MANAGEMENT OF OPERATIONAL
RISK IN FOREIGN EXCHANGE (I)
Pre-Trade Preparation and Documentation
Process
Description
The
pre-trade preparation and documentation process initiates the business
relationship between two parties. During this process, both partiesÕ KàU needs and
business practices should be established. An understanding of each
counterpartyÕ KàUs trading characteristics and level of technical sophistication
should also develop. In summary, the pre-trade process allows both parties to
mutually agree on procedures and practices to ensure that business is conducted
in a safe and sound manner.
In
the pre-trade process, a bank develops an understanding of the inherent
business risks and risk mitigants of each of its counterparty relationships.
The documentation and agreements reflecting the relationship should be
identified and, if possible, executed before trading. Thus, pre-trade
preparation involves coordination with sales and trading and operations as well
as other support areas such as systems, credit, legal, and compliance to
establish trade capture parameters and requirements that should be in place
prior to trading. This process is especially important when the business
requirements may be unique and require additional controls.
Best Practice no. 1:Know Your Customer
A
bank should know the identity of its counterparties, the activities they intend
to undertake with the bank, and why they are undertaking those activities.
All
firms should have strong Know Your Customer (KYC) procedures for collecting information
required to understand who the customer is and why they are conducting
business. KYC procedures have long been the first line of defense for banks in
setting appropriate credit limits, determining the most appropriate
documentation for the activities being contemplated, identifying additional
business opportunities, and protecting against fraud.
KYC
procedures have, more recently, also become the cornerstone for combating
criminal activity. Illicit activity has become more sophisticated in the methods
used to conceal and move proceeds. The global response has been to develop laws
and regulations requiring institutions to establish familiarity with each of
their counterparties to better identify and report suspicious activity.
At
a minimum, information relating to the identity of a counterparty and the
counterpartyÕ KàUs activity should be gathered to satisfy applicable laws and
regulations for prudent business conduct. The reputation and legal risk to
banks of not being vigilant in knowing their customers and complying with KYC
laws and regulations can be severe. In the United States, examples of laws and
regulations that impose obligations of this sort on banks are the Bank Secrecy
Act, money laundering regulations, U.S. Treasury, Office of Foreign Assets
Control (OFAC) regulations, and the USA PATRIOT Act.
Best Practice no. 2:Determine Documentation Requirements
A
bank should determine its documentation requirements in advance of trading and
know whether or not those requirements have been met prior to trading.
A
bank should execute transactions only if it has the proper documentation in
place. The types of documentation that may be required include 1) master
agreements (see Best Practice no. 3), 2) authorized signatory lists, and 3)
standard settlement instructions. Such documents should be routinely checked
before executing trades. An institution should also establish a policy on
whether or not it will trade, and in what circumstances, without first
obtaining a master agreement (for example, IFEMA, ICOM, FEOMA, or the ISDA
Master) with a customer covering the transactions. It should also be noted that
electronic trading often requires special documentation. Specifically, customer
and user identification procedures, as well as security procedures, should be
documented.
This
recommendation emphasizes the principles of awareness and information with
respect to documentation. In practice, it may be difficult to do business with
a policy that requires documentation to be in place in every instance. In many
cases, the risks of not having a particular piece of documentation may be
acceptable. Nonetheless, it is crucial that all relevant personnel 1) know the
policy of the institution on documentation, 2) know when the documentation is
or is not in place, and 3) be able to produce reports regarding documentation
status.
Representatives
of the business, operations, credit, legal, and compliance areas, for example,
need to establish the institutionÕ KàUs policies and document their understanding
of these policies in writing. The institution should have adequate tracking
systems (manual or other) to determine when policy requirements are satisfied
or not. These systems should be able to produce reports necessary for proper
contract monitoring.
If
the policy of the institution is to have a master agreement in place, the
institution should be able to produce a report displaying any missing master
agreements. Such reports should classify data by age and be distributed to
management. Lastly, there should be escalation and support procedures in place
for dealing with missing documentation when normal efforts are not enough to
obtain it.
Best Practice no. 3:Use Master Netting Agreements
If
a bank elects to use a master agreement with a counterparty, the master
agreement should contain legally enforceable provisions for Ò KˆHcloseoutÓ K€H netting
and settlement netting.
“ Closeout” and settlement netting provisions in
master agreements permit a bank to decrease credit exposures, increase business
with existing counterparties, and decrease the need for credit support of
counterparty obligations. Closeout netting clauses provide for 1) appropriate
events of default, including default upon insolvency or bankruptcy, 2)
immediate closeout of all covered transactions, and 3) the calculation of a
single net obligation from unrealized gains and losses. Closeout provisions
have the added benefit of a positive balance sheet effect under Financial
Accounting Standards Board (FASB) Interpretation 39, which allows the netting
of assets and liabilities in the unrealized gains and losses account if netting
is legally enforceable in the relevant jurisdiction.
Closeout
netting provisions help to protect a bank in the event of a counterparty
default. When a counterparty defaults, and a closeout netting agreement is not
in place, the bankruptcy trustee of the defaulting party may demand payment on
all contracts that are in-the-money and refuse to pay on those where it is
out-of-the-money. If the defaulting counterparty takes this action, the
nondefaulting party may be left with a larger-thanexpected loss. A master
agreement signed by both parties with enforceable closeout netting provisions
ensures that the counterparty remains responsible for all existing contracts
and not just those it chooses to endorse.
Settlement
netting permits parties to settle multiple trades with a counterparty with only
one payment instead of settling each trade individually with separate payments.
Consequently, settlement netting decreases operational risk to the bank in
addition to reducing settlement risk. To realize the settlement netting
benefits, however, a bankÕ KàUs operations function must commence settling on a net
basis. Therefore, it is essential that operations receive a copy of the
agreement or be notified of the terms of the executed agreement. Given the
benefits of settlement netting, it is in a bankÕ KàUs best interest to include
settlement netting in any master agreement that it may enter into.
The
following master agreements have been developed as industry-standard forms.
Each form includes provisions for settlement netting (included as an optional
term) and closeout netting:
Ó K€HÓ K€HÓ K€HÓ K€HÓ K€HÓ K€H _ ISDA Master Agreement
Ó K€HÓ K€HÓ K€HÓ K€HÓ K€HÓ K€H _ IFEMA Agreement covering spot and
forward currency transactions
Ó K€HÓ K€HÓ K€HÓ K€HÓ K€HÓ K€H _ ICOM Agreement covering currency
options
Ó K€HÓ K€HÓ K€HÓ K€HÓ K€HÓ K€H _ FEOMA Agreement covering spot and
forward currency transactions and currency options
These
netting provisions should satisfy relevant accounting and regulatory standards
as long as legal opinions are able to conclude that the agreements are legally
enforceable in each jurisdiction in which they are applied. Banks should confer
with local legal counsel in all relevant jurisdictions to ensure that netting
provisions are enforceable. To the extent that local counsel suggests that
certain provisions of a master netting agreement may be unenforceable, the bank
should ensure that other provisions in the agreement could be enforced
nonetheless.
Best Practice no. 4:Agree upon Trading and Operational Practices
Trading
and operational practices should be established with all counterparties.
Most
banks reach an understanding with all counterparties as to the type of business
they will be transacting and how they should interact. Banks should include key
operational practices such as providing timely confirmation or affirmation, the
use of standing settlement instructions (SSIs), and timely notification of
splits.
The
level of trading activity with fund managers and investment advisors
hasescalated in recent years. These clients transact in block or bulk trades,
which are then split into smaller amounts and entered into specific client
accounts managed by fund managers or investment advisors. Until a block or bulk
trade is properly allocated to the specific accounts of each fund entity,
inaccurate credit risk management information may exist.
The
understanding should clearly establish confirmation and settlement procedures
for all counterparties and delineate both the bank and clientÕ KàUs obligations in
the process flow. A bank should strongly encourage clients to confirm bulk trades
as soon as possible after the trade is executed. In addition, a bank should
request that fund managers provide them with the Ò KˆHsplitÓ K€H information on the
trade date for all trade types (spot, forwards, swaps, tom/next, etc.)
regardless of maturity, so that the bankÕ KàUs credit information can be updated as
soon as possible.
Best Practice no. 5:Agree upon and Document Special Arrangements
If,
in the course of the documentation set-up and establishment of trade and
operational practices, it becomes clear that a counterparty requires special
arrangements such as thirdparty payments or prime brokerage serviceÓ K€H those arrangements should be agreed upon and
documented in advance of trading.
Counterparties
at times may request thirdparty payments to facilitate underlying commercial
transactions. Third-party payments are the transfer of funds in settlement of a
FX transaction to the account of an entity other than that of the counterparty
to the transaction. However, third-party payments raise important issues that need
to be closely considered by an organization engaged in such practices.
Firms
should recognize that third-party payments cause a significant increase in
operational risk. Since the identity and entitlement of the third party is not
known to the bank, extreme care should be taken in verifying payment
instructions to third parties. Regulatory requirements such as the USA PATRIOT
Act, OFAC, and the Bank Secrecy Act should also be applied to third parties.
Both the counterparty and bank management should be aware of the risks involved
with these transactions and should establish clear procedures beforehand for
validating both the authenticity and correctness of such requests.
Prime
brokerage arrangements may also involve special occasions for misunderstanding
the respective rights and obligations of the various parties. Such arrangements
should be evidenced by written agreements (prime broker and dealer, prime
broker and customer, dealer and customer) that have been reviewed and approved
by legal counsel.