulties when the bank makes
procedures, intramarket payment patterns, efforts to determine why errors occurred.
finality rules of local payments systems, and
operating hours of the local payments systems
when a counterparty defaults. Settlement risk Best Practice no. 30:
may have significant ramifications and is Use Electronic Messages for Expected
Receipts
controlled through the continuous monitoring
A bank should send its nostro banks an electronic
of the bank’s nostro balances and through
message that communicates its expected receipts.
the establishment of counterparty limits.
A maximum settlement risk limit is usually With the receipt of an electronic message
established for each counterparty. advising of expected receipts, nostro banks
can identify payments that are directed to an
Notably, the introduction of the CLS Bank
incorrect account early in the process. This
has increased the efficiency of settlement by
allows nostro banks to correct payment
introducing a mechanism for simultaneous
errors on a timely basis and aids in the
exchange of currencies on an intraday and
formulation of escalation procedures. This
multilateral basis. process can help a bank to receive the exact
funds they expect and to eliminate
unmatched or unreceived payments. Some
nostro banks will take the transaction
reference number from an incoming

15For
additional information on settlement risk, please see the following: Foreign Exchange Committee, “Defining and Measuring FX
Settlement Exposure,” in The Foreign Exchange Committee 1995 Annual Report (New York: Federal Reserve Bank of New York, 1996).
Foreign Exchange Committee, “Reducing FX Settlement Risk,” In The Foreign Exchange Committee 1994 Annual Report (New York: Federal
Reserve Bank of New York, 1995).

32 FOREIGN EXCHANGE COMMITTEE


electronic message and put the number on deadlines for payment amendments because a
its outgoing nostro activity statement. real-time link provides more time to process the
changes. Such a link also decreases the
Some nostro banks, however, are not chance that a bank will miss the payment
equipped to process these expected receipt deadline and should prevent incorrect
messages. Given the benefits that accrue payments from being released.
through the use of expected receipt
messages, a bank should consider a nostro’s
ability to process these messages when Best Practice no. 32:
Implement Timely Payment Cutoffs
choosing which nostro bank to use.
Management should work to achieve the latest
possible cut-off times for cancellation and
Best Practice no. 31: alteration of payment instructions to nostro
Use Automated Cancellation banks as well as the earliest possible times for
and Amendment Facilities confirmation of final receipts.
A bank should establish a real-time
communication mechanism with its nostro bank By eliminating restrictive payment cancel-
to process the cancellation and amendment of lation deadlines and shortening the time it
payment instructions. takes to identify the final and failed receipt of
currencies, a bank can lower its actual and
A bank may need to change or cancel potential settlement exposure. A bank should
payment instructions after they have been understand when it can unilaterally cancel or
released to nostro banks. Problems may arise amend a payment instruction and negotiate
if this information is not processed in a timely with its nostro banks to make this cutoff as late
manner. Amendments occur when an error in as possible. In addition, such policies give a
the original instruction has been identified or bank more control over its payments, allowing
a counterparty has made a last minute it to react to any problems that arise late in the
change. Because execution of the erroneous settlement process.
payment instruction will certainly create an
improper settlement, the bank needs to be
sure the amendment is acted upon so that its Best Practice no. 33:
nostro balance predictions are accurate. Report Payment Failures to Credit
Officers
More importantly, a bank may wish to cancel
Operations should ensure that credit reports
a payment instruction if it is reasonably
appropriately update settlement exposure
confidant that a counterparty may not fulfill its
resulting from projected cash flow movements.
obligation to pay the counter-currency.
Exposure amounts should include any failed
An automated feed from the operations receipts from previous transactions.
system to the nostro bank will make communi-
To properly manage its credit risks, a bank
cation of amendments and cancellations easier.
needs to monitor settlement exposure to each
Nostro banks will be able to establish later

MANAGEMENT OF OPERATIONAL RISK IN FOREIGN EXCHANGE 33


of its counterparties. Settlement exposure recorded, when they become irrevocable, and
exists for a FX transaction from the time that when confirmation of counterparty payment is
the payment instruction issued by the bank is received with finality. Knowledge of these items
no longer unilaterally revocable by the nostro allows the duration and amount of FX
bank to the time that the bank knows it has settlement exposure to be better quantified.
received the counter-currency from the
counterparty. Therefore, credit officers need Both credit and risk managers should
to know the projected settlement amounts for develop accurate methods to quantify
each counterparty. In addition, any settlement risk. A bank’s actual exposure
nonreceipts should be included in current when settling an FX trade equals the full
exposure amounts reported to the credit amount of the currency purchased, and lasts
officers. Nonreceipts indicate an increased from the time a payment instruction for the
exposure to the counterparty until the amount currency sold can no longer be canceled
has been paid, and may also suggest a more unilaterally until the currency purchased is
serious problem with the counterparty. received with finality.16

Best Practice no. 34: Best Practice no. 35:


Understand the Settlement Process Prepare for Crisis Situations
and Settlement Exposure outside Your Organization
All senior managers should obtain a high level Operations employees should understand the
understanding of the settlement process. procedures for crisis situations affecting
Additionally, both credit and risk managers settlement. They should know who to notify if
(those managing position risk and credit risk) payments must be canceled or if settlement
should be cognizant of the impact their internal procedures must be changed.17
procedures have on settlement exposure.
Crisis situations such as a failure of a bank’s
Settlement risk may be reduced if those settlement processing systems, potential
involved in the process better understand the bankruptcy, or political unrest present critical
ramifications of its possible failure. Senior decisions for a bank, especially with regard to
management, sales and trading, operations, risk credit and liquidity management. Firms should
management, and credit management should anticipate crises and prepare internally. A bank’s
understand the process and be aware of the failure to settle properly with counterparties
timing of the following key events in the could prove harmful if a counterparty defaults
process: when payment instructions are on the expected payments. Consequently,

16 Foreign Exchange Committee, “Defining and Measuring FX Settlement Exposure,” in The Foreign Exchange Committee 1995 Annual Report
(New York: Federal Reserve Bank of New York, 1996).
17 Foreign Exchange Committee, “Reducing FX Settlement Risk,” In The Foreign Exchange Committee 1994 Annual Report (New York: Federal

Reserve Bank of New York, 1995).

34 FOREIGN EXCHANGE COMMITTEE


operations should know precisely what to do in unit identifies those trades that are valued for
a crisis. Current nostro bank staff contact lists settlement the next business day. Operations
should be distributed. These lists should aggregates all payments for that value date,
contain emergency contact numbers and taking into account netted payments and
contact information for each nostro bank’s determining what the expected cash
contingency operation. movement will be for each of its nostro
accounts. This process allows the bank to
Operations should also understand accurately fund those nostro accounts.
alternative settlement procedures and how
they are executed. Finally, operations staff The main objective of the nostro
should know who to inform and how to reconciliation function is to ensure that
inform them of changes or cancellations in expected cash movements agree with the
payment instructions. A bank may wish to actual cash movements of currency at the
consider simulated exercises of crisis nostro bank. This involves comparing
situations to ensure that employees are expected cash movements with actual cash
familiar with alternative procedures and can movements both paid out and received in by
manage them effectively. the nostro bank. If the reconciliation indicates
a difference from expected amounts, there
are six possible reasons. A bank may have
Nostro Reconciliation
 expected to receive funds and did not,
Process Description
Nostro reconciliation occurs at the end of the  expected to receive funds and received
trade settlement process to ensure that a the wrong amount,
trade has settled properly and that all expect-
ed cash flows have occurred. A bank should
 received funds and did not expect to
receive them,

 expected to pay funds and did not,


begin reconciliation as soon as it receives
notification from its nostro bank that pay-
ments are received. If possible, reconciliation
should be performed before the payment system
 expected to pay funds and paid the wrong
amount, or
associated with each currency closes. Early
reconciliation enables a bank to detect any  paid funds and did not expect them
problems in cash settlement and resolve them to be paid.
on the settlement date. Typically, however, a
bank does not receive notification from its If any differences are found, the bank must
nostro banks until one day after settlement, follow up with the nostro bank and/or the
which does not allow them to correct pay- counterparty to resolve the discrepancy. The
ment errors on the settlement date. cause for the difference might be that wrong
settlement or trade information was captured
Reconciliation begins with the prediction or that the nostro bank made an error. Most of
of cash movements. The bank’s operations such errors can be avoided if the confirmation

MANAGEMENT OF OPERATIONAL RISK IN FOREIGN EXCHANGE 35


process is followed without exception. If the allowing the reconciliation process to begin
discrepancy was caused by an error at the before the end of the day. In no instance,
bank, then the bank must arrange to pay the however, should the reconciliation be done
counterparty with good value or to pay the later than the day following settlement date.
counterparty compensation. Similarly, if the The sooner reconciliations are performed, the
error occurred at the counterparty or at the sooner a bank knows its true nostro balances
nostro bank, then the bank should expect to so that it can take appropriate actions to ensure
receive good value or compensation. that its accounts are properly funded. In
addition, nonreceipt of funds may indicate
If the nostro reconciliation is not performed, credit problems at a counterparty. The sooner
or is performed incorrectly, then the balances this information is known, the sooner a bank
at the nostro bank will be different from those can prevent further payments from being made
the traders believe they are funding. to that counterparty.
Consequently, the bank will be paying
overdraft costs on any short balances or
receiving less than market rates on any long Best Practice no. 37:
Automate Nostro Reconciliations
balances. In some currencies, the central banks
A bank should be capable of receiving automated
have penalties for carrying short balances in
feeds of nostro activity statements and implement
addition to the overdraft charges due. Failure to
automated nostro reconciliation systems.
notify counterparts of problems in a timely
manner may lead them to dismiss claims that A bank should establish facilities for
are over a certain age, causing the bank to automatically downloading the settlement
absorb the overdraft costs. In addition, nostro information it receives from nostro banks as well
reconciliation serves as a main line of defense as its own expected settlement data. A bank
in detecting fraudulent activity. should establish an electronic reconciliation
system to compare these two streams of data
Banks should implement procedures to
(confirmed payments and receipts from the
periodically review the terms and conditions
nostro bank against the expected cash
of each nostro agent and evaluate usage of
movements from the operations system) to
each nostro account.
allow for the timely identification of differences.
Escalation procedures should be in place to
Best Practice no. 36: deal with any unreconciled trades and/or
Perform Timely Nostro Account unsettled trades. These procedures should be
Reconciliation initiated when settlement and/or nostro
Full reconciliation of nostro accounts should be reconciliations are not successful.
completed as early as possible.

A bank should attempt to establish Best Practice no. 38:


capabilities that allow for intraday processing of Identify Nonreceipt of Payments
nostro confirmations of receipts, thereby Management should establish procedures for

36 FOREIGN EXCHANGE COMMITTEE


detecting non-receipt of payments and for should be in place describing the necessary
notifying appropriate parties of these operating procedures that all users should
occurrences. Escalation procedures should be in follow. Without clear rules for sharing in place,
place for dealing with counterparties who fail to the bank runs the risk of overdraft problems.
make payments.

A bank should attempt to identify, as early Accounting/Financial


in the process as possible, any expected Control
payments that are not received. They should
Process Description
be prioritized by counterparty credit ratings,
The accounting function ensures that FX
payment amount and currency, or by an
transactions are properly recorded to the
internally generated counterparty watch list.
balance sheet and income statement. If
All failed receipts should be subject to
transaction information is not recorded cor-
established follow-up procedures. A bank
rectly, a bank’s reputation may be impaired if
should also report nonreceipts to credit
material restatements of financial accounts
management and to sales and trading,
are necessary.
particularly for any recurring failures with one
particular counterparty. Management may Accounting entries are first booked
wish to consider a limited dealing relationship following the initiation of a trade. At this
with counterparties who have a history of point, details of the deal are posted to
settlement problems and continue to fail on contingent accounts (typically in a system
their payments to the bank. Payment of used by operations). At the end of each trade
interest and penalties should be prompt. day, all sub-ledger accounts flow through to
the general ledger. There are two common
Best Practice no. 39: methods for transferring and validating P&L
Establish Operational Standards information in the general ledger.
for Nostro Account Users
A bank should require all other users of its nostro In some banks, the sales and trading system
accounts to comply with the same operational compiles all of this data and develops a P&L
standards as FX users. figure for each day. The operations staff later
verifies the P&L figure. Other banks calculate
The FX department of a bank may be the two P&L figures independently: one is
primary user of nostro accounts. However, calculated by sales and trading, and one by
other business groups (for example, fixed the operations system. An independent party,
income, commodities, emerging markets, and such as the risk management division, verifies
derivatives) may also be users. Clear both P&L figures. Each morning, the P&L of
procedures should be established outlining the prior day’s business is verified by the
how each account is funded (that is, individual financial management function and analyzed
or group funding). Consistent standards by senior management.

MANAGEMENT OF OPERATIONAL RISK IN FOREIGN EXCHANGE 37


The accounting area should ensure that Best Practice no. 40:
following the initial entry of a trade into the Conduct Daily General Ledger
general ledger, the position is continually Reconciliation
marked to market until it is closed out. Daily Systematic reconciliations of 1) the general
marking to market calculates unrealized gains ledger to the operations system, and of 2) sales
and losses on the positions that are fed into and trading systems to the operations systems
the general ledger and the daily P&L. Once should be done daily.
these positions are closed out, realized gains
and losses are calculated and reported. Timely reconciliations will allow for prompt
detection of errors in the general ledger
All subsidiary ledger accounts (including all and/or sub-ledgers and should minimize
brokerage accounts and suspense accounts) accounting and reporting problems. This
are reconciled to the general ledger daily. reconciliation will ensure that the general
Additionally, on a monthly basis (usually at ledger presents an accurate picture of an
month-end) an independent check is done to institution’s market position. When problems
ensure that all subsystem accounts reconcile are detected, they should be resolved as soon
to the general ledger accounts. All as possible. Senior management should be
discrepancies are investigated as soon as notified of accounting discrepancies to review
possible to ensure that the bank’s books and and update control procedures as needed.
records reflect accurate information. In
addition, all discrepancies that have an
Best Practice no. 41:
impact on how the bank reports gains or Conduct Daily Position
losses are reported to senior management. and P&L Reconciliation
Daily P&L and position reconciliations should
Cash flow movements that take place on
take place between the sales and trading and
settlement date are also posted to the general
operations systems.
ledger in accordance with accepted accounting
procedures. The receipt and payment of Position reconciliations allow a bank to
expected cash flows at settlement are ensure that all managed positions are the
calculated in a bank’s operations system. There same as those settled by operations. This
are times when cash flows must be changed control is imperative when all deal entries and
because of trade capture errors, which require adjustments are not passed electronically
changes to a sub-ledger account. Accounting between sales and trading and operations.
entries are modified so that the general ledger When straight-through processing is in place,
accurately reflects business activities; the the reconciliation ensures that all deals were
change flows to the operations system where successfully processed from sales and trading
appropriate cash flow adjustments are made. to operations, along with all amendments.
Because a discrepancy in P&L between sales
and trading and operations can indicate a
difference in positions or market parameters

38 FOREIGN EXCHANGE COMMITTEE


(that is, rates or prices) all differences should quotations. In addition, at least once a month,
be reported, investigated, and resolved in a the results of the models should be checked
timely manner. against other dealers and/or brokers to ensure
that the valuations produced by the bank’s
Banks that maintain a single system for models are consistent with other dealers.
trade capture data should ensure that the data
source is properly controlled. Illiquid markets present additional risk to a
bank because illiquid instruments are
Best Practice no. 42: infrequently traded, making them difficult to
Conduct Daily Position Valuation price. Often, it is hard for a bank to obtain
Position valuations should be verified daily by a market quotes, thereby preventing timely and
staff that is separate from sales and trading. consistent position monitoring. P&L may be
Preferably, position valuation should be distorted and risk may not be properly
conducted by an independent third party such as managed. In such instances, a bank should
the risk management staff. Position valuation seek to obtain quotes from other
should be checked against independent price counterparties active in the market.
sources (such as brokers or other banks). This is Management should be aware of these
particularly important for banks that are active procedures so that they may effectively
in less liquid forward markets or in exotic options manage and evaluate illiquid market
markets. Trading management should be positions. These procedures allow a bank to
informed of the procedures used for marking to mark to market its positions and to evaluate
market to ensure that they can appropriately associated risks. All market participants
manage trade positions. should be aware that an FX option portfolio is
not effectively marked to market unless the
P&L is an integral part of the daily control valuation reflects the shape of the volatility
process; thus, it is important for the curve. With consideration given to the size of
calculation to be correct. The appropriate portfolio and daily activity, positions should
end of day rates and prices that are used to wherever possible be revalued reflecting the
create the position valuations should be “smile effect” when the firm wishes to mark to
periodically checked by an independent market. Where appropriate, firms should
source. Either operations or risk management reserve against liquidity and pricing risk.
should check that the rates and prices used by
Marking to market reflects the current value
sales and trading for end-of-day valuation are
of FX cash flows to be managed and provides
close to the market rates.
information about market risk.18 Senior
Position valuations should be verified using management will be able to better manage and
independent sources such as market rate evaluate market positions when they know
screens, other dealers, and/or broker how positions are valued on a daily basis.

18Group of Thirty, Global Derivatives Study Group, Derivatives: Practices and Principles (Group of Thirty, 1993), p.19.

MANAGEMENT OF OPERATIONAL RISK IN FOREIGN EXCHANGE 39


Best Practice no. 43: features that need to be handled differently
Review Trade Prices for Off-Market than spot and forward FX transactions.
Rates Specifically in the areas of

 option exercise and expiry,


Trade prices for both internal and external trades
should be independently reviewed to ensure
reasonableness within the market prices that
existed on the trade date.
 rate fixings for NDFs and some nonvanilla
options, and
Any trades executed at prices not
consistent with the market rates that existed at
 premium settlements for options.
the time of execution may result in an error Options exercise/expiry requires the
for the bank or may unduly enrich the bank or determination of the intrinsic value of the
the counterparty. Banks should institute a instrument. The intrinsic value is the amount by
daily procedure that provides for which the option is in-the-money. To
independent manual or automated review of determine this value, the strike price of an
trade prices versus prevailing market rates. option must be better than the market rate at
the time of expiration. This special event is one
Best Practice no. 44: of the unique features of options. Options have
Use Straight-Through Processing inherent risk associated with failure to perform
of Rates and Prices events such as exercising in-the-money
Rates and prices should be fed electronically transactions or obtaining fixings for non-vanilla
from source systems. options (such as average rate or average strike).
Senior operations management should clearly
The valuation of positions requires many define roles and responsibilities to ensure that
different rates and prices, sometimes these inherent risks are reduced.
collected from different sources. To eliminate
the errors associated with collecting and re- NDFs, much like options, also require
keying the required rates and prices, a bank additional processing. NDFs are cash-settled
should establish electronic links from the FX instruments that require a rate fixing to
systems that source the rates and price determine the cash settlement amount. Daily
information to the position valuation systems. review of outstanding transactions must be
performed to ensure that fixings are obtained
as required in the confirmation language.
Unique Features of Foreign Fixings are communicated by notification of a
Exchange Options fixing advice. Responsibility for the
and Non-Deliverable Forwards notification of the fixing advice should be part
of the confirmation process and performed
Process Description
by operations personnel.
Foreign exchange (FX) options and non-
deliverable forwards (NDFs) have unique

40 FOREIGN EXCHANGE COMMITTEE


The confirmation process for both FX electronically flow to the back-office FX
options and NDFs is comparable to straight FX processing system if a separate application is
trades. The difference is that FX options and used from the option processing system.
NDFs require additional language and staff
must understand more than the usual terms Best Practice no. 46:
and conditions in order to reduce operational Obtain Appropriate Fixings for
risk. In all other respects, FX options and NDFs Nonstandard Transactions
should be treated the same way as spot and Ensure that nonstandard transactions (such as
forward FX trades as outlined in this document. non-deliverable forwards [NDFs], barrier,
average rate, and average strike options) with
Best Practice no. 45: indexing components are fixed with the
Establish Clear Policies and appropriate rates as provided in the language of
Procedures for the Exercise of Options the confirmation or master agreement
Banks should have clear policies and procedures documentation.
that define roles and responsibilities and
Operations staff, independent of sales and
describe internal controls on the process of
trading, should obtain the fixing rates as
exercising and expiring foreign currency options.
defined in the confirmations for all
Banks should mitigate operational risk by nonstandard transaction types (such as NDFs,
implementing policies and procedures in average rate, average strike option trades).
conjunction with oversight departments and Confirmations should be reviewed on the
by assigning clearly defined roles and trade date to determine the fixing source. This
responsibilities. Determination of an in-the- fixing information should be captured by the
money option and notification to the back-office operational transaction
counterparty should be performed via an processing system and noted on the
independent, audible electronic system. individual confirmations. On the fixing date,
Exercising options, for example, should be fixing advices should be generated and
segregated from sales and trading and forwarded electronically (where possible) to
performed by staff that communicates the counterparty reflecting the fixing rate and
between the front- and back-office personnel. settlement amount.

Additionally, to reduce the likelihood that


Best Practice no. 47:
transactions are not exercised, systems Closely Monitor Option Settlements
should be designed to auto-exercise in-the- Option premium settlements should be closely
money transactions. Oversight is necessary in monitored to reduce the potential for out-trades.
the form of measuring options against market
rates, thereby ensuring that in-the-money Premium settlement of options should be
transactions are exercised appropriately. monitored closely to reduce the potential for
Foreign exchange trades resulting from out-trades. Option premium amounts can be
exercised options should automatically and small and not reflect the notional amount of

MANAGEMENT OF OPERATIONAL RISK IN FOREIGN EXCHANGE 41


the option transaction. Ensuring that the Examples of good practices include:
counterparty receives the settlement of the
premium can be an indication that the  precluding individuals from having both
trading and confirmation/settlement
counterparty is aware of the position, albeit
responsibilities concurrently,
not the details of the trade, which would be
covered in the confirmation.  precluding sales and trading personnel
from issuing and authorizing payments,

General Best Practices  precluding individuals from having both


posting and reconciling access to the gen-
Process Description eral ledger,
This section suggests general best practices that
apply to all segments of the FX process flow.  not allowing established procedures to
be overridden without operations man-
agement’s consent, and

 separate database functions between


Best Practice no. 48:
Ensure Segregation of Duties
The reporting line for operations personnel sales and trading and operations.
should be independent of the reporting line for
other business lines (sales and trading, credit, Best Practice no. 49:
accounting, audit, and so on). For key areas, Ensure That Staff Understand
operations management should ensure that an Business and Operational Roles
appropriate segregation of duties exists within Operations and sales and trading personnel
operations and between operations and other should fully understand all FX business strategies
business lines. and the role of each participant within the FX
process flow (for example, clients, credit,
Operations cannot be completely effective compliance, and audit). Policies and procedures
in performing its control functions if its should be documented and updated periodically.
members report to an area that they are
assisting. Operations must be able to report Business strategies, roles, responsibilities,
any and all issues to an independent and policies and procedures continually
management team. To do so, operations must change and evolve. Each group or individual
have a reporting line that is not directly playing a role in the FX process flow should
subject to an organizational hierarchy that have a complete understanding of how FX
could lead to a compromise of control. In trades are initiated, processed, confirmed,
addition, the compensation process for settled, controlled, and accounted.
operations personnel should be clearly Insufficient knowledge of the overall FX
segregated from that of the compensation process, or the role played by each individual
process of sales and trading. or group, can lead to an improper segregation

19See the “What Is Operational Risk?” in this document, p. 3.

42 FOREIGN EXCHANGE COMMITTEE


of duties, insufficient controls, and/or Best Practice no. 51:
increased risk. All market participants should Identify Procedures for Introducing
provide continuous employee education New Products, New Customer Types,
regarding business strategies, roles, or New Trading Strategies
responsibilities, and policies and procedures. All market participants should have adequate
The development of effective “front-to-back” procedures and controls in place for introducing
training should be encouraged to ensure that new products, new customers types, or new
all elements of the FX business are clearly trading strategies. These procedures and controls
understood by all. All market participants should include a provision to ensure that the
should insure that policies and procedure participant has the capability to initiate, price,
documents are current, documented, value, confirm, and settle these new types of
maintained, and available to all. transactions, customers, or strategies. The
market participant should also be able to
measure, monitor, and report all risks associated
Best Practice no. 50: with new products, customers, or strategies.
Understand Operational Risks
Market participants should fully understand When a new product, new customer, or
operational risks.19 To help mitigate operational new business strategy is introduced, all areas-
risks, every market participant should implement operations, sales and trading, financial
adequate controls, modify processes and flows control, risk control, legal, compliance,
when appropriate, and/or invest in improved technology, and others—should be fully
technology. Current as well as potential knowledgeable and prepared to execute and
operational risks associated with new industry process the new dealings in a controlled
process changes (for example, the CLS Bank, environment. New products, new customer
web portals, and so on), should be assessed on a types, or new business strategies may
regular basis, quantified wherever possible, and introduce different types of risks or increase
reported to senior management. existing risks. They may also result in different
methods of trade capture, confirmation,
Areas of exposure within the FX processing
netting, settling, reconciling, and/or P&L
cycle need to be identified, quantified where
reporting. Any change to existing processes,
possible, and adequately controlled. With
practices, or policies should be effectively
better information regarding operational risks,
controlled and reported. Procedures and
institutions can make informed decisions
controls that detail operational and systems
about which risks they are going to assume
support guidelines should be documented
and which risks need to be managed either
and published.
through enhanced process flows and controls
or through investments in improved
technology. Proactive thinking concerning
current and future trends is recommended.

MANAGEMENT OF OPERATIONAL RISK IN FOREIGN EXCHANGE 43


Best Practice no. 52: should have limited access to production systems,
Ensure Proper Model Sign-off and and only in a strictly controlled environment. Each
Implementation system should have access controls that allow only
Quantitative models often support FX trading authorized individuals to alter the system and/or
activities. As a result, their implementation and gain user access. Function-specific user access
management should be a coordinated effort “profiles” are suggested.
among the various FX business lines. Model
implementation and maintenance should ensure As alternative technologies (for example,
that all FX business lines (Sales & Trading, web-based trading) continue to emerge in the
Operations, financial control, risk control, FX trading and processing environments,
technology, audit, and others) approve, support, rigorous controls need to be implemented
and understand the model purpose and and monitored to ensure that data integrity
and security are not sacrificed. External user
capabilities, as well as the roles and responsibilities
access controls should be as robust as internal
of each business line. Further, to maintain
user access controls.
appropriate segregation of duties, model
validation, model technical development, and Access to production systems should only
data input and output reporting should all be allowed for those individuals who require
be performed independently from Sales & Trading. access in order to perform their job function.
When creating user access profiles, system
Models may be used to report positions, to
administrators should tailor the profile to
manage position risk, or to price financial
match the user’s specific job requirements,
instruments. New models, or modifications to
which may include “view only” access. System
existing models, may change or challenge
access and entitlements should be
established policies, procedures, and/or
periodically reviewed, and users who no
practices. It is important that all FX business
longer require access to a system should have
lines understand how the pricing of certain
their access revoked. Under no circumstance
instruments will change and how position
should operations or sales and trading have
monitoring will be evaluated if a new model is
the ability to modify a production system for
introduced or an existing model modified.
which they are not authorized.
Model risk and potential business disruptions
can be effectively controlled through cross
business line approval, implementation, Best Practice no. 54:
management, and education. Establish Strong Independent
Audit/Risk Control Groups
Market participants should have sophisticated
Best Practice no. 53: and independent audit/risk control groups. It is
Control System Access recommended that market participants perform
Users of a system (for example, operations, sales rigorous self-assessments and publish regular
and trading) should not be able to alter the reporting of such to management, the business
functionality of production systems. Developers line, and audit/risk control groups. Firms should

44 FOREIGN EXCHANGE COMMITTEE


implement policies and procedures that enable Market participants may employ Service
employees to raise concerns anonymously. Level Agreements (SLAs) as a way of improving
and controlling operational performance. SLAs
The audit/risk control groups play a most should always be exchanged when outsourcing
important role. They ensure that quantifiable all or part of a participant’s operation. SLAs
and effective controls are in place and working should clearly define, measure, and report on
properly and that policies and procedures are operational performance. External (outsourced)
relevant as well as followed. The goal of these performance measurements should be as
groups is to protect the market participant robust as internal performance measurements.
against financial or reputation loss by
monitoring or uncovering flaws in the process
Best Practice no. 56:
or procedures and suggesting corrective
Ensure That Service Outsourcing
action. These groups must not have a reporting Conforms to Industry Standards
line that is subject to an organizational and Best Practices
hierarchy that could lead to a compromise of If a bank chooses to outsource all or a portion of
control, assessment, or escalation. its operational functions, it should ensure that its
internal controls and industry standards are met.
Best Practice no. 55: A bank that outsources should have adequate
Use Internal and External operational controls in place to monitor that the
Operational Performance Measures outsourcer is performing its functions according
Operational performance reports should be to agreed-upon standards and industry best
established to clearly measure and report on the practices.
quality of both internal and external
(outsourced) operational performance. The A bank may choose to outsource some or
report measurements should focus on all of its operations functions. However,
operational efficiency and controls, and be outsourcing should in no way compromise a
reviewed on a regular basis by both operations bank’s internal standards for confirmations,
and sales and trading management. settlement and payments. Controls should be
Operational performance reporting should in place to monitor vendors to ensure that
contain quantifiable performance metrics at internal standards are met. For example,
the levels of detail and summary, and indicate trades should still be confirmed in a timely
the status of operational activities. Typical key manner and proper escalation and
performance measures would include notification procedures must be followed.
confirmation, acceptance and aging reporting,
nostro and cash balance reporting, operational Best Practice no. 57:
error and loss reporting, and any other relevant Implement Globally Consistent
data deemed necessary by the participant. Processing Standards
These reports should serve to control and When a bank has multiple processing centers, it
proactively monitor risk and performance.
should ensure that bankwide standards are met

MANAGEMENT OF OPERATIONAL RISK IN FOREIGN EXCHANGE 45


in each location. Banks should use consistent agreement between the parties. Documentation
procedures and methodologies throughout the should cover communication not only between
institution. Satellite offices or separate entities the sales and trading groups of the bank and the
require close oversight to ensure that they counterparty but also between the operations
conform to the standards of the bank. area of the bank and the counterparty.

Some banks may maintain multiple Deal execution and confirmation documen-
processing centers in different locations around tation can aid institutions in verifying trade
the world. Regional processing may allow a firm details and ensure that amounts were confirmed
to maintain around-the-clock processing for as expected. This step may help a bank if it
multiple front-end trading locations. However, becomes involved in counterparty disputes. For
it is essential that a firm’s standards and each trade, the following information should be
processes are consistent throughout the bank. documented: currencies, amount, price, trade
Although different processing centers may rely date, value date and the notional currency of
on different systems or technology, the each transaction.
standards and procedures should be the same
in every processing center. For example, The length of time that a bank keeps
valuation methodologies should remain records (which may be left to management’s
consistent throughout the firm. discretion) depends on the type of business
they transact and may also be subject to local
In addition, some firms may rely on regulations. Record retention, for example,
centralized booking and operations, but may may depend on the character of a bank’s
have specific exceptions, such as satellite forward trading or long-dated options trading.
offices, or branches that serve as separate
It is important to note that trades conducted
legal entities. Such sites should be carefully
over the telephone pose particular risks. The
monitored to ensure that their bank’s
phone conversation is the only bilateral record
standards are being met.
of the trade details, at least until the trade is
validated through the traditional confirmation
Best Practice no. 58: process. Until this confirmation process is
Maintain Records of Deal Execution completed, market participants should
and Confirmations establish close controls to minimize the
Banks should maintain documentation exposure inherent in such trades.
supporting the execution of foreign exchange
trades. Such documentation should provide a
Best Practice no. 59:
sufficient audit trail of the events throughout the
Maintain Procedures for Retaining
deal execution, trade, and validation process. Transaction Records
This documentation may be in the form of The operations group is responsible for retaining
written or electronic communication, a tape adequate records of all transactions and supporting
recording, or other forms evidencing the documentation for the financial statements.

46 FOREIGN EXCHANGE COMMITTEE


Operations must maintain detailed records contingency plans should cover both long-term
of all transactions executed and of all and short-term incapacitation of a trading or
information to support its P&L and position operations site, the failure of a system, the failure
calculations. Each market participant should of a communication link between systems, or the
determine appropriate record retention failure of an internal/external dependency. These
based on tax, regulatory, and legal plans should include informing, monitoring,
requirements for each jurisdiction. It is and coordinating personnel.20
recommended that records be maintained in
duplicate and in a location separate from The primary risk of a major disaster is that a
where primary processing occurs. market participant may not be able to meet its
obligation to monitor its market positions.
If and when external vendors or storage Many market participants deal in high
facilities are employed, it is essential that they volumes of large trades. Failure to be able to
provide a similar backup facility. Records can trade or settle transactions from a given center
be maintained on paper, optical, or magnetic (or several trading centers in the case of
media. If a computer-based format is used, centralized operations processing) could
the programs and their documentation need subject the market participant to severe
to be retained so that the data can be read at financial and reputational repercussions.
a later date. Special care must be taken
because newer versions of software Market participants should identify various
frequently cannot read older data files. Older types of potential disasters and identify how
programs may also not run correctly on newer each may prohibit the participant from satisfying
operating systems or machines. In addition, its obligations (that is, issuing and receiving
magnetic media must be maintained carefully confirmations, performing settlements, and
because it degrades in adverse conditions. completing daily trading). Disaster recovery
plans should identify requisite systems and
procedural backups, management objectives,
Best Practice no. 60:
Develop and Test Contingency Plans people plans, and the methodology or plan for
Operations and sales and trading should dealing with each type of disaster. Disaster
recovery plans should be reviewed on a regular
develop plans for operating in the event of an
basis, and tested periodically, to gauge the
emergency. Contingency plans should be
effectiveness of the plans themselves and
periodically reviewed, updated, and tested. These
measure staff readiness.

20Additionalguidance on foreign exchange contingency planning is provided by Foreign Exchange Committee, “Contingency Planning:
Issues and Recommendations,” In The Foreign Exchange Committee 2001 Annual Report (New York: Federal Reserve Bank of New York,
2002). Several regulatory bodies offer guidance on firmwide contingency planning. The Federal Reserve Bank of New York offers guidance
at <http://www.newyorkfed.org/bankinfo/circular/10952.pdf>. Broker/dealers may look to several documents from the Securities and
Exchange Commission and the Securities Industry Association for guidance, including <http://www.sec.gov/divisions/marketreg/lessons
learned.htm> and <http://www.sia.com/business_continuity/pdf/bestpractices.pdf>

MANAGEMENT OF OPERATIONAL RISK IN FOREIGN EXCHANGE 47


An emergency crisis team, equipped with critical processing systems. Backup sites
key personnel contact lists, should be should be able to access critical confirmation
established to monitor crisis and coordinate and netting systems, key liquidity providers,
recovery efforts. Market participants should and other industry utilities. Business
develop contingency contact lists (for both continuity plans should also consider the
internal and external dependencies) and recovery capabilities of critical service
distribute them to employees. All personnel providers, in particular, their clearing and
should know whom to contact in the event third party settlement banks.
of a disaster. Market participants should also
maintain emergency contact information to Additionally, all market participants should
reach primary counterparties. Counterparty identify and practice alternative methods of
information records should include confirmation and settlement communication
contingency site phone numbers and with nostro banks. These methods may
emergency contact information for key require the use of fax or telex to ensure
personnel. proper processing.

Backup sites that can accommodate the During a disaster, a bank should notify its
essential staff and systems of operations and counterparties of potential processing changes.
sales and trading should be set up, A bank should also provide counterparties with
maintained, and tested on a regular basis. current contact information for key personnel
Particularly for operations, market participants to ensure that counterparties can contact the
should consider developing a backup site that bank in an emergency.
relies on a separate infrastructure (electricity,
Market participants should ensure that the
telecommunications, etc.) and an alternative
communication tools used by operations and
workforce. Banks may want to leverage
sales and trading are secure. If phone systems
multiple processing sites to serve as
fail, backup systems should exist (that is, cellular
emergency backup facilities in the event of an
emergency. In case of primary system failure, or non-PBX phones). All market participants
backup systems should be available and should be connected to multiple phone
capable of acting as primary systems. These substations to further prepare for disaster.
systems should provide for payment and
During market disturbances, market
settlement as well as the monitoring and
participants should pay special attention to
managing of both position and settlement risk.
guidance communicated by industry groups
Backup systems should have access to current
such as the Foreign Exchange Committee and
and historical data which should be backed-
the Singapore Foreign Exchange Market
up in a separate location from the primary site.
Committee. Industry groups may provide
Market participants’ business continuity special recommendations in times of market
plans should take into consideration the stress to aid the flow of information on special
technical support requirements of their issues that may arise.

48 FOREIGN EXCHANGE COMMITTEE


Conclusion operations. However, such segregation of
This paper has reviewed the entire foreign duties does not imply that operations should
exchange process flow and best practices for be viewed as separate from other business
maintaining a properly controlled environment.
However, as noted in the introduction, several lines. On the contrary, the authors of this
trends in the industry will affect a bank’s ability paper feel that the closer operations manage-
to implement the best practices as listed in this ment is to the pulse of business, and the bet-
document. Although the market will continue ter the communication between sales and
to evolve and develop mitigating controls, and trading management and operations manage-
any set of recommendations will eventually ment, the more responsive operations can be
require revision, management should consider to changes in the business environment.
the practices suggested here as helpful Ultimately, better links between an institu-
responses to recent developments in tech-
tion’s divisions will enable business as a whole
nology, instruments, and innovations in the
to be better controlled.
marketplace.

The first step toward a properly controlled


environment is an appropriate segregation of
duties between sales and trading, and

MANAGEMENT OF OPERATIONAL RISK IN FOREIGN EXCHANGE 49


Acknowledgments
This document was originally completed in 1996 thanks to a task force of people representing various
institutions on the FX Committee. That task force included:

Arthur Magnus (Chair) Charles LeBrun Stephanie Reiter


J.P. Morgan and Co., Inc. Bank One, NA J.P. Morgan and Co., Inc.
Pauline Chen John Moran Michael Richter
Federal Reserve Bank Midland Bank Citibank, N.A.
of New York
Paul Puskuldjian Marlene Wiseman
Wayne Ferguson Lehman Brothers Bankers Trust Company
Citibank Dealing Resources

The task force for the 2003 revision included:

Charles LeBrun (Chair) Erik Johnsen Julie Seifert


Bank One, NA FleetBoston Financial FleetBoston Financial
Kimberly Agostinelli** Keith McDonald Robert White***
Bank One, NA Credit Suisse First Boston Standard Chartered Bank
Andy Burton Arthur Magnus** Robert Eby
JP Morgan Chase JP Morgan Chase Lehman Brothers
Paul Ginsberg Angela Meyer
EBS Dealing Resources, Inc. Foreign Exchange
Committee
Mel Gunewardena
Goldman Sachs & Co. Joe Palamara
Wachovia Bank
Tony Hamablet
Deutsche Bank AG Rick Rua***
Mellon Bank, N.A.
Pamela Hutson*
Bank One, NA Phillip Scott
Bank of New York
Cynthia Ingram
(Coordinator) Gary Sims*
Bank One, NA Bank of New York

* Financial Markets Lawyers Group representative


** Guest participant
*** Foreign Exchange Committee representative

50 FOREIGN EXCHANGE COMMITTEE


Works Consulted
Bank for International Settlements. Basel Committee ———. “Guidelines for FX Settlement Netting.” In The
on Banking Supervision. Operational Risk Foreign Exchange Committee 1996 Annual Report.
Supporting Documentation to the New Basel Capital New York: Federal Reserve Bank of New York,
Accord. Basel: BIS, 2002. 1997.
———. “Guidelines for the Management of FX
Triennial Central Bank Survey of Foreign Exchange
Trading Activities.” In The Foreign Exchange
and Derivatives Market Activity 2004. Basel: BIS,
Committee 2000 Annual Report. New York:
2004.
Federal Reserve Bank of New York, 2001.
Board of Governors of the Federal Reserve System.
———. “Reducing FX Settlement Risk.” In The Foreign
“Evaluating the Risk Management and Internal
Exchange Committee 1994 Annual Report. New
Controls of Securities and Derivative Contracts
York: Federal Reserve Bank of New York, 1995.
Used in Non-trading Activities.” SR 95-17.
Washington, D.C.: GPO, 1995. ———. “Standardizing the Confirmation Process.” In
The Foreign Exchange Committee 1995 Annual
Financial Accounting Standards Board.
Report. New York: Federal Reserve Bank of New
“Disclosure of Information about Financial
York, 1996.
Instruments with Off-Balance-Sheet Risk and
Financial Instruments with Concentrations of ———. “Supplementary Guidance on Electronic
Credit Risk.” In FASB Statement No. 105. FASB, Validations and Confirmation Messaging.” In
March 1990. The Foreign Exchange Committee 2001 Annual
Report. New York: Federal Reserve Bank of New
———. “Offsetting of Amounts Related to Certain
York, 2002.
Contracts: An Interpretation of APB Opinion
No. 10 and FASB Statement No. 105.” In FASB Group of Thirty. Global Derivatives Study Group.
Interpretation No. 39. FASB, March 1992. Derivatives: Practices and Principles. Washington,
D.C.: Group of Thirty, 1993.
Foreign Exchange Committee. “Defining and
Measuring FX Settlement Exposure.” In The U.S. Comptroller of the Currency. Banking Circular
Foreign Exchange Committee 1995 Annual Report. 277. Washington, D.C.: GPO, 1993.
New York: Federal Reserve Bank of New York,
1996.

MANAGEMENT OF OPERATIONAL RISK IN FOREIGN EXCHANGE 51


Best Practices Map to 1996 Version and Checklist

Checklist 2003 Version 1996 Version

Pre-Trade Preparation and


Documentation
Process Description

BP no. 1: Know Your Customer

BP no. 2: Determine Documentation BP no. 4: Trading and Operational Practices


Requirements Should be Agreed Upon

BP no. 3: Use Master Netting Agreements BP no. 19: Master Netting Agreements

BP no. 4: Agree upon Trading and


Operational Practices

BP no. 5: Agree upon and Document


Special Arrangements

Trade Capture
BP no. 6: Enter Trades in a Timely Manner BP no. 1: Timely Trade Entry

BP no. 7: Use Straight-Through Processing BP no. 2: Straight-Through Processing


of Transactions

BP no. 8: Use Real-Time Credit Monitoring BP no. 3: Credit Information Available


Online

BP no. 9: Use Standing Settlement BP no. 5: All Market Participants Should


Instructions Use SSIs

BP no. 10: Operations Should Be BP no. 6: Operations Responsibility


Responsible for Settlement Instructions for Settlement Instructions

BP no. 11: Review Amendments BP no. 8: Review of Amendments

BP no. 12: Closely Monitor Off-Market BP no. 7: Review of Third-Party Payments


and Deep-in-the-Money Option
Transactions

52 FOREIGN EXCHANGE COMMITTEE 2003 ANNUAL REPORT


Checklist 2003 Version 1996 Version

Confirmation
BP no. 13: Confirm and Affirm Trades BP no. 9: Timely Confirmation/Affirmation
in a Timely Manner BP no. 14: Timely Resolution
of Confirmation Exceptions

BP no. 14: Be Diligent When


Confirming by Nonsecure Means

BP no. 15: Be Diligent When Confirming


Structured or Nonstandard Trades

BP no. 16: Be Diligent When Confirming


by Telephone

BP no. 17: Institute Controls for Trades


Transacted through Electronic Trading
Platforms

BP no. 18: Verify Expected Settlement BP no. 10: Expected Settlement


Instructions Instructions

BP no. 19: Confirm All Netted Transactions BP no. 11: Confirm All Netted Transactions

BP no. 20: Confirm All Internal BP no. 13: Confirm All Internal Transactions
Transactions

BP no. 21: Confirm All Block Trades BP no. 12: Confirm All Split Trades
and Split Allocations

BP no. 22: Review Third-Party Advices BP no. 16: Review of Reuters Logs and
Brokers’ Advices

BP no. 23: Automate the Confirmation BP no. 18: Automation of the Confirmation
Matching Process Matching Process

BP no. 24: Establish Exception Processing BP no. 17: Escalation Procedures/


and Escalation Procedures Non-confirming Counterparties

MANAGEMENT OF OPERATIONAL RISK IN FOREIGN EXCHANGE 53


Checklist 2003 Version 1996 Version

Netting
BP no. 25: Use Online Settlement BP no. 20: Online Payment Netting
Netting Systems Systems

BP no. 26: Confirm Bilateral Net Amounts BP no. 21: Confirmation of Bilateral Net
Amounts

BP no. 27: Employ Timely Cutoffs BP no. 22: Timely Cutoffs for Netting
for Netting

BP no. 28: Establish Consistency between BP no. 23: Consistent Operational and
Operational Practices and Documentation Policies
Documentation

Settlement
BP no. 29: Use Real-Time Nostro BP no. 24: Online Real-Time Nostro
Balance Projections Balance Projections

BP no. 30: Use Electronic Messages BP no. 25: Electronic Messages for
for Expected Receipts Expected Receipts

BP no. 31: Use Automated Cancellation BP no. 26: Automated Cancellation and
and Amendment Facilities Amendment Facilities

BP no. 32: Implement Timely Payment BP no. 27: Timely Payment Cutoffs
Cutoffs

BP no. 33: Report Payment Failures BP no. 28: Reporting Payment Failures
to Credit Officers to Credit

BP no. 34: Understand the Settlement BP no. 29: Knowledge of the Settlement
Process and Settlement Exposure Process and Settlement Exposure

BP no. 35: Prepare for Crisis Situations BP no. 30: Crisis Situations Preparation
Outside Your Organization

Nostro Reconciliation
BP no. 36: Perform Timely Nostro BP no. 31: Timely Nostro Account
Account Reconciliation Reconciliation

54 FOREIGN EXCHANGE COMMITTEE 2003 ANNUAL REPORT


Checklist 2003 Version 1996 Version

BP no. 37: Automate Nostro BP no. 32: Automated Nostro


Reconciliations Reconciliations

BP no. 38: Identify Nonreceipt BP no. 33: Identification of Nonreceipt


of Payments of Payments

BP no. 39: Establish Operational BP no. 34: Operational Standards


Standards for Nostro Account Users for Nostro Account Users

Accounting/Financial Control
BP no. 40: Conduct Daily General BP no. 35: Daily General Ledger
Ledger Reconciliation Reconciliation

BP no. 41: Conduct Daily Position BP no. 36: Daily Position and P&L
and P&L Reconciliation Reconciliation

BP no. 42: Conduct Daily Position BP no. 37: Daily Position Valuation
Valuation

BP no. 43: Review Trade Prices BP no. 38: Review Trade Prices
for Off-Market Rates for Off-Market Rates

BP no. 44: Use Straight-Through BP no. 39: Straight-Through Processing


Processing of Rates and Prices of Rates and Prices

Unique Features of Foreign Exchange


Options and Non-Deliverable Forwards
BP no. 45: Establish Clear Policies and
Procedures for the Exercise of Options

BP no. 46: Obtain Appropriate Fixings


for Nonstandard Transactions

BP no. 47: Closely Monitor Option


Settlements

General Best Practices


BP no. 48: Ensure Segregation of Duties BP no. 40: Segregation of Duties

MANAGEMENT OF OPERATIONAL RISK IN FOREIGN EXCHANGE 55


Checklist 2003 Version 1996 Version

BP no. 49: Ensure That Staff Understand


Business and Operational Roles

BP no. 50: Understand Operational Risks BP no. 41: Understanding Business and
Operational Roles
BP no. 42: Understand Operational Risks

BP no. 51: Identify Procedures for BP no. 43: Procedures for Introducing
Introducing New Products, New Products
New Customer Types, or
New Trading Strategies

BP no. 52: Ensure Proper Model Sign-off BP no. 44: Model Sign-off/Implementation
and Implementation

BP no. 53: Control System Access BP no. 45: System Access Control

BP no. 54: Establish Strong Independent BP no. 48: Strong Independent Audit
Audit/Risk Control Groups Group

BP no. 55: Use Internal and External BP no. 46: Operational Performance
Operational Performance Measures Measures

BP no. 56: Ensure That Service


Outsourcing Conforms to Industry
Standards and Best Practices

BP no. 57: Implement Globally


Consistent Processing Standards

BP no. 58: Maintain Records of BP no. 47: Taped Conversations between


Deal Execution and Confirmation Counterparties

BP no. 59: Maintain Procedures BP no. 49: Responsibility for Record


for Retaining Transaction Records Retention

BP no. 60: Develop and Test BP no. 50: Contingency Plans


Contingency Plans

56 FOREIGN EXCHANGE COMMITTEE 2003 ANNUAL REPORT

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