management of operational risk in foreign exchange

The Foreign Exchange CommitteeNovember 2004

Managementof

RiskOperational

in Foreign Exchange

2 FOREIGN EXCHANGE COMMITTEE

Introduction .....................................5The FX Marketplace ..........................................5The Changing Marketplace...............................5The History of This Document .........................6What Is Operational Risk? ................................6What Are “Best Practices”?................................7How to Use This Document.............................8Future Trends.....................................................8Figure 1 —The FX Process Flow..........................9Definitions of Key Terms...................................9

Pre-Trade Preparationand Documentation.........................10

Process Description ........................................10Best Practice no. 1: Know Your Customer .........11Best Practice no. 2: Determine

Documentation Requirements......................11Best Practice no. 3: Use Master Netting

Agreements....................................................12Best Practice no. 4: Agree upon Trading

and Operational Practices.............................13Best Practice no. 5: Agree upon and Document

Special Arrangements ...................................14

Trade Capture.................................15Process Description .........................................15Best Practice no. 6: Enter Trades

in a Timely Manner .......................................16Best Practice no. 7: Use Straight-Through

Processing......................................................16Best Practice no. 8: Use Real-Time Credit

Monitoring .....................................................17Best Practice no. 9: Use Standing

Settlement Instructions..................................17Best Practice no. 10: Operations Should Be

Responsible for Settlement Instructions ......18Best Practice no. 11: Review Amendments .......18Best Practice no. 12: Closely Monitor

Off-Market and Deep-in-the-MoneyOption Transactions ......................................19

Confirmation...................................20Process Description........................................20Best Practice no. 13: Confirm and Affirm

Trades in a Timely Manner ...........................22Best Practice no. 14: Be Diligent When

Confirming by Nonsecure Means ................22

Best Practice no. 15: Be Diligent WhenConfirming Structured or Nonstandard Trades..23

Best Practice no. 16: Be Diligent WhenConfirming by Telephone.............................24

Best Practice no. 17: Institute Controlsfor Trades Transacted through ElectronicTrading Platforms ..........................................24

Best Practice no. 18: Verify ExpectedSettlement Instructions.................................25

Best Practice no. 19: Confirm All NettedTransactions...................................................25

Best Practice no. 20: Confirm All InternalTransactions...................................................25

Best Practice no. 21: Confirm All BlockTrades and Split Allocations .........................26

Best Practice no. 22: Review Third-Party Advices ...26Best Practice no. 23: Automate the

Confirmation Matching Process ...................27Best Practice no. 24: Establish Exception

Processing and Escalation Procedures.........28

Netting ...........................................29Process Description ........................................29Best Practice no. 25: Use Online

Settlement Netting Systems .........................29Best Practice no. 26: Confirm Bilateral Net

Amounts........................................................30Best Practice no. 27: Employ Timely

Cutoffs for Netting ........................................30Best Practice no. 28: Establish Consistency

between Operational Practicesand Documentation.....................................30

Settlement ......................................31Process Description .........................................31Best Practice no. 29: Use Real-Time Nostro

Balance Projections ......................................32Best Practice no. 30: Use Electronic

Messages for Expected Receipts ..................32Best Practice no. 31: Use Automated

Cancellation and Amendment Facilities ......33Best Practice no. 32: Implement Timely

Payment Cutoffs ............................................33Best Practice no. 33: Report Payment

Failures to Credit Officers .............................33

3MANAGEMENT OF OPERATIONAL RISK IN FOREIGN EXCHANGE

Table of Contents


Best Practice no. 34: Understand the SettlementProcess and Settlement Exposure ................34

Best Practice no. 35: Prepare for CrisisSituations Outside Your Organization .........34

Nostro Reconciliation......................35Process Description ........................................35Best Practice no. 36: Perform Timely

Nostro Account Reconciliation....................36Best Practice no. 37: Automate Nostro

Reconciliations .............................................36Best Practice no. 38: Identify Nonreceipt

of Payments...................................................36Best Practice no. 39: Establish Operational

Standards for Nostro Account Users............37

Accounting/Financial Control ...........37Process Description ........................................37Best Practice no. 40: Conduct Daily General

Ledger Reconciliation...................................38Best Practice no. 41: Conduct Daily

Position and P&L Reconciliation..................38Best Practice no. 42: Conduct Daily

Position Valuation.........................................39Best Practice no. 43: Review Trade

Prices for Off-Market Rates ..........................40Best Practice no. 44: Use Straight-Through

Processing of Rates and Prices.....................40

Unique Features of ForeignExchange Options andNon-Deliverable Forwards .................40

Process Description........................................40Best Practice no. 45: Establish Clear Policies

and Procedures for the Exercise of Options....41Best Practice no. 46: Obtain Appropriate

Fixings for Nonstandard Transactions ...........41Best Practice no. 47: Closely Monitor

Option Settlements .......................................41

General Best Practices .....................42Process Description ........................................42Best Practice no. 48: Ensure Segregation

of Duties........................................................42Best Practice no. 49: Ensure That Staff

Understand Business andOperational Roles.........................................42

Best Practice no. 50: UnderstandOperational Risks..........................................43

Best Practice no. 51: Identify Procedures forIntroducing New Products, New CustomerTypes, or New Trading Strategies .................43

Best Practice no. 52: Ensure ProperModel Sign-off and Implementation ...........44

Best Practice no. 53: Control System Access ...44Best Practice no. 54: Establish Strong

Independent Audit/Risk Control Groups....44Best Practice no. 55: Use Internal and External

Operational Performance Measures............45Best Practice no. 56: Ensure That Service

Outsourcing Conforms to IndustryStandards and Best Practices........................45

Best Practice no. 57: Implement GloballyConsistent Processing Standards..................45

Best Practice no. 58: Maintain Recordsof Deal Execution and Confirmations .........46

Best Practice no. 59: Maintain Proceduresfor Retaining Transaction Records ...............46

Best Practice no. 60: Develop and TestContingency Plans ........................................47

Conclusion ......................................49

Acknowledgments ...........................50

Works Consulted .............................51

Best Practices Mapto 1996 Version of Checklist ............52

5

Introduction

The FX MarketplaceThe foreign exchange (FX) market is the largest and most liquid sector of the globaleconomy. According to the 2004 Triennial Survey conducted by the Bank forInternational Settlements, FX turnover averages $1.9 trillion per day in the cashexchange 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 primarymechanism for making payments across borders, transferring funds, and determiningexchange rates between different national currencies.

The Changing MarketplaceOver 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 participantsalso include commercial as well as investment banks, FX dealers and brokeragecompanies, multinational corporations, money managers, commodity tradingadvisors, insurance companies, governments, central banks, pension and hedgefunds, 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 hascontinued to globalize. The value of transactions that are settled globally each dayhas risen exponentially—from $1 billion in 1974 to $1.9 trillion in 2004.

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

Managementof

RiskOperational

in Foreign Exchange


affected the FX market more broadly over thelast few years. Those changes include

� introduction of the euro,

� increased consolidation of both FX dealersand nostro banks, resulting in market-place consolidation,

� consolidation of FX processing in globalor regional processing centers,

� outsourcing of back office functions,

� introduction of CLS Bank in order tosubstantially reduce FX settlement risk,

� increased focus on crisis management andcontingency planning in the wake of severalcurrency crises and the destruction of theWorld Trade Center in New York City,

� increased focus on “know your customer”anti-money-laundering efforts and otherregulatory requirements to limit access byterrorists to worldwide clearing systems,

� increasing use of web portals for FX trans-actions,

� expansion of prime brokerage, and

� regulatory focus on capital allocations foroperational risk.

Developments like these make it crucialthat operations, operational technology, andsettlement risk management keep pace withthe changing FX market.

The History of This DocumentIn 1995, the Foreign Exchange Committee (theCommittee) recognized the need for a check-list of best practices that could aid industryleaders as they develop internal guidelinesand procedures to foster improvement in thequality of risk management. The original versionof Management of Operational Risk in ForeignExchange was published in 1996 by theCommittee’s Operations Managers WorkingGroup to serve as a resource for firms as theyperiodically evaluate their policies and proce-dures to manage operational risks properly.This update, written in 2003 by the workinggroup listed at the end of this document, takesinto account market practices that haveevolved since the paper’s original publicationand supercedes previous recommendationsby the Committee on operational issues.

In addition to this document, theCommittee has often offered recommen-dations on specific issues related tooperational risk. Although the best practiceshere are directed at FX dealers primarily, theCommittee has also offered guidance to othermarket participants. Such guidance ismentioned periodically in the best practiceshere and may also be found at the Committee’swebsite, <www.newyorkfed.org/fxc/>.

What Is Operational Risk?Operational risk is the risk of direct or indirectloss resulting from inadequate or failed inter-nal procedures, people, and systems, or fromexternal events.2 For the purposes of this

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

Capital Accord (Basel: BIS, 2002), p. 2.


paper, we adopt this definition of operationalrisk put forth by the Bank for InternationalSettlements. However, while reputational riskis not considered part of operational risk forBasel capital purposes, the importance ofreputational risk in foreign exchange is reflectedin the best practices outlined in this document.

Operational risk for foreign exchange inparticular involves problems with processing,product pricing, and valuation. Theseproblems can result from a variety of causes,including natural disasters, which can causethe loss of a primary trading site, or a changein the financial details of the trade orsettlement instructions on a FX transaction.Operational risk may also emanate from poorplanning and procedures, inadequatesystems, failure to properly supervise staff,defective controls, fraud, and human error.3

Failure to adequately manage operationalrisk, in turn, can decrease a firm’s profitability.Incorrect settlement of FX transactions, forexample, can have direct costs in improperpayments and receipts. In addition, tradeprocessing and settlement errors can lead toindirect costs, such as compensation paymentsto counterparts for failed settlements or thedevelopment of large losses in a firm’s portfolioas a result of managing the wrong position.Furthermore, investigating problems andnegotiating a resolution with a counterpartymay carry additional costs. Failure to manageoperational risk may also harm a firm’sreputation and contribute to a loss of business.

Operational risk has another distinctivequality. Unlike credit and market risk,operational risk is very difficult to quantify.Clearly, an institution can measure some ofthe losses associated with operational errorsor losses that result from the failure of theoperational process to catch errors made bysales and trading areas. Determiningexpected losses, however, given theuncertainty surrounding those losses, is muchmore complicated for operational risks thanfor other risk categories.

What Are “Best Practices”?

This document offers a collection of practicesthat may mitigate some of the operationalrisks that are specific to the FX industry. Theimplementation of these practices may alsohelp to reduce the level of risk in the FX marketmore generally. Finally, acceptance of thesepractices may help reduce operational costs.When robust controls are in place, less timeand energy is needed to investigate andaddress operational problems.

The best practices in this document arealready used to varying degrees by theworking group members responsible for thispaper. Collectively, the working group feelsthat these are practices toward which allmarket participants should strive. Therefore,this compilation is meant to provide achecklist for organizations new to the market,

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

but it is also designed to serve as a tool forestablished market participants as theyperiodically review the integrity of theiroperating procedures. Each firm isencouraged to take into account its ownunique characteristics, such as transactionvolume and role in the market, as it makes useof the recommendations. These best practicesare intended as goals, not binding rules.

The best practices listed here arerecommendations that all parties engaging inFX, regardless of the institution’s size or role inthe marketplace, should consider adopting forboth internal (with the exception of practicesthat are inapplicable such as creditmanagement and documentation) andexternal transactions. In addition, it is clear thatthe larger the participant, the more importantit is to implement the recommendations in themost automated manner possible. Smallerparticipants should make sure that they haveappropriate controls in place for any bestpractice that proves too expensive toautomate. Given the differences in the size offirms, it may be helpful to underscore thatfirms are not bound to integrate all of therecommended practices in this document,but should use them as a benchmark forexamining their existing practices.

How to Use This DocumentThis document is divided into sections basedon the seven steps of the FX trade process flow1) pre-trade preparation, 2) trade capture,3) confirmation, 4) netting, 5) settlement,6) nostro reconciliation, and 7) accounting/financial control processes. How each of theseseven phases integrates with the others in the

FX process flow is outlined in Figure 1 below.Each section of this paper provides a processdescription of the steps involved in the tradephase discussed in that section, followed by alist of best practices specific to that phase. Thepaper concludes with a list of general bestpractices that apply more widely to the overallmanagement of operational risk, includingguidance for contingency planning.

This document concentrates on some ofthe most common areas where operationalrisk arises in the various stages of the FXprocess. Often operational errors result froma breakdown in the information flow in thesequential steps of the process. To avoid suchproblems, it is essential that marketparticipants clearly understand each of theseven stages of FX trade and settlement, andfully comprehend how each phase is relatedto the larger process flow. A break in theprocess, especially in the feedback loop, maylead to a breakdown in the flow ofinformation, which in turn increases thepotential for financial loss. Properprocedures, including those concerningescalation and notification, should be inplace for management to deal with problemswherever they occur in the process flow.

Future TrendsIt is important to acknowledge at the outsetthat the FX business is constantly evolving.Technology continues to advance, tradingvolume in emerging market currencies continuesto increase, new exotic structures are continuallyintroduced, and many institutions are region-alizing their sales and trading and operationsareas by creating small satellite offices. Some



of the major trends that will continue to affectFX operational risk are as follows:

� Technology continues to advance rapidly,enabling traders and salespeople to executemany more transactions during periods ofmarket volatility.

� Systems are becoming more standard-ized, and will use new communicationformats (for example, XML protocol).

� Trading volume in emerging marketcurrencies continues to grow as manydeveloping nations become more activein international capital markets. Thisincrease in volume is coupled with newand problematic settlement proceduresfor these currencies.

� Traders and salespeople continue todevelop new and more exotic types oftransactions, especially in FX derivativeproducts. These require special, oftenmanual, processing by operations groupsuntil new transaction types can be includedin the main processing cycle.

� New types of clients continue to enter theFX market, which require development ofnew operational procedures.

All of these trends, and many others, willcontinue to change the industry, eliminatingsome risks and introducing new ones. It isimperative that management thoroughlyunderstands the operations cycle and bestpractices surrounding operational riskmanagement to manage risks properly as theFX marketplace continues to evolve.

Definitions of Key TermsTo clarify terms used in this document:

Bank refers here to all market makers in FX,whether commercial or investment banks.

From a bank’s viewpoint all deals areconducted with a counterparty, which canbe another bank, or a corporate, institutional,or retail client. The concepts in this documentapply to all such market participants.

Figure 1The FX Process Flow

Accounting/Financial Control

NostroReconciliation

Netting SettlementConfirmationTradeCapture

Pre-TradePreparation

Problem Investigation and Resolution

ManagementManagement and Exception Reports

Sales and trading refers to the front office.Trading employees execute customer ordersand take positions; they may act as a marketmaker, dealer, proprietary trader, intermediary,or end user. A bank may also have a sales forceor marketing staff, which is part of the frontoffice. Salespersons receive price quotes fromthe bank’s trading staff and present marketopportunities to current and potential clients.

Operations is used throughout this docu-ment when referring to the processing, settle-ment, back-office, or middle-office areas.Specifically, operations provide support serviceto sales and trading.

Interdealer refers to trading between marketmakers.

Nostro bank, correspondent bank, agentbank, and clearing bank are used inter-changeably here. A bank may use the servicesof one or more affiliated or unaffiliated nostrobanks to make and receive payments, or itmay act as its own nostro bank. Banks gener-ally use a different nostro bank for each cur-rency that they trade.

Vanilla options refers to options that arestandard in the industry. In other words, vanil-la options are European style and expire atan agreed date and time and have no fixingor averaging of the strike price.

Nonvanilla options generally refer to optionsthat have a fixing or averaging component orare part of a structured (combination) optiontype, for example, average rate options. Anycurrency option that is not vanilla is consid-ered nonvanilla, ranging from American styleoptions to heavily structured options.

P&L refers to the profit and loss record of aportfolio or transaction.

Prime brokerage describes an arrangement thatallows customers to conduct FX transactions (spot,forward, and options) in the name of a bank or“prime broker.” In a typical prime brokeragearrangement, the customer chooses one or twoprime brokers to service their account. Theprime broker’s responsibility is to set up docu-mentation and procedures that allow thecustomer to conduct FX transactions directlywith several counterparties, but in the name ofthe prime broker. These executing counter-parties recognize the prime broker as their legalcounterparty in such trades. The prime brokerenters into equal and opposite trades with thecustomer and executing counterparties. Specificprocedures are agreed upon among the cus-tomer, prime broker, and executing counter-parties to effectuate the trading and “give up”relationships. The prime broker typicallycharges the customer a fee for prime brokerage.

Pre-Trade Preparationand Documentation

Process DescriptionThe pre-trade preparation and documenta-tion process initiates the business relationshipbetween two parties. During this process,both parties’ needs and business practicesshould be established. An understanding ofeach counterparty’s trading characteristics andlevel of technical sophistication should alsodevelop. In summary, the pre-trade processallows both parties to mutually agree onprocedures and practices to ensure that businessis conducted in a safe and sound manner.



In the pre-trade process, a bank developsan understanding of the inherent businessrisks and risk mitigants of each of its counter-party relationships. The documentation andagreements reflecting the relationship shouldbe identified and, if possible, executedbefore trading. Thus, pre-trade preparationinvolves coordination with sales and tradingand operations as well as other support areassuch as systems, credit, legal, and complianceto establish trade capture parameters andrequirements that should be in place prior totrading. This process is especially importantwhen the business requirements may beunique and require additional controls.

Best Practice no. 1:Know Your CustomerA bank should know the identity of itscounterparties, the activities they intend toundertake with the bank, and why they areundertaking those activities.

All firms should have strong Know YourCustomer (KYC) procedures for collectinginformation required to understand who thecustomer is and why they are conductingbusiness. KYC procedures have long been thefirst line of defense for banks in settingappropriate credit limits, determining themost appropriate documentation for theactivities being contemplated, identifyingadditional business opportunities, andprotecting against fraud.

KYC procedures have, more recently, alsobecome the cornerstone for combatingcriminal activity. Illicit activity has becomemore sophisticated in the methods used toconceal and move proceeds. The global

response has been to develop laws andregulations requiring institutions to establishfamiliarity with each of their counterparties tobetter identify and report suspicious activity.

At a minimum, information relating tothe identity of a counterparty and thecounterparty’s activity should be gathered tosatisfy applicable laws and regulations forprudent business conduct. The reputationand legal risk to banks of not being vigilant inknowing their customers and complying withKYC laws and regulations can be severe. Inthe United States, examples of laws andregulations that impose obligations of this sorton banks are the Bank Secrecy Act, moneylaundering regulations, U.S. Treasury, Office ofForeign Assets Control (OFAC) regulations,and the USA PATRIOT Act.

Best Practice no. 2:Determine DocumentationRequirementsA bank should determine its documentationrequirements in advance of trading and knowwhether or not those requirements have beenmet prior to trading.

A bank should execute transactions only ifit has the proper documentation in place. Thetypes of documentation that may be requiredinclude 1) master agreements (see BestPractice no. 3), 2) authorized signatory lists,and 3) standard settlement instructions. Suchdocuments should be routinely checkedbefore executing trades. An institution shouldalso establish a policy on whether or not it willtrade, and in what circumstances, without firstobtaining a master agreement (for example,IFEMA, ICOM, FEOMA, or the ISDA Master)


with a customer covering the transactions. Itshould also be noted that electronic tradingoften requires special documentation.Specifically, customer and user identificationprocedures, as well as security procedures,should be documented.

This recommendation emphasizes theprinciples of awareness and information withrespect to documentation. In practice, it maybe difficult to do business with a policy thatrequires documentation to be in place inevery instance. In many cases, the risks of nothaving a particular piece of documentationmay be acceptable. Nonetheless, it is crucialthat all relevant personnel 1) know the policyof the institution on documentation, 2) knowwhen the documentation is or is not in place,and 3) be able to produce reports regardingdocumentation status.

Representatives of the business, opera-tions, credit, legal, and compliance areas, forexample, need to establish the institution’spolicies and document their understanding ofthese policies in writing. The institutionshould have adequate tracking systems(manual or other) to determine when policyrequirements are satisfied or not. Thesesystems should be able to produce reportsnecessary for proper contract monitoring.

If the policy of the institution is to have amaster agreement in place, the institutionshould be able to produce a report displaying

any missing master agreements. Such reportsshould classify data by age and be distributedto management. Lastly, there should beescalation and support procedures in placefor dealing with missing documentation whennormal efforts are not enough to obtain it.

Best Practice no. 3:Use Master Netting AgreementsIf a bank elects to use a master agreement with acounterparty, the master agreement shouldcontain legally enforceable provisions for“closeout” netting and settlement netting.

“Closeout” and settlement nettingprovisions in master agreements permit a bankto decrease credit exposures, increasebusiness with existing counterparties, anddecrease the need for credit support ofcounterparty obligations.4 Closeout nettingclauses provide for 1) appropriate events ofdefault, including default upon insolvency orbankruptcy, 2) immediate closeout of allcovered transactions, and 3) the calculation ofa single net obligation from unrealized gainsand losses. Closeout provisions have theadded benefit of a positive balance sheet effectunder Financial Accounting Standards Board(FASB) Interpretation 39, which allows thenetting of assets and liabilities in the unrealizedgains and losses account if netting is legallyenforceable in the relevant jurisdiction.5

Closeout netting provisions help to protect abank in the event of a counterparty default.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 FinancialInstruments with Off-Balance-Sheet Risk and Financial Instruments with Concentrations of Credit Risk, (FASB, March 1990).


netting agreement is not in place, thebankruptcy trustee of the defaulting party maydemand payment on all contracts thatare in-the-money and refuse to pay on thosewhere it is out-of-the-money. If the defaultingcounterparty takes this action, the non-defaulting party may be left with a larger-than-expected loss. A master agreement signed byboth parties with enforceable closeout nettingprovisions ensures that the counterpartyremains responsible for all existing contractsand not just those it chooses to endorse.6

Settlement netting permits parties to settlemultiple trades with a counterparty with onlyone payment instead of settling each tradeindividually with separate payments.Consequently, settlement netting decreasesoperational risk to the bank in addition toreducing settlement risk. To realize thesettlement netting benefits, however, a bank’soperations function must commence settlingon a net basis. Therefore, it is essential thatoperations receive a copy of the agreementor be notified of the terms of the executedagreement. Given the benefits of settlementnetting, it is in a bank’s best interest to includesettlement netting in any master agreementthat it may enter into.

The following master agreements havebeen developed as industry-standard forms.Each form includes provisions for settlementnetting (included as an optional term) andcloseout netting:

� ISDA Master Agreement

� IFEMA Agreement covering spot andforward currency transactions

� ICOM Agreement covering currencyoptions

� FEOMA Agreement covering spot andforward currency transactions and currencyoptions

These netting provisions should satisfyrelevant accounting and regulatory standards aslong as legal opinions are able to conclude thatthe agreements are legally enforceable in eachjurisdiction in which they are applied. Banksshould confer with local legal counsel in allrelevant jurisdictions to ensure that nettingprovisions are enforceable. To the extent thatlocal counsel suggests that certain provisions ofa master netting agreement may be unenforce-able, the bank should ensure that otherprovisions in the agreement could be enforcednonetheless.

Best Practice no. 4:Agree upon Trading and OperationalPracticesTrading and operational practices should beestablished with all counterparties.

Most banks reach an understanding with allcounterparties as to the type of business theywill be transacting and how they shouldinteract. Banks should include keyoperational practices such as providing timelyconfirmation or affirmation, the use ofstanding settlement instructions (SSIs), andtimely notification of splits.

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


The level of trading activity with fundmanagers and investment advisors hasescalated in recent years. These clients transactin block or bulk trades, which are then split intosmaller amounts and entered into specificclient accounts managed by fund managers orinvestment advisors. Until a block or bulk tradeis properly allocated to the specific accounts ofeach fund entity, inaccurate credit riskmanagement information may exist.

The understanding should clearly establishconfirmation and settlement procedures forall counterparties and delineate both thebank and client’s obligations in the processflow. A bank should strongly encourage clientsto confirm bulk trades as soon as possible afterthe trade is executed.7 In addition, a bankshould request that fund managers providethem with the “split” information on the tradedate for all trade types (spot, forwards, swaps,tom/next, etc.) regardless of maturity, so thatthe bank’s credit information can be updatedas soon as possible.

Best Practice no. 5:Agree upon and Document SpecialArrangementsIf, in the course of the documentation set-up andestablishment of trade and operationalpractices, it becomes clear that a counterpartyrequires special arrangements—such as third-party payments or prime brokerage service—those arrangements should be agreed upon anddocumented in advance of trading.

Counterparties at times may request third-party payments to facilitate underlyingcommercial transactions. Third-partypayments are the transfer of funds insettlement of a FX transaction to the accountof an entity other than that of thecounterparty to the transaction. However,third-party payments raise important issuesthat need to be closely considered by anorganization engaged in such practices.

Firms should recognize that third-partypayments cause a significant increase inoperational risk. Since the identity andentitlement of the third party is not known tothe bank, extreme care should be taken inverifying payment instructions to third parties.Regulatory requirements such as the USAPATRIOT Act, OFAC, and the Bank Secrecy Actshould also be applied to third parties. Boththe counterparty and bank managementshould be aware of the risks involved withthese transactions and should establish clearprocedures beforehand for validating both theauthenticity and correctness of such requests.

Prime brokerage arrangements may alsoinvolve special occasions for misunderstandingthe respective rights and obligations of thevarious parties. Such arrangements should beevidenced by written agreements (primebroker and dealer, prime broker and customer,dealer and customer) that have been reviewedand approved by legal counsel.

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

Trade Capture

Process DescriptionThe trade capture function is the secondphase of the FX processing flow. Deals may betransacted directly over a recorded phoneline, through a voice broker, via an electronicmatching system (for example EBS andReuters), or through Internet based systems(for example, proprietary trading systems ormultidealer trading platforms).

After the deal is executed, the trader, ortrader’s assistant, inputs trade data into thefront-office system or writes a ticket to beentered into a bank’s operations system.Deals done over electronic dealing systemssuch as Reuters or EBS allow deal informationto flow electronically to the front-officesystem. Trade information typically includestrade date, time of trade, settlement date,counterparty, financial instrument traded,amount transacted, price or rate, and mayinclude settlement instructions.

The system used in the front-officeprocesses this information and can provide“real-time” position and profit and lossupdates. Trade information captured in thefront office system flows to the credit systemwhere settlement risk and mark-to-market(also referred to as pre-settlement) credit riskmeasures and limits are updated.

Trade information from front-officesystems flows through to the operationssystem, where it is posted to sub-ledgeraccounts, and the general ledger is updatedas trades are processed. Operations staffshould be responsible for ensuring that

appropriate settlement instructions arecaptured so that the required confirmationmessage can be issued. For interbank,institutional, and corporate counterpartieswith Standard Settlement Instructions (SSIs)on file, the deal is immediately moved to theconfirmation process.

However, if SSIs are overwritten or not inplace, operations staff must obtainsettlement instructions from thecounterparty or confirm the settlementinstructions received by sales and trading.For forward trades that are not settled untilsometime in the future, operations staff maycontact the counterparty at a later date forsettlement instructions. The financial detailsof the deal, however, must be confirmed onthe trade date. If deals need to be amended,changes should be implemented in acontrolled manner involving both sales andtrading and operations.

Fund managers and investment advisorsfrequently trade for more than one underlyingfund or counterparty at once. Typically, theytransact a single “block” or “bulk” trade, whichthey then “split” into a series of smaller tradesas they allocate the block trade to theunderlying funds or counterparties.Operations staff needs to receive splitinformation soon after trade execution to issueconfirmations for each of the split transactions.

Inaccurate or untimely trade capture canhave implications for P&L and risk managementfor a bank. If a bank does not capture thecorrect transaction, then its positions andreported credit exposure will be incorrect.


Best Practice no. 6:Enter Trades in a Timely MannerAll trades, external and internal, should beentered immediately and be accessible for bothsales and trading and operations processing assoon as they are executed.

It is crucial that all trades are enteredimmediately so that all systems and processesare provided with timely, updatedinformation. No matter how sophisticated thesystem, data may not be accurate if users enterit incorrectly or delay its entry. For that reason,it is important to ensure that the duties of tradeentry are appropriately segregated. Front-endsystems that capture deal information mayinterface with other systems that monitor andupdate the following:

� credit limit usage,

� intra-day P&L,

� trader positions,

� confirmation processing records,

� settlement instructions, and

� general ledger activity.

A bank’s ability to manage risk may beadversely affected if it does not have accuratetransaction updates in each of the aboveareas. Inaccuracies in each category not onlyerode a bank’s profitability, but may alsotarnish a bank’s reputation. In the event of asettlement error, for example, the bank mustpay compensation costs to the counterpartyand cover short cash positions. Moreover,incorrect financial statements arising fromproblems in general ledger data can harm the

reputation of the bank. Further, if creditpositions are not properly updated, the bankmay take on more risk to a counterparty,industry, or country than would be prudent.

In addition, it is important to note thatinternal trades should be subject to the samedegree of diligence as external trades in termsof timely entry because they carry the samerisks (with the exception of credit risk).

Best Practice no. 7:Use Straight-Through ProcessingWhen sales and trading and operations useseparate systems, electronic feeds should auto-matically feed all deals, adjustments, and can-cellations from one system to the other. Ideally,the transaction data should also be carriedstraight-through for posting to the generalledger, updating credit information, generatingmoney transfer instructions, and feeding nostroreconciliation systems.

To ensure timely processing by operationsand eliminate potential errors that can occurif trades are reentered into the operationssystems, straight-through processing shouldexist between sales and trading andoperations. Such a link should move deals,adjustments, and cancellations to theoperations system as soon as sales and tradingfinalizes them. This transaction data—alsopassed straight through to other systems inthe institution—will further decrease potentialerrors that can occur when information ismanually keyed into systems. This practicealso improves the timeliness of the data.

Most brokered transactions are nowexecuted over automated broker systems.


Therefore, straight-through processing linksfrom these systems into sales and trading shouldalso be implemented when volume warrants.

Best Practice no. 8:Use Real-Time Credit MonitoringCredit lines and usage information should beupdated as soon as deals are entered, and theinformation should be accessible to sales andtrading and risk managers. A bank shouldestablish real-time credit systems to calculateand aggregate exposures globally across alltrading centers.

A bank should execute transactions only ifcredit lines have been approved and areavailable for a designated counterparty. Notrade should be finalized without confirmingthe availability of sufficient credit. Electronicbroker credit prescreening schemes arepreferable to the practice of brokers switchingcounterparties. In the event of default by acounterparty, a bank could lose the positivemarket value of the positions it has with thedefaulting party or, if default occurs in themiddle of settlement, it could lose the entireprincipal of the deal.

A sales and trading area should be able toquickly assess its institution’s credit exposureto its counterparties globally. Theseexposures should be communicated in real-time to the trading system. The system shouldtake into account changes in static credit linesfor electronic trading platforms thatperiodically may have to be updated orrevised. The system should also automatically

update a counterparty’s credit status when thecounterparty deals with the bank on a globalaggregate basis. This requires straight-throughprocessing from the trade capture system to areal-time credit system.

Sales and trading should see the effects of adeal on a counterparty’s credit statusimmediately, and that unit should know whena counterparty’s credit limit is close to beingfilled and be prevented from dealing withcounterparties who have reached or exceededsuch limits. Sales and trading and creditmanagement should produce reports of creditline excesses and exceptions on a regular basisfor review. Exception reports should identifyboth counterparties involved and the sales andtrading personnel executing the transactions.

Real-time credit systems also allow a bank’scredit managers to assess the credit exposureto a counterparty throughout the life of atransaction. Credit officers are better able tomanage crisis situations and to adjust limits asthe creditworthiness of a counterpartychanges. A real-time credit system ensuresthat any changes in the credit limit of acounterparty are reflected in the sales andtrading system immediately.8

Best Practice no. 9:Use Standing Settlement InstructionsStanding Settlement Instructions (SSIs) should bein place for all counterparties. Marketparticipants should issue new SSIs, as well as anychanges to SSIs, to each of their trading partnersin a secure manner. For banks, the preferable


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

method is through an authenticated mediumsuch as SWIFT messages.

SSIs allow for complete trade details to beentered quickly, so that the confirmationprocess can begin as soon after trade executionas possible. In general, when SSIs are in place, itis possible to take full advantage of straight-through processing because operations maynot have to manually intervene in thetransaction during the settlement process. SSIsalso allow for payments to be formattedproperly and for readable SWIFT codes to beissued. If SSIs are not established, operationsmust contact the counterparty to obtainsettlement instructions and the deal recordmust subsequently be changed to reflect thesesettlement instructions. The extra work involvedin inputting, formatting, and confirming settle-ment instructions increases the opportunity forerrors in settlement, making SSIs important forrisk management and efficiency.

Institutions should update their recordspromptly when changes to SSIs are receivedfrom their counterparties. When an institutionchanges its SSIs, it should give as much time aspossible—a minimum of two weeks notice—toits counterparties so that they can updatetheir records before the date that the new SSIsbecome effective. A bank should periodicallyreview the SSIs that it has on file.

SSIs for forward transactions can changebetween the time a deal is confirmed and thetime it finally settles. Consequently, a bankshould either reconfirm all settlementinstructions for forward deals beforesettlement, or it should reconfirm alloutstanding deals whenever SSIs are changed.

SSIs should be in a SWIFT/ISO format tofacilitate reference data maintenance and toeliminate the potential for errors intranslation. Any deal record with exceptionsto an existing SSI should be processed usingthe same procedures as for nonstandardsettlement instructions.

Best Practice no. 10:Operations Should Be Responsiblefor Settlement InstructionsOperations should be responsible for ensuringthat settlement instructions are collected andconfirmed. If no SSIs are in place, operationsshould be responsible for obtaining andverifying the instructions.

Although SSIs are preferred, they are notalways available, and at times SSIs may not beappropriate for all trades. When SSIs are notused, the settlement instructions may berecorded at the time that sales and tradingconducts the trade. These exception settlementinstructions should be delivered by the close ofbusiness on the trade date (if spot) or at least oneday prior to settlement (if forward). Nonstandardsettlement instructions should be exchangedelectronically if possible and should be checkedby operations when the trade is confirmed. Bytaking responsibility for settlement instructions,operations serve the role of an independentcontrol on sales and trading activity.

Best Practice no. 11:Review AmendmentsAmendments to transaction details should beconducted in a controlled manner that includesboth sales and trading and operations in theprocess. Particular care should be taken for


amendments to FX swap transactions after thesettlement of the near leg.

If incorrect information was captured indeal entry, certain trades will need to bechanged or canceled after they have beenreleased to operations. Mistakes occur whena trader or salesperson enters the wrongcounterparty for a deal, an incorrect valuedate or rate, or makes other data errors.

Although either operations or sales andtrading staff can initiate amendments andcancellations, both sales and trading andoperations should be involved in the processto maintain proper control. It is imperative,however, that the duties related to processingamendments and cancellations are clearlysegregated between operations and sales andtrading. This segregation of duties is one ofthe key control mechanisms of any institution.

The specific process for handlingamendments and cancellations will vary fromfirm to firm and is often dictated by systemconstraints. However, if operations staff isresponsible for amending or canceling a deal,it should obtain supporting documentationand receive prior written authorization fromsales and trading before processing theamendments or cancellations. Exceptionreporting on amendments and cancellationsshould be made available to sales and tradingand operations management regularly. Thecriteria used for reporting and the frequencyof distribution will vary by firm.

Amendments to swap transactions maypresent difficulties for a bank if the near leghas already settled. When the swap or

outright is initially entered into the system,traders cover any resulting currency andinterest rate exposure by entering intooffsetting deals. The offsetting deals also needto be amended if the swap is enteredincorrectly, which may affect P&L. Becausethe near leg has settled, it cannot be changedto reflect P&L differences. Thus, amendmentsto swaps should be made with care so thatresulting positions and P&L are accurate.

Best Practice no. 12:Closely Monitor Off-Market and Deep-in-the-Money Option TransactionsAll dealer institutions that permit requests forHistorical Rate Roll-overs (HRRs) should havewritten procedures to guide their use and shoulddetail the added controls required in the tradingand reporting of off-market transactions.Operational responsibilities should be clearlydefined in regard to monitoring, reporting, andspecial confirmations, if any are needed. Suchspecial confirmations may be necessary to identifythe market forward rate in effect when the HRRwas executed. The sale of deep-in-the-moneyoptions warrants special attention and specificprocedures applicable to sales and trading staff(and, if necessary, senior management).

Historical rate rollovers involve the extensionof a forward foreign exchange contract by adealer on behalf of a customer at an off-marketrate. As a general rule, all transactions areexecuted at current market rates. However, attimes commercial considerations may dictateotherwise. For more information, see TheForeign Exchange Committee Annual Report2000, “Guidelines for the Management of FXTrading Activities,” p. 74, and The Foreign


Exchange Committee Annual Report 1995, “Letteron Historical Rate Rollovers.”

The sale of deep-in-the-money optionswarrants special attention and specificprocedures applicable to sales and tradingstaff (and, if necessary, senior management).There may be legitimate reasons for the saleof such options—for example, the “sell back”of an option or the implied delta within aseparate derivatives product. However, itshould also be recognized that the sale ofdeep-in-the-money options can be used toexploit weaknesses in a counterparty'srevaluation or accounting process that couldcreate erroneous results. Procedures shouldensure an appropriate level of review—ifnecessary, by senior trading management orrisk management outside the sales andtrading area—to guard against potential legal,reputational, and other risks.

Confirmation

Process DescriptionThe transaction confirmation is legal evidenceof the terms of a FX or a currency derivativetransaction. Therefore, the management ofthe confirmation process is an essential con-trol. This process is handled in many wayswithin FX markets. For vanilla spot, forwardFX, or currency option transactions, counter-parties exchange electronic or paper confir-mations that identify transaction details andprovide other relevant information. For struc-tured and nonstandard transactions (non-

deliverable forwards [NDFs] and currencyoption transactions), documents are pre-pared and 1) exchanged and matched by bothcounterparties, in the case of most dealers, or2) signed and returned in the case of certainclients or counterparties.9 In either case, it isthe market practice to verbally confirm (on arecorded line) the primary economic details ofan NDF or exotic currency option transactionbetween the two counterparties on the daythe transaction is executed. Notwithstandingthe fact that trades are verbally confirmed, it isstill important that a hardcopy confirmation issent and that the means of such delivery isagreed between the parties.

Given the significance of the confirmationprocess, it is important that the process ishandled independently of the trading room.In most institutions, the operationsdepartment performs this activity. Anyexceptions to sending confirmations toclients should be reviewed and approved bycompliance or legal personnel, and businessand operations management.

Exchanging confirmations is essential formitigating risk in the FX markets. Therefore,outgoing confirmations should be dispatchedto the counterparty at the earliest possibleopportunity. It is also the responsibility ofboth counterparties to actively match andvalidate their own transaction records ofincoming electronic or verbal confirmationswith counterparties by the end of thebusiness day on the trade date. For some non-


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

vanilla trades, a same day confirmation maycover some specific financials, but acomplete long-form confirm may follow at alater date with nonfinancial information.

Confirmations should be transmitted in asecure manner whenever possible. In themost developed markets, confirmations aregenerally sent via electronic messages throughsecure networks. In some instances,proprietary systems have been developed toprovide access to confirmations to clients.However, a significant number of transactionconfirmations are also sent via mail, e-mail,and fax. It is important to note that when theseopen communication methods are used thereis a greater risk of fraudulent correspondence.

A transaction confirmation should includeall relevant data that will allow the twocounterparties to accurately agree to theterms of a transaction. All relevant settlementinstructions for each transaction should beclearly identified in each confirmation. Allconfirmations should either be subject to the1998 FX and Currency Option Definitions issuedby the Foreign Exchange Committee,Emerging Markets Traders Association(EMTA), and International Swaps andDerivatives Association (ISDA), or be subjectto other appropriate guidelines, and shouldreference a bilateral master agreement—if oneexists between the parties.

Foreign exchange trades are executed inmultiple ways, including by phone (direct),voice brokers, electronic dealing platforms,and electronic brokers. As an increasingnumber of FX transactions are being executedthrough secure electronic platforms (forexample EBS, Reuters) or online electronicdealing platforms, some counterparties havechosen, on a bilateral basis, to eliminatetraditional confirmation messages with oneanother in lieu of electronic affirmationfacilities offered by electronic trading systems.These facilities allow operations to reviewtrading system data and validate trade details.

Market participants can affirm that the tradedetails reflected in the electronic tradingsystem correspond to their own internal booksand records. It is important to note, however,that such validation exercises are notequivalent to traditional confirmationmessaging because they do not confirm thattrade details have been correctly entered intothe books and records of each counterparty.10

Some transactions between banks are alsoexecuted via voice brokers. These bilateraltransactions should be checked against thebroker advice that is typically received on thetrade date from the voice broker. Similarly, inthe case of FX prime brokerage relationships,these same procedures should be followed ina timely manner by all three participants. It isimportant to note that broker confirmationsare not bilateral confirmations between the


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

principals of the trade and therefore do notcarry the weight of a bilateral confirmation.

When trades are not confirmed, exposureto market risk arises. To mitigate this risk,standard escalation procedures should be inplace to pursue and resolve all discrepanciesin a timely manner. Operations staff isresponsible for reporting all unconfirmedtrades and unmatched incoming con-firmations to sales and trading. Whennecessary, the taped phone conversation or thelog from the electronic execution system can beused to resolve the discrepancy. Once theproblem has been identified, the counterpartywith the error should correct the affected dealin its system and issue a corrected confirmation.

Best Practice no. 13:Confirm and Affirm Tradesin a Timely MannerBoth parties should make every effort to sendconfirmations, or positively affirm trades, withintwo hours after execution and in no event laterthan the end of the day. This guideline applies totrades executed with both external and internalcounterparties. Any exception to this rule shouldbe clearly documented and approved byoperations management and compliance staff.

Prompt confirmations are key to the orderlyfunctioning of the marketplace because theyminimize market risk and minimize losses dueto settlement errors. In order for confirmationsto be timely and accurate, they should beformatted based on trade data captured in thebank’s operations system. In order to ensurethat confirmations are accurate, they should begenerated and sent directly from the operationssystem to the counterparty without passing

through any other internal departments. Senioroperations management and compliance staffmust approve any exceptions.

Counterparties should either send out theirown confirmations, or sign and return (affirm)incoming confirmations. Under no circum-stances should either party simply acceptreceipt of the counterparty confirmation ascompletion of the confirmation process.

Data included in the confirmation shouldcontain the following: the counterparty to theFX transaction; the office through which they areacting; the broker (if applicable); the transactiondate; the value date; the amounts of thecurrencies being bought and sold; the buyingand selling parties; and settlement instructions.

These procedures are meant as practicesfor executions directly between two parties.In the case of prime brokerage relationships,(in which one financial institution extends itscredit to a third party dealing with theinstitution’s customer), confirmations shouldbe exchanged among the three parties inaddition to the fulfillment of other requirementsfor exchanging information. Prime brokerrelationships alter the control proceduresemployed with direct dealing; therefore, theprime broker should consider incorporatingprocesses to ensure that communication ofnotice of execution is correct.

Best Practice no. 14:Be Diligent When Confirmingby Nonsecure MeansA procedure should be in place to call back acounterparty any time the confirmation processoccurs via nonsecure media.


Various communication media arecurrently used for the confirmation process,including fax, mail, and secure electronicmessaging such as SWIFT. Authenticatedelectronic messaging is the most secure meansof transmitting confirmations. When othercommunication media are used, various risksare introduced, ranging from human error topossible fraudulent correspondence. Whenemploying open communication systems,especially mail platforms, this risk increases.There is a direct correlation between theopenness of communication links and thepossibility of fraudulent actions.

It is recommended that a bilateralagreement that includes a callback procedurebe established when any unauthenticatedelectronic message system is used. Thisprocedure should include the callback to anauthorized individual other than theindividual who sent the nonsecureconfirmation. This conversation should bedone on a recorded telephone line andproperly noted.

Best Practice no. 15:Be Diligent When ConfirmingStructured or Nonstandard TradesSpecial care must be taken when confirming thedetails of structured transactions or nonstandardtrades that cannot be confirmed by a bank’snormal procedures or processes. Wheneverpossible, standard confirmation formats shouldbe used. These formats should identify thecalculation agent, special rights and respon-sibilities assigned to each counterparty, andspecial instructions on pricing sources, if any.

Structured transactions, including non-deliverable forwards (NDFs), often containunique features such as special pricing orsettlement conventions. Trade details mayalso assign responsibilities to eachcounterparty by identifying the calculationagent or the confirming party. Every feature ofthe trade detail affects the valuation of thetrade. Consequently, the price, price source,calculation agent, and confirming party mustbe carefully validated.

Currently, the standard SWIFT confirmationformat cannot accommodate all the uniquefeatures of structured trades. Confirmationssupporting these transactions are oftenmanually prepared, transmitted by fax, andmanually matched against accountingrecords. Because of the complexity of thesetrades, and the fact that they are oftenmanually confirmed, there is a significant riskthat the confirmation process may fail todetect errors or omissions.

Unlike standard trades, confirmations forstructured transactions are usually providedby a calculation agent or jointly between twocalculation agents. It should be clear which ofthe two counterparties is acting as calculationagent (or joint calculation agent status shouldbe indicated). Additionally, the roles andresponsibilities of the calculation agent orjoint agents should be specified. Thecalculation agent may also have certain rightsand obligations related to price observationsand confirmations. These rights should beclearly identified in the text of theconfirmation or in the trade contract.


Standardizing the confirmation process cansubstantially reduce the operational riskassociated with this process. Every effortshould be made to use the standardconfirmation formats outlined by the FXCommittee, the Emerging Markets TradersAssociation (EMTA), and the InternationalSwaps and Derivatives Association (ISDA). Notonly should these formats be employed, butevery confirmation should also clarify whennonstandard price sources, disruption events,expiration times, or any other nonstandardelements of a trade are introduced.

Best Practice no. 16:Be Diligent When Confirmingby TelephoneExtra care is necessary when confirming tradedetails by telephone. Phone confirmationsshould be conducted over recorded lines betweenappropriate individuals. Following the telephoneconfirmation, both parties should exchange andmatch a written or electronic confirmation viafax, mail, SWIFT or secured electronic meanssuch as SWIFT.

Not all trades can be fully confirmedelectronically; some structured trades are oneexample. In addition, some counterparties donot have the ability to confirm tradeselectronically on the trade date. In suchinstances, the most common method ofconfirming transactions is by telephone.However, telephone confirmations are the leastreliable method for confirming trades and proneto errors. When using this method, attention todetail and clarity must be emphasized.

Operations should aim to complete phoneconfirmations within two hours from trade

execution, and in no event later than the endof the day. It is imperative that theseconversations are conducted over recordedtelephone lines. The confirmation conver-sation should also take place betweenappropriate individuals only. All relevantinformation, financial details, and settlementinstructions should be confirmed. Followingthe telephone confirmation, both partiesshould record the date, time, telephone line,and the name of the individual with whomthe trade was confirmed. In addition to thetelephone confirmation, both parties shouldexchange and match a formal (mail, SWIFT, orother electronic) confirmation or a callbackprocedure should follow.

Best Practice no. 17:Institute Controls for Trades Transactedthrough Electronic Trading PlatformsIf two parties bilaterally choose to validate tradedata against an electronic front-end trading systemin place of exchanging traditional confirmationmessages, both parties should ensure that tradedata flows straight through from the front-endsystem to their respective operations systems. Strictcontrols must be in place to ensure that the flow ofdata between the two systems is not changed andthat data is not deleted.

Issuing traditional confirmations is alwaysconsidered a best practice from a riskperspective because they reflect the booksand records of both counterparties. However,firms with well-established controls andstraight-through processing may consider abilateral agreement with a counterparty toaccept validation of trade data over a secureelectronic platform to constitute a legally


binding confirmation, if the recorded tradedetails are deemed sufficient to validate thetrade terms. Only institutions that have directfeeds from dealing systems all the waythrough their operations systems, however,should employ this exception process andconsider this acceptable as an alternative totraditional confirmations.

Best Practice no. 18:Verify Expected SettlementInstructionsA bank should include its own settlementinstructions as well as the settlement instructionsof its counterparty on confirmations. Uponreceipt of a confirmation, firms shouldsystematically check both parties’ settlementsinstructions and ensure that they coincide withthose agreed upon at trade capture.

It is in the best interest of a bank to send itsown settlement instructions to counterparties.This step provides counterparties with writtenconfirmation of the settlement instructionsand can help reduce mistakes and thepossibility of fraud.

Similarly, if a bank receives settlementinstructions on an inbound confirmation, thebank should check that the instructions matchthe instructions included in the tradeagreement. It is best to discover and correcterrors in settlement instructions beforepayment instructions are issued in order toreduce the incidence of error for both parties.

Best Practice no. 19:Confirm All Netted Transactions11

All transactions, even those that will be netted,should be confirmed individually.

Netting trades for settlement is animportant operational function because itallows a bank to reduce settlement risk andoperational cost. However, it is still necessaryto confirm all transactions individually. Ifnetted trades are not confirmed individually,trades may be mistakenly added or removedfrom the net agreement, which will be difficultto detect on settlement day. Incorrect nettingwill distort credit and settlement risk. It mayalso cause losses to a bank if it must pay grossamounts instead of netted amounts or if it hasto cover overdrafts resulting from incorrectsettlement. The confirmation of these dealsshould be performed as it would be in anyother transaction or with the aid of a nettingservice provider.

Best Practice no. 20:Confirm All Internal TransactionsInternal transactions should be subject to thesame procedures as those in place for externalclients. Internal counterparties should confirm oraffirm transactions as if they transacted a dealwith external counterparties.

Quite often, operations and managementrelax their control procedures whenexecuting internal deals. In some cases,confirmations are not sent to the internalcounterparty, and not affirmed by thereceiving internal counterparty. However,


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

when confirmations are not properly issuedand affirmed, trade details are not verified,and a greater probability of error results.

A bank should recognize that deals donewith internal counterparties are not immunefrom errors. Lack of confirmations will preventthe timely recognition of trade errors, therebyincreasing the risk of settlement mistakes orincorrect funding. Consequently, a bankshould issue confirmations and should abideby the standard confirmation process for allinternal counterparties to preserve controlsand risk management procedures.

If multiple systems are used by aninstitution, then the confirmation processshould be automated across those systems. Ininstitutions in which only one system is usedacross internal counterparties, a processshould be set up within that system to insurethat both sides of the transaction are properlyrecorded and matched.

Best Practice no. 21:Confirm All Block Tradesand Split AllocationsWhen block trades combine several split trades,the full amount of the block trade should beconfirmed within two hours of the trade. Allallocations for split trades should be confirmedseparately within four hours and no later thanthe end of the business day on the trade date.Sub-account allocations are necessary toevaluate not only credit exposure but alsopotential regulatory compliance.

In recent years, the use of block (or bulk)trades has increased as trading with fundmanagers and investment advisors has grown.

Such fiduciaries combine several client tradesinto larger block trades that are then allocatedto the fiduciary’s specific clients. Until a block isproperly allocated to the specific client,inaccurate credit risk management informationmay exist. Banks should use particular cautionwhen establishing practices for block trades.

Although confirmations of block trade, bythemselves, reduce a bank’s market risk,confirming only the block trade does notprovide the essential customer data for thefirm’s credit and compliance systems. For abank to fully understand its counterparty risk,all deals must be confirmed at the split(counterparty) level.

The recommended best practice is to sendthese confirmations via electronic messagesthrough secure networks within four hours andno later than the end of the day on the tradedate. A bank should require that fund managersprovide them with the allocation informationon the trade date for all trade types regardless ofmaturity, so that the bank’s credit informationcan be updated as soon as possible.

Best Practice no. 22:Review Third-Party AdvicesBanks should confirm trades conducted througha broker directly with one another. Review ofReuter’s logs, EBS trade tickets, and voice brokeradvices should not serve as the primary methodof bilateral confirmation. These logs and advicesshould be treated as a third-party verification oftrade information.

Bilateral confirmations are written statementsof all the essential economic terms of a


transaction. Reuters logs and EBS trade ticketsare effective ways for operations to review tradeinformation captured in the operations system,and to verify that the economic terms, includingsettlement instructions, of the trade wereproperly captured in the risk and confirmationsystems of the firm.

However, Reuter’s logs, EBS trade tickets,and voice broker advices do not ensure thatthe counterparty has captured the correcttrade information in its operations systems.Therefore, institutions should not rely solelyon an incoming broker advice. As the contractbinds the two principals to the transaction,direct and timely bilateral confirmationsshould be exchanged between the twocounterparties for every transaction. If a firmdoes not receive a bilateral confirmation fromits counterparty, then it should review with itslegal counsel whether the counterparty isbound to the terms and agreement of thedeal as documented by the broker advice.

As stated in the process description thatbegins this section, institutions that havedirect feeds from secure electronic platforms(for example EBS, Reuters) and that inaddition pass straight through to theoperations systems may consider bilaterallyagreeing to eliminate any further exchange ofconfirmation on these transactions.

Best Practice no. 23:Automate the ConfirmationMatching ProcessElectronic confirmation matching and trackingsystems should be adopted as standardoperating procedures.12

Electronic confirmation matching requiresthat two parties agree to electronically matchtheir confirmations through an in-houseproprietary system or a third-party vendor.Electronic confirmation matching is the mostreliable method of confirming transactions.Such matching decreases market risk andtrade errors, minimizes settlement andcompensation payments, and reducesoperational and overhead costs. Electronicconfirmation matching allows a bank toincrease the volume of transactionsconfirmed in a timely manner.

The confirmation process should beadditionally controlled by establishing anautomated confirmation tracking and follow-up system. Such a system will decrease thechances that deals are not settled properlyand help management track and escalatenonconfirmation. Moreover, automatingconfirmation tracking and follow-up enablesa bank to identify counterparties that do notconfirm on a regular basis so that they can beaddressed. Finally, automation, as opposed toa purely manual system, decreases potentialerrors caused by human intervention (phoneand paper) and reduces operational costs.13


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

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

Best Practice no. 24:Establish Exception Processingand Escalation ProceduresEscalation procedures should be established toresolve any unconfirmed or disputed deals.Periodic reports containing transactions thathave not been confirmed or affirmed, andcounterparties that do not confirm or affirm,should be issued to sales and trading and seniormanagement.

Exposure to market risk arises when tradesare not confirmed. To mitigate this risk,standard escalation procedures should be inplace to pursue and resolve all discrepanciesin a timely manner. Unconfirmed deals mayindicate trade entry errors, such as a failure toenter the trade, or that a counterparty did notrecognize a trade. Repeated problems mayindicate that the counterparty does notexecute operational procedures correctly,which may signal the need to reevaluate thetrade relationship.

Internal procedures should be establishedto monitor unconfirmed trades. When aconfirmation is received from a counterparty,and no record of the deal exists internally,operations should immediately establishwhether a deal has in fact been conducted bycontacting the appropriate person in sales andtrading. Operations should then verify thetrade information from a related source (forexample, Reuters conversation or brokerconfirmation) or by contacting thecounterparty directly. In either case,operations needs to follow escalation

practices regarding unconfirmed trades asoutlined by the firm. Under no circumstancesshould a dispute be carried over for more thanone day after the trade date, and if such adispute should arise, it should be carried overonly with the approval of senior management.

Escalation procedures should also includenotification to sales and trading so that theyknow which counterparties do not comply withbest practices. Senior management should alsobe informed of unconfirmed deals so that theycan evaluate the level of operating risk beingintroduced by maintaining dealing relationshipswith noncompliant counterparties. Compen-sating controls—such as sending out periodicstatements with all outstanding forward trades—can be implemented, but it must be recognizedthat such controls do not eliminate the risksinherent with unconfirmed trades.

The segregation of duties between salesand trading and operations can pose specialchallenges when dealing with exceptions.Under no circumstances should operationsconcede control of unconfirmed trades tosales and trading. If confirmations arereceived that operations does not recognize,it is imperative that operations maintaincontrol of such confirmations until either acancellation or amendment is received.When trades remain unconfirmed, escalationprocedures should be strictly followed andsenior operations management shouldformally review any exceptions to policy.


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

Netting

Process DescriptionBilateral settlement netting is the practiceof combining all trades between twocounterparties due on a particular settlementdate and calculating a single net payment ineach currency. If, for example, a bank doestwenty-five trades in dollar-yen with the samecounterparty, all of which settle on the sameday, bilateral settlement netting will enable thebank to make only one or two netted paymentsinstead of twenty-five.14 The establishment ofsettlement netting agreements betweencounterparties may be used to reduce settle-ment risk, operational risk, and operational costs.

Multilateral settlement netting is thepractice of combining all trades betweenmultiple counterparties and calculating asingle net payment in each currency. Thispractice is supported by CLS Bank (CLS). CLSBest Practices can be found on the website<www.cls-services.com>.

Netted payments are calculated fortransactions done in the same currencies withequal value dates. The bank and counterpartycontinue to confirm all deals on a daily basiseither directly or through a system that helpssupport settlement netting. These systemsallow a bank to view netted amounts of tradeson a screen.

A summary of netted amounts by currenciesand value date can also be monitored andindividual netted trades can be reviewedsubsequently. Trades that have been matchedand confirmed are typically identified as well.Any disputes should be investigated and

resolved between bank and counterpartyoperations units. Operations generally confirmsnetted amounts again on the day beforesettlement date in addition to confirming thetransaction itself on the trade date (see theconfirmation section and Best Practice no. 19).

The operational process of settlementnetting should be supported by a legalagreement. Such an agreement may be asimple one-page document that onlysupports settlement netting, or the settlementnetting provision may be included in a masteragreement (see Best Practice no. 3)

Best Practice no. 25:Use Online SettlementNetting SystemsThe use of an online settlement netting system isencouraged to calculate net payments in eachcurrency. Online software for calculation ofnetted payments should be used to ensure propercalculations.

Correct calculations of netted payments areimportant to ensure accurate settlementamounts, enhance efficiency of operations, andpreserve client relationships. If, for example, abank mistakenly expects a payment of$2 million from a counterparty but receives$1 million, it will initiate investigationprocedures and possibly escalation procedureswith the counterparty, thus possibly damagingthe relationship between institutions. Faultynetting calculations also create an inaccurateassessment of a bank’s credit risk with thecounterparty.

Because of these risks, a bank should useonline (real-time) software to calculate netted


payments. By using online software, bothcounterparties can enter deal information intothe trade capture system. The system willconfirm the transactions, and will calculate, ona currency-by-currency basis, the net amountdue to each counterparty. The two counter-parties to the transaction will be notified ifthese amounts are not equal and the resultingdiscrepancy may be resolved immediately.

Using online netting systems also helps toreduce settlement risk. Because onlinesystems allow banks to quickly recognize andcorrect netting errors, currency exposures canbe managed more effectively. If a bankconducts ten trades (within the samecurrency) with a counterparty, it will onlyexperience a currency exposure for twonetted amounts (one for the amount it ispaying and one for the amount it is receiving)and not for twenty different amounts. Whenadditional trades are done, the resultingexposure is added to the net exposure.

Best Practice no. 26:Confirm Bilateral Net AmountsFinal amounts should be confirmed bilaterallywith the counterparty if they are not doneelectronically.

Third-party electronic settlement nettingsystems inform both bilateral parties of theamount that they owe and can expect toreceive at some predetermined cutoff time.However, if electronic settlement nettingsystems are not used, then the calculationsperformed by one party’s operations groupmay contain an error. To protect against animproper settlement of a net amount,counterparties should confirm the net

payment amount with each other at somepredetermined cutoff time.

Best Practice no. 27:Employ Timely Cutoffs for NettingA bank should adopt the latest cutoff timepossible for confirming netted trades. Creditsystem functions should be in place to accuratelyreflect the effect of netting.

To include all transactions done betweentwo counterparties and achieve the maximumrisk reduction, the net payment amountsshould be confirmed at the latest possibletime. This measure will allow trades done forsettlement on the trade date to be included inthe net amount. As netting occurs and othertrades are done with the counterparty, creditsystems should be updated. Credit systemsshould be adapted to account for legallyenforceable netting agreements and shouldreflect changes in credit-line usageappropriately. This allows sales and trading toappropriately deal with counterparties basedon available credit and to gauge the riskassociated with each deal. Deals that miss thenetting cutoff should be settled gross andreflected as such for credit purposes.

Best Practice no. 28:Establish Consistency betweenOperational Practicesand DocumentationManagement should ensure that operatingpractices are consistent with credit policies andother documentation. Credit systems should notreflect settlement netting benefits unlessdocumentation exists to support settlement withcounterparties on a net payment basis.


Sometimes operational practices do notfollow documented policy. The trade capturesystem may not indicate netting counter-parties, for example, thus preventing the bankfrom realizing the benefits of netting. In anothervariance from policy, a bank might practicenetting although a formal agreement has notbeen established with the counterparty to doso. A bank that is caught in a legal dispute,however, will not be able to justify its practiceswithout legal and operational support.Additionally, a bank may be prevented fromeffectively managing its risk position.

To this end, operations managementshould strive to establish procedures that arein line with operational goals and followdocumented procedures. Managementshould be certain that operational proce-dures ensure that netting is carried outbetween a bank and designated counter-parties. Operations should also ensure thatnetted trades are reflected in trade capturesystems and credit systems so that netting issuccessfully executed. The operationalprocedures should include any necessary cut-off times, standing settlement instructions(SSIs), and an agreed method of confirmationand affirmation should be supported by eachcounterparty’s documentation policy.

Settlement

Process DescriptionSettlement is the exchange of paymentsbetween counterparties on the value date ofthe transaction. The settlement of FXtransactions can involve the use of varioussecure international and domestic paymentsystem networks.

Settlement occurs and payments areexchanged on the value date of thetransaction. For counterparties that are notsettled on a net basis, payment instructionsare sent to nostro banks for all the amountsowed—as well as for expected receipts.Settlement instructions are sent one daybefore settlement, or on the settlement date,depending on the currency’s settlementrequirements. Settlement instructions shouldinclude the counterparty’s nostro agent’sname and SWIFT address and accountnumbers if applicable. Systems generatepredictions of expected movements in nostroaccounts to help manage liquidity andreconcile actual cash movements against thenostro accounts.

All payments are exchanged through theaforementioned nostro accounts. Theseaccounts are denominated in the currency ofthe country where they are located. When abank enters into a contract to buy dollars andsell yen, for example, it will credit its yen nostroaccount and debit its dollar nostro account.The counterparty credits its dollar nostroaccount and debits its yen nostro account inJapan. Both banks initiate a money transfer topay their respective counterparties; this is doneby a funds movement between the two banksusing the local payment system. The moneytransfer is complete when both counterpartieshave been paid the appropriate amounts.

If settlement error occurs in the process, it istypically quite costly. If a bank fails to make apayment, it must compensate its counterparty,thus generating additional expense.Settlement errors may also cause a bank’s cashposition to be different than expected.


In addition, settlement risk—the risk that abank makes its payment but does not receivethe payment it expects—can cause a largeloss. This risk arises in FX trading becausepayment and receipt of payment often do notoccur simultaneously. A properly managedsettlement function reduces this risk.Settlement risk is measured as the full amountof the currency purchased and is consideredat risk from the time a payment instruction forthe currency sold becomes irrevocable untilthe time the final receipt of the currencypurchased is confirmed.15

Sources of this risk include internalprocedures, intramarket payment patterns,finality rules of local payments systems, andoperating hours of the local payments systemswhen a counterparty defaults. Settlement riskmay have significant ramifications and iscontrolled through the continuous monitoringof the bank’s nostro balances and throughthe establishment of counterparty limits.A maximum settlement risk limit is usuallyestablished for each counterparty.

Notably, the introduction of the CLS Bankhas increased the efficiency of settlement byintroducing a mechanism for simultaneousexchange of currencies on an intraday andmultilateral basis.

Best Practice no. 29:Use Real-Time Nostro BalanceProjectionsNostro balance projections should be made on areal-time basis and should incorporate the latesttrades, cancellations, and amendments.

A bank is exposed to risk when managingits nostro funds if expected cash positionsvary greatly from actual cash positions. If morecash is needed than the balance in an account,the bank will incur overdraft costs to fund thepositions. Continual overdraft balances willgenerate expenses for the bank and may causeoperational difficulties when the bank makesefforts to determine why errors occurred.

Best Practice no. 30:Use Electronic Messages for ExpectedReceiptsA bank should send its nostro banks an electronicmessage that communicates its expected receipts.

With the receipt of an electronic messageadvising of expected receipts, nostro bankscan identify payments that are directed to anincorrect account early in the process. Thisallows nostro banks to correct paymenterrors on a timely basis and aids in theformulation of escalation procedures. Thisprocess can help a bank to receive the exactfunds they expect and to eliminateunmatched or unreceived payments. Somenostro banks will take the transactionreference number from an incoming


15For additional information on settlement risk, please see the following: Foreign Exchange Committee, “Defining and Measuring FXSettlement 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: FederalReserve Bank of New York, 1995).

electronic message and put the number onits outgoing nostro activity statement.

Some nostro banks, however, are notequipped to process these expected receiptmessages. Given the benefits that accruethrough the use of expected receiptmessages, a bank should consider a nostro’sability to process these messages whenchoosing which nostro bank to use.

Best Practice no. 31:Use Automated Cancellationand Amendment FacilitiesA bank should establish a real-timecommunication mechanism with its nostro bankto process the cancellation and amendment ofpayment instructions.

A bank may need to change or cancelpayment instructions after they have beenreleased to nostro banks. Problems may ariseif this information is not processed in a timelymanner. Amendments occur when an error inthe original instruction has been identified ora counterparty has made a last minutechange. Because execution of the erroneouspayment instruction will certainly create animproper settlement, the bank needs to besure the amendment is acted upon so that itsnostro balance predictions are accurate.More importantly, a bank may wish to cancela payment instruction if it is reasonablyconfidant that a counterparty may not fulfill itsobligation to pay the counter-currency.

An automated feed from the operationssystem to the nostro bank will make communi-cation of amendments and cancellations easier.Nostro banks will be able to establish later

deadlines for payment amendments because areal-time link provides more time to process thechanges. Such a link also decreases thechance that a bank will miss the paymentdeadline and should prevent incorrectpayments from being released.

Best Practice no. 32:Implement Timely Payment CutoffsManagement should work to achieve the latestpossible cut-off times for cancellation andalteration of payment instructions to nostrobanks as well as the earliest possible times forconfirmation of final receipts.

By eliminating restrictive payment cancel-lation deadlines and shortening the time ittakes to identify the final and failed receipt ofcurrencies, a bank can lower its actual andpotential settlement exposure. A bank shouldunderstand when it can unilaterally cancel oramend a payment instruction and negotiatewith its nostro banks to make this cutoff as lateas possible. In addition, such policies give abank more control over its payments, allowingit to react to any problems that arise late in thesettlement process.

Best Practice no. 33:Report Payment Failures to CreditOfficersOperations should ensure that credit reportsappropriately update settlement exposureresulting from projected cash flow movements.Exposure amounts should include any failedreceipts from previous transactions.

To properly manage its credit risks, a bankneeds to monitor settlement exposure to each


of its counterparties. Settlement exposureexists for a FX transaction from the time thatthe payment instruction issued by the bank isno longer unilaterally revocable by the nostrobank to the time that the bank knows it hasreceived the counter-currency from thecounterparty. Therefore, credit officers needto know the projected settlement amounts foreach counterparty. In addition, anynonreceipts should be included in currentexposure amounts reported to the creditofficers. Nonreceipts indicate an increasedexposure to the counterparty until the amounthas been paid, and may also suggest a moreserious problem with the counterparty.

Best Practice no. 34:Understand the Settlement Processand Settlement ExposureAll senior managers should obtain a high levelunderstanding of the settlement process.Additionally, both credit and risk managers(those managing position risk and credit risk)should be cognizant of the impact their internalprocedures have on settlement exposure.

Settlement risk may be reduced if thoseinvolved in the process better understand theramifications of its possible failure. Seniormanagement, sales and trading, operations, riskmanagement, and credit management shouldunderstand the process and be aware of thetiming of the following key events in theprocess: when payment instructions are

recorded, when they become irrevocable, andwhen confirmation of counterparty payment isreceived with finality. Knowledge of these itemsallows the duration and amount of FXsettlement exposure to be better quantified.

Both credit and risk managers shoulddevelop accurate methods to quantifysettlement risk. A bank’s actual exposurewhen settling an FX trade equals the fullamount of the currency purchased, and lastsfrom the time a payment instruction for thecurrency sold can no longer be canceledunilaterally until the currency purchased isreceived with finality.16

Best Practice no. 35:Prepare for Crisis Situationsoutside Your OrganizationOperations employees should understand theprocedures for crisis situations affectingsettlement. They should know who to notify ifpayments must be canceled or if settlementprocedures must be changed.17

Crisis situations such as a failure of a bank’ssettlement processing systems, potentialbankruptcy, or political unrest present criticaldecisions for a bank, especially with regard tocredit and liquidity management. Firms shouldanticipate crises and prepare internally. A bank’sfailure to settle properly with counterpartiescould prove harmful if a counterparty defaultson the expected payments. Consequently,


16Foreign 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: FederalReserve Bank of New York, 1995).

operations should know precisely what to do ina crisis. Current nostro bank staff contact listsshould be distributed. These lists shouldcontain emergency contact numbers andcontact information for each nostro bank’scontingency operation.

Operations should also understandalternative settlement procedures and howthey are executed. Finally, operations staffshould know who to inform and how toinform them of changes or cancellations inpayment instructions. A bank may wish toconsider simulated exercises of crisissituations to ensure that employees arefamiliar with alternative procedures and canmanage them effectively.

Nostro Reconciliation

Process DescriptionNostro reconciliation occurs at the end of thetrade settlement process to ensure that atrade has settled properly and that all expect-ed cash flows have occurred. A bank shouldbegin reconciliation as soon as it receivesnotification from its nostro bank that pay-ments are received. If possible, reconciliationshould be performed before the payment systemassociated with each currency closes. Earlyreconciliation enables a bank to detect anyproblems in cash settlement and resolve themon the settlement date. Typically, however, abank does not receive notification from itsnostro banks until one day after settlement,which does not allow them to correct pay-ment errors on the settlement date.

Reconciliation begins with the predictionof cash movements. The bank’s operations

unit identifies those trades that are valued forsettlement the next business day. Operationsaggregates all payments for that value date,taking into account netted payments anddetermining what the expected cashmovement will be for each of its nostroaccounts. This process allows the bank toaccurately fund those nostro accounts.

The main objective of the nostroreconciliation function is to ensure thatexpected cash movements agree with theactual cash movements of currency at thenostro bank. This involves comparingexpected cash movements with actual cashmovements both paid out and received in bythe nostro bank. If the reconciliation indicatesa difference from expected amounts, thereare six possible reasons. A bank may have

� expected to receive funds and did not,

� expected to receive funds and receivedthe wrong amount,

� received funds and did not expect toreceive them,

� expected to pay funds and did not,

� expected to pay funds and paid the wrongamount, or

� paid funds and did not expect themto be paid.

If any differences are found, the bank mustfollow up with the nostro bank and/or thecounterparty to resolve the discrepancy. Thecause for the difference might be that wrongsettlement or trade information was capturedor that the nostro bank made an error. Most ofsuch errors can be avoided if the confirmation


process is followed without exception. If thediscrepancy was caused by an error at thebank, then the bank must arrange to pay thecounterparty with good value or to pay thecounterparty compensation. Similarly, if theerror occurred at the counterparty or at thenostro bank, then the bank should expect toreceive good value or compensation.

If the nostro reconciliation is not performed,or is performed incorrectly, then the balancesat the nostro bank will be different from thosethe traders believe they are funding.Consequently, the bank will be payingoverdraft costs on any short balances orreceiving less than market rates on any longbalances. In some currencies, the central bankshave penalties for carrying short balances inaddition to the overdraft charges due. Failure tonotify counterparts of problems in a timelymanner may lead them to dismiss claims thatare over a certain age, causing the bank toabsorb the overdraft costs. In addition, nostroreconciliation serves as a main line of defensein detecting fraudulent activity.

Banks should implement procedures toperiodically review the terms and conditionsof each nostro agent and evaluate usage ofeach nostro account.

Best Practice no. 36:Perform Timely Nostro AccountReconciliationFull reconciliation of nostro accounts should becompleted as early as possible.

A bank should attempt to establishcapabilities that allow for intraday processing ofnostro confirmations of receipts, thereby

allowing the reconciliation process to beginbefore the end of the day. In no instance,however, should the reconciliation be donelater than the day following settlement date.The sooner reconciliations are performed, thesooner a bank knows its true nostro balancesso that it can take appropriate actions to ensurethat its accounts are properly funded. Inaddition, nonreceipt of funds may indicatecredit problems at a counterparty. The soonerthis information is known, the sooner a bankcan prevent further payments from being madeto that counterparty.

Best Practice no. 37:Automate Nostro ReconciliationsA bank should be capable of receiving automatedfeeds of nostro activity statements and implementautomated nostro reconciliation systems.

A bank should establish facilities forautomatically downloading the settlementinformation it receives from nostro banks as wellas its own expected settlement data. A bankshould establish an electronic reconciliationsystem to compare these two streams of data(confirmed payments and receipts from thenostro bank against the expected cashmovements from the operations system) toallow for the timely identification of differences.Escalation procedures should be in place todeal with any unreconciled trades and/orunsettled trades. These procedures should beinitiated when settlement and/or nostroreconciliations are not successful.

Best Practice no. 38:Identify Nonreceipt of PaymentsManagement should establish procedures for


detecting non-receipt of payments and fornotifying appropriate parties of theseoccurrences. Escalation procedures should be inplace for dealing with counterparties who fail tomake payments.

A bank should attempt to identify, as earlyin the process as possible, any expectedpayments that are not received. They shouldbe prioritized by counterparty credit ratings,payment amount and currency, or by aninternally generated counterparty watch list.All failed receipts should be subject toestablished follow-up procedures. A bankshould also report nonreceipts to creditmanagement and to sales and trading,particularly for any recurring failures with oneparticular counterparty. Management maywish to consider a limited dealing relationshipwith counterparties who have a history ofsettlement problems and continue to fail ontheir payments to the bank. Payment ofinterest and penalties should be prompt.

Best Practice no. 39:Establish Operational Standardsfor Nostro Account UsersA bank should require all other users of its nostroaccounts to comply with the same operationalstandards as FX users.

The FX department of a bank may be theprimary user of nostro accounts. However,other business groups (for example, fixedincome, commodities, emerging markets, andderivatives) may also be users. Clearprocedures should be established outlininghow each account is funded (that is, individualor group funding). Consistent standards

should be in place describing the necessaryoperating procedures that all users shouldfollow. Without clear rules for sharing in place,the bank runs the risk of overdraft problems.

Accounting/FinancialControl

Process DescriptionThe accounting function ensures that FXtransactions are properly recorded to thebalance sheet and income statement. Iftransaction information is not recorded cor-rectly, a bank’s reputation may be impaired ifmaterial restatements of financial accountsare necessary.

Accounting entries are first bookedfollowing the initiation of a trade. At thispoint, details of the deal are posted tocontingent accounts (typically in a systemused by operations). At the end of each tradeday, all sub-ledger accounts flow through tothe general ledger. There are two commonmethods for transferring and validating P&Linformation in the general ledger.

In some banks, the sales and trading systemcompiles all of this data and develops a P&Lfigure for each day. The operations staff laterverifies the P&L figure. Other banks calculatetwo P&L figures independently: one iscalculated by sales and trading, and one bythe operations system. An independent party,such as the risk management division, verifiesboth P&L figures. Each morning, the P&L ofthe prior day’s business is verified by thefinancial management function and analyzedby senior management.


The accounting area should ensure thatfollowing the initial entry of a trade into thegeneral ledger, the position is continuallymarked to market until it is closed out. Dailymarking to market calculates unrealized gainsand losses on the positions that are fed intothe general ledger and the daily P&L. Oncethese positions are closed out, realized gainsand losses are calculated and reported.

All subsidiary ledger accounts (including allbrokerage accounts and suspense accounts)are reconciled to the general ledger daily.Additionally, on a monthly basis (usually atmonth-end) an independent check is done toensure that all subsystem accounts reconcileto the general ledger accounts. Alldiscrepancies are investigated as soon aspossible to ensure that the bank’s books andrecords reflect accurate information. Inaddition, all discrepancies that have animpact on how the bank reports gains orlosses are reported to senior management.

Cash flow movements that take place onsettlement date are also posted to the generalledger in accordance with accepted accountingprocedures. The receipt and payment ofexpected cash flows at settlement arecalculated in a bank’s operations system. Thereare times when cash flows must be changedbecause of trade capture errors, which requirechanges to a sub-ledger account. Accountingentries are modified so that the general ledgeraccurately reflects business activities; thechange flows to the operations system whereappropriate cash flow adjustments are made.

Best Practice no. 40:Conduct Daily General LedgerReconciliationSystematic reconciliations of 1) the generalledger to the operations system, and of 2) salesand trading systems to the operations systemsshould be done daily.

Timely reconciliations will allow for promptdetection of errors in the general ledgerand/or sub-ledgers and should minimizeaccounting and reporting problems. Thisreconciliation will ensure that the generalledger presents an accurate picture of aninstitution’s market position. When problemsare detected, they should be resolved as soonas possible. Senior management should benotified of accounting discrepancies to reviewand update control procedures as needed.

Best Practice no. 41:Conduct Daily Positionand P&L ReconciliationDaily P&L and position reconciliations shouldtake place between the sales and trading andoperations systems.

Position reconciliations allow a bank toensure that all managed positions are thesame as those settled by operations. Thiscontrol is imperative when all deal entries andadjustments are not passed electronicallybetween sales and trading and operations.When straight-through processing is in place,the reconciliation ensures that all deals weresuccessfully processed from sales and tradingto operations, along with all amendments.Because a discrepancy in P&L between salesand trading and operations can indicate adifference in positions or market parameters


(that is, rates or prices) all differences shouldbe reported, investigated, and resolved in atimely manner.

Banks that maintain a single system fortrade capture data should ensure that the datasource is properly controlled.

Best Practice no. 42:Conduct Daily Position ValuationPosition valuations should be verified daily by astaff that is separate from sales and trading.Preferably, position valuation should beconducted by an independent third party such asthe risk management staff. Position valuationshould be checked against independent pricesources (such as brokers or other banks). This isparticularly important for banks that are activein less liquid forward markets or in exotic optionsmarkets. Trading management should beinformed of the procedures used for marking tomarket to ensure that they can appropriatelymanage trade positions.

P&L is an integral part of the daily controlprocess; thus, it is important for thecalculation to be correct. The appropriateend of day rates and prices that are used tocreate the position valuations should beperiodically checked by an independentsource. Either operations or risk managementshould check that the rates and prices used bysales and trading for end-of-day valuation areclose to the market rates.

Position valuations should be verified usingindependent sources such as market ratescreens, other dealers, and/or broker

quotations. In addition, at least once a month,the results of the models should be checkedagainst other dealers and/or brokers to ensurethat the valuations produced by the bank’smodels are consistent with other dealers.

Illiquid markets present additional risk to abank because illiquid instruments areinfrequently traded, making them difficult toprice. Often, it is hard for a bank to obtainmarket quotes, thereby preventing timely andconsistent position monitoring. P&L may bedistorted and risk may not be properlymanaged. In such instances, a bank shouldseek to obtain quotes from othercounterparties active in the market.Management should be aware of theseprocedures so that they may effectivelymanage and evaluate illiquid marketpositions. These procedures allow a bank tomark to market its positions and to evaluateassociated risks. All market participantsshould be aware that an FX option portfolio isnot effectively marked to market unless thevaluation reflects the shape of the volatilitycurve. With consideration given to the size ofportfolio and daily activity, positions shouldwherever possible be revalued reflecting the“smile effect” when the firm wishes to mark tomarket. Where appropriate, firms shouldreserve against liquidity and pricing risk.

Marking to market reflects the current valueof FX cash flows to be managed and providesinformation about market risk.18 Seniormanagement will be able to better manage andevaluate market positions when they knowhow positions are valued on a daily basis.


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

Best Practice no. 43:Review Trade Prices for Off-MarketRatesTrade prices for both internal and external tradesshould be independently reviewed to ensurereasonableness within the market prices thatexisted on the trade date.

Any trades executed at prices notconsistent with the market rates that existed atthe time of execution may result in an errorfor the bank or may unduly enrich the bank orthe counterparty. Banks should institute adaily procedure that provides forindependent manual or automated review oftrade prices versus prevailing market rates.

Best Practice no. 44:Use Straight-Through Processingof Rates and PricesRates and prices should be fed electronicallyfrom source systems.

The valuation of positions requires manydifferent rates and prices, sometimescollected from different sources. To eliminatethe errors associated with collecting and re-keying the required rates and prices, a bankshould establish electronic links from thesystems that source the rates and priceinformation to the position valuation systems.

Unique Features of ForeignExchange Optionsand Non-Deliverable Forwards

Process DescriptionForeign exchange (FX) options and non-deliverable forwards (NDFs) have unique

features that need to be handled differentlythan spot and forward FX transactions.Specifically in the areas of

� option exercise and expiry,

� rate fixings for NDFs and some nonvanillaoptions, and

� premium settlements for options.

Options exercise/expiry requires thedetermination of the intrinsic value of theinstrument. The intrinsic value is the amount bywhich the option is in-the-money. Todetermine this value, the strike price of anoption must be better than the market rate atthe time of expiration. This special event is oneof the unique features of options. Options haveinherent risk associated with failure to performevents such as exercising in-the-moneytransactions or obtaining fixings for non-vanillaoptions (such as average rate or average strike).Senior operations management should clearlydefine roles and responsibilities to ensure thatthese inherent risks are reduced.

NDFs, much like options, also requireadditional processing. NDFs are cash-settledFX instruments that require a rate fixing todetermine the cash settlement amount. Dailyreview of outstanding transactions must beperformed to ensure that fixings are obtainedas required in the confirmation language.Fixings are communicated by notification of afixing advice. Responsibility for thenotification of the fixing advice should be partof the confirmation process and performedby operations personnel.


The confirmation process for both FXoptions and NDFs is comparable to straight FXtrades. The difference is that FX options andNDFs require additional language and staffmust understand more than the usual termsand conditions in order to reduce operationalrisk. In all other respects, FX options and NDFsshould be treated the same way as spot andforward FX trades as outlined in this document.

Best Practice no. 45:Establish Clear Policies andProcedures for the Exercise of OptionsBanks should have clear policies and proceduresthat define roles and responsibilities anddescribe internal controls on the process ofexercising and expiring foreign currency options.

Banks should mitigate operational risk byimplementing policies and procedures inconjunction with oversight departments andby assigning clearly defined roles andresponsibilities. Determination of an in-the-money option and notification to thecounterparty should be performed via anindependent, audible electronic system.Exercising options, for example, should besegregated from sales and trading andperformed by staff that communicatesbetween the front- and back-office personnel.

Additionally, to reduce the likelihood thattransactions are not exercised, systemsshould be designed to auto-exercise in-the-money transactions. Oversight is necessary inthe form of measuring options against marketrates, thereby ensuring that in-the-moneytransactions are exercised appropriately.Foreign exchange trades resulting fromexercised options should automatically and

electronically flow to the back-office FXprocessing system if a separate application isused from the option processing system.

Best Practice no. 46:Obtain Appropriate Fixings forNonstandard TransactionsEnsure that nonstandard transactions (such asnon-deliverable forwards [NDFs], barrier,average rate, and average strike options) withindexing components are fixed with theappropriate rates as provided in the language ofthe confirmation or master agreementdocumentation.

Operations staff, independent of sales andtrading, should obtain the fixing rates asdefined in the confirmations for allnonstandard transaction types (such as NDFs,average rate, average strike option trades).Confirmations should be reviewed on thetrade date to determine the fixing source. Thisfixing information should be captured by theback-office operational transactionprocessing system and noted on theindividual confirmations. On the fixing date,fixing advices should be generated andforwarded electronically (where possible) tothe counterparty reflecting the fixing rate andsettlement amount.

Best Practice no. 47:Closely Monitor Option SettlementsOption premium settlements should be closelymonitored to reduce the potential for out-trades.

Premium settlement of options should bemonitored closely to reduce the potential forout-trades. Option premium amounts can besmall and not reflect the notional amount of


the option transaction. Ensuring that thecounterparty receives the settlement of thepremium can be an indication that thecounterparty is aware of the position, albeitnot the details of the trade, which would becovered in the confirmation.

General Best Practices

Process DescriptionThis section suggests general best practices thatapply to all segments of the FX process flow.

Best Practice no. 48:Ensure Segregation of DutiesThe reporting line for operations personnelshould be independent of the reporting line forother business lines (sales and trading, credit,accounting, audit, and so on). For key areas,operations management should ensure that anappropriate segregation of duties exists withinoperations and between operations and otherbusiness lines.

Operations cannot be completely effectivein performing its control functions if itsmembers report to an area that they areassisting. Operations must be able to reportany and all issues to an independentmanagement team. To do so, operations musthave a reporting line that is not directlysubject to an organizational hierarchy thatcould lead to a compromise of control. Inaddition, the compensation process foroperations personnel should be clearlysegregated from that of the compensationprocess of sales and trading.

Examples of good practices include:

� precluding individuals from having bothtrading and confirmation/settlementresponsibilities concurrently,

� precluding sales and trading personnelfrom issuing and authorizing payments,

� precluding individuals from having bothposting and reconciling access to the gen-eral ledger,

� not allowing established procedures tobe overridden without operations man-agement’s consent, and

� separate database functions betweensales and trading and operations.

Best Practice no. 49:Ensure That Staff UnderstandBusiness and Operational RolesOperations and sales and trading personnelshould fully understand all FX business strategiesand the role of each participant within the FXprocess flow (for example, clients, credit,compliance, and audit). Policies and proceduresshould be documented and updated periodically.

Business strategies, roles, responsibilities,and policies and procedures continuallychange and evolve. Each group or individualplaying a role in the FX process flow shouldhave a complete understanding of how FXtrades are initiated, processed, confirmed,settled, controlled, and accounted.Insufficient knowledge of the overall FXprocess, or the role played by each individualor group, can lead to an improper segregation


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

of duties, insufficient controls, and/orincreased risk. All market participants shouldprovide continuous employee educationregarding business strategies, roles,responsibilities, and policies and procedures.The development of effective “front-to-back”training should be encouraged to ensure thatall elements of the FX business are clearlyunderstood by all. All market participantsshould insure that policies and proceduredocuments are current, documented,maintained, and available to all.

Best Practice no. 50:Understand Operational RisksMarket participants should fully understandoperational risks.19 To help mitigate operationalrisks, every market participant should implementadequate controls, modify processes and flowswhen appropriate, and/or invest in improvedtechnology. Current as well as potentialoperational risks associated with new industryprocess changes (for example, the CLS Bank,web portals, and so on), should be assessed on aregular basis, quantified wherever possible, andreported to senior management.

Areas of exposure within the FX processingcycle need to be identified, quantified wherepossible, and adequately controlled. Withbetter information regarding operational risks,institutions can make informed decisionsabout which risks they are going to assumeand which risks need to be managed eitherthrough enhanced process flows and controlsor through investments in improvedtechnology. Proactive thinking concerningcurrent and future trends is recommended.

Best Practice no. 51:Identify Procedures for IntroducingNew Products, New Customer Types,or New Trading StrategiesAll market participants should have adequateprocedures and controls in place for introducingnew products, new customers types, or newtrading strategies. These procedures and controlsshould include a provision to ensure that theparticipant has the capability to initiate, price,value, confirm, and settle these new types oftransactions, customers, or strategies. Themarket participant should also be able tomeasure, monitor, and report all risks associatedwith new products, customers, or strategies.

When a new product, new customer, ornew business strategy is introduced, all areas-operations, sales and trading, financialcontrol, risk control, legal, compliance,technology, and others—should be fullyknowledgeable and prepared to execute andprocess the new dealings in a controlledenvironment. New products, new customertypes, or new business strategies mayintroduce different types of risks or increaseexisting risks. They may also result in differentmethods of trade capture, confirmation,netting, settling, reconciling, and/or P&Lreporting. Any change to existing processes,practices, or policies should be effectivelycontrolled and reported. Procedures andcontrols that detail operational and systemssupport guidelines should be documentedand published.


Best Practice no. 52:Ensure Proper Model Sign-off andImplementationQuantitative models often support FX tradingactivities. As a result, their implementation andmanagement should be a coordinated effortamong the various FX business lines. Modelimplementation and maintenance should ensurethat all FX business lines (Sales & Trading,Operations, financial control, risk control,technology, audit, and others) approve, support,and understand the model purpose andcapabilities, as well as the roles and responsibilitiesof each business line. Further, to maintainappropriate segregation of duties, modelvalidation, model technical development, anddata input and output reporting should allbe performed independently from Sales & Trading.

Models may be used to report positions, tomanage position risk, or to price financialinstruments. New models, or modifications toexisting models, may change or challengeestablished policies, procedures, and/orpractices. It is important that all FX businesslines understand how the pricing of certaininstruments will change and how positionmonitoring will be evaluated if a new model isintroduced or an existing model modified.Model risk and potential business disruptionscan be effectively controlled through crossbusiness line approval, implementation,management, and education.

Best Practice no. 53:Control System AccessUsers of a system (for example, operations, salesand trading) should not be able to alter thefunctionality of production systems. Developers

should have limited access to production systems,and only in a strictly controlled environment. Eachsystem should have access controls that allow onlyauthorized individuals to alter the system and/orgain user access. Function-specific user access“profiles” are suggested.

As alternative technologies (for example,web-based trading) continue to emerge in theFX trading and processing environments,rigorous controls need to be implementedand monitored to ensure that data integrityand security are not sacrificed. External useraccess controls should be as robust as internaluser access controls.

Access to production systems should onlybe allowed for those individuals who requireaccess in order to perform their job function.When creating user access profiles, systemadministrators should tailor the profile tomatch the user’s specific job requirements,which may include “view only” access. Systemaccess and entitlements should beperiodically reviewed, and users who nolonger require access to a system should havetheir access revoked. Under no circumstanceshould operations or sales and trading havethe ability to modify a production system forwhich they are not authorized.

Best Practice no. 54:Establish Strong IndependentAudit/Risk Control GroupsMarket participants should have sophisticatedand independent audit/risk control groups. It isrecommended that market participants performrigorous self-assessments and publish regularreporting of such to management, the businessline, and audit/risk control groups. Firms should


implement policies and procedures that enableemployees to raise concerns anonymously.

The audit/risk control groups play a mostimportant role. They ensure that quantifiableand effective controls are in place and workingproperly and that policies and procedures arerelevant as well as followed. The goal of thesegroups is to protect the market participantagainst financial or reputation loss bymonitoring or uncovering flaws in the processor procedures and suggesting correctiveaction. These groups must not have a reportingline that is subject to an organizationalhierarchy that could lead to a compromise ofcontrol, assessment, or escalation.

Best Practice no. 55:Use Internal and ExternalOperational Performance MeasuresOperational performance reports should beestablished to clearly measure and report on thequality of both internal and external(outsourced) operational performance. Thereport measurements should focus onoperational efficiency and controls, and bereviewed on a regular basis by both operationsand sales and trading management.

Operational performance reporting shouldcontain quantifiable performance metrics atthe levels of detail and summary, and indicatethe status of operational activities. Typical keyperformance measures would includeconfirmation, acceptance and aging reporting,nostro and cash balance reporting, operationalerror and loss reporting, and any other relevantdata deemed necessary by the participant.These reports should serve to control andproactively monitor risk and performance.

Market participants may employ ServiceLevel Agreements (SLAs) as a way of improvingand controlling operational performance. SLAsshould always be exchanged when outsourcingall or part of a participant’s operation. SLAsshould clearly define, measure, and report onoperational performance. External (outsourced)performance measurements should be asrobust as internal performance measurements.

Best Practice no. 56:Ensure That Service OutsourcingConforms to Industry Standardsand Best PracticesIf a bank chooses to outsource all or a portion ofits operational functions, it should ensure that itsinternal controls and industry standards are met.A bank that outsources should have adequateoperational controls in place to monitor that theoutsourcer is performing its functions accordingto agreed-upon standards and industry bestpractices.

A bank may choose to outsource some orall of its operations functions. However,outsourcing should in no way compromise abank’s internal standards for confirmations,settlement and payments. Controls should bein place to monitor vendors to ensure thatinternal standards are met. For example,trades should still be confirmed in a timelymanner and proper escalation andnotification procedures must be followed.

Best Practice no. 57:Implement Globally ConsistentProcessing StandardsWhen a bank has multiple processing centers, itshould ensure that bankwide standards are met


in each location. Banks should use consistentprocedures and methodologies throughout theinstitution. Satellite offices or separate entitiesrequire close oversight to ensure that theyconform to the standards of the bank.

Some banks may maintain multipleprocessing centers in different locations aroundthe world. Regional processing may allow a firmto maintain around-the-clock processing formultiple front-end trading locations. However,it is essential that a firm’s standards andprocesses are consistent throughout the bank.Although different processing centers may relyon different systems or technology, thestandards and procedures should be the samein every processing center. For example,valuation methodologies should remainconsistent throughout the firm.

In addition, some firms may rely oncentralized booking and operations, but mayhave specific exceptions, such as satelliteoffices, or branches that serve as separatelegal entities. Such sites should be carefullymonitored to ensure that their bank’sstandards are being met.

Best Practice no. 58:Maintain Records of Deal Executionand ConfirmationsBanks should maintain documentationsupporting the execution of foreign exchangetrades. Such documentation should provide asufficient audit trail of the events throughout thedeal execution, trade, and validation process.This documentation may be in the form ofwritten or electronic communication, a taperecording, or other forms evidencing the

agreement between the parties. Documentationshould cover communication not only betweenthe sales and trading groups of the bank and thecounterparty but also between the operationsarea of the bank and the counterparty.

Deal execution and confirmation documen-tation can aid institutions in verifying tradedetails and ensure that amounts were confirmedas expected. This step may help a bank if itbecomes involved in counterparty disputes. Foreach trade, the following information should bedocumented: currencies, amount, price, tradedate, value date and the notional currency ofeach transaction.

The length of time that a bank keepsrecords (which may be left to management’sdiscretion) depends on the type of businessthey transact and may also be subject to localregulations. Record retention, for example,may depend on the character of a bank’sforward trading or long-dated options trading.

It is important to note that trades conductedover the telephone pose particular risks. Thephone conversation is the only bilateral recordof the trade details, at least until the trade isvalidated through the traditional confirmationprocess. Until this confirmation process iscompleted, market participants shouldestablish close controls to minimize theexposure inherent in such trades.

Best Practice no. 59:Maintain Procedures for RetainingTransaction RecordsThe operations group is responsible for retainingadequate records of all transactions and supportingdocumentation for the financial statements.


Operations must maintain detailed recordsof all transactions executed and of allinformation to support its P&L and positioncalculations. Each market participant shoulddetermine appropriate record retentionbased on tax, regulatory, and legalrequirements for each jurisdiction. It isrecommended that records be maintained induplicate and in a location separate fromwhere primary processing occurs.

If and when external vendors or storagefacilities are employed, it is essential that theyprovide a similar backup facility. Records canbe maintained on paper, optical, or magneticmedia. If a computer-based format is used,the programs and their documentation needto be retained so that the data can be read ata later date. Special care must be takenbecause newer versions of softwarefrequently cannot read older data files. Olderprograms may also not run correctly on neweroperating systems or machines. In addition,magnetic media must be maintained carefullybecause it degrades in adverse conditions.

Best Practice no. 60:Develop and Test Contingency PlansOperations and sales and trading shoulddevelop plans for operating in the event of anemergency. Contingency plans should beperiodically reviewed, updated, and tested. These

contingency plans should cover both long-termand short-term incapacitation of a trading oroperations site, the failure of a system, the failureof a communication link between systems, or thefailure of an internal/external dependency. Theseplans should include informing, monitoring,and coordinating personnel.20

The primary risk of a major disaster is that amarket participant may not be able to meet itsobligation to monitor its market positions.Many market participants deal in highvolumes of large trades. Failure to be able totrade or settle transactions from a given center(or several trading centers in the case ofcentralized operations processing) couldsubject the market participant to severefinancial and reputational repercussions.

Market participants should identify varioustypes of potential disasters and identify howeach may prohibit the participant from satisfyingits obligations (that is, issuing and receivingconfirmations, performing settlements, andcompleting daily trading). Disaster recoveryplans should identify requisite systems andprocedural backups, management objectives,people plans, and the methodology or plan fordealing with each type of disaster. Disasterrecovery plans should be reviewed on a regularbasis, and tested periodically, to gauge theeffectiveness of the plans themselves andmeasure staff readiness.


20Additional guidance 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 guidanceat <http://www.newyorkfed.org/bankinfo/circular/10952.pdf>. Broker/dealers may look to several documents from the Securities andExchange Commission and the Securities Industry Association for guidance, including <http://www.sec.gov/divisions/marketreg/lessonslearned.htm> and <http://www.sia.com/business_continuity/pdf/bestpractices.pdf>

An emergency crisis team, equipped withkey personnel contact lists, should beestablished to monitor crisis and coordinaterecovery efforts. Market participants shoulddevelop contingency contact lists (for bothinternal and external dependencies) anddistribute them to employees. All personnelshould know whom to contact in the eventof a disaster. Market participants should alsomaintain emergency contact information toreach primary counterparties. Counterpartyinformation records should includecontingency site phone numbers andemergency contact information for keypersonnel.

Backup sites that can accommodate theessential staff and systems of operations andsales and trading should be set up,maintained, and tested on a regular basis.Particularly for operations, market participantsshould consider developing a backup site thatrelies on a separate infrastructure (electricity,telecommunications, etc.) and an alternativeworkforce. Banks may want to leveragemultiple processing sites to serve asemergency backup facilities in the event of anemergency. In case of primary system failure,backup systems should be available andcapable of acting as primary systems. Thesesystems should provide for payment andsettlement as well as the monitoring andmanaging of both position and settlement risk.Backup systems should have access to currentand historical data which should be backed-up in a separate location from the primary site.

Market participants’ business continuityplans should take into consideration thetechnical support requirements of their

critical processing systems. Backup sitesshould be able to access critical confirmationand netting systems, key liquidity providers,and other industry utilities. Businesscontinuity plans should also consider therecovery capabilities of critical serviceproviders, in particular, their clearing andthird party settlement banks.

Additionally, all market participants shouldidentify and practice alternative methods ofconfirmation and settlement communicationwith nostro banks. These methods mayrequire the use of fax or telex to ensureproper processing.

During a disaster, a bank should notify itscounterparties of potential processing changes.A bank should also provide counterparties withcurrent contact information for key personnelto ensure that counterparties can contact thebank in an emergency.

Market participants should ensure that thecommunication tools used by operations andsales and trading are secure. If phone systemsfail, backup systems should exist (that is, cellularor non-PBX phones). All market participantsshould be connected to multiple phonesubstations to further prepare for disaster.

During market disturbances, marketparticipants should pay special attention toguidance communicated by industry groupssuch as the Foreign Exchange Committee andthe Singapore Foreign Exchange MarketCommittee. Industry groups may providespecial recommendations in times of marketstress to aid the flow of information on specialissues that may arise.


ConclusionThis paper has reviewed the entire foreignexchange process flow and best practices formaintaining a properly controlled environment.However, as noted in the introduction, severaltrends in the industry will affect a bank’s abilityto implement the best practices as listed in thisdocument. Although the market will continueto evolve and develop mitigating controls, andany set of recommendations will eventuallyrequire revision, management should considerthe practices suggested here as helpfulresponses to recent developments in tech-nology, instruments, and innovations in themarketplace.

The first step toward a properly controlledenvironment is an appropriate segregation ofduties between sales and trading, and

operations. However, such segregation ofduties does not imply that operations shouldbe viewed as separate from other business

lines. On the contrary, the authors of thispaper feel that the closer operations manage-ment is to the pulse of business, and the bet-ter the communication between sales andtrading management and operations manage-ment, the more responsive operations can beto changes in the business environment.Ultimately, better links between an institu-tion’s divisions will enable business as a wholeto be better controlled.


Arthur Magnus (Chair)J.P. Morgan and Co., Inc.

Pauline ChenFederal Reserve Bankof New York

Wayne FergusonCitibank Dealing Resources

Charles LeBrunBank One, NA

John MoranMidland Bank

Paul PuskuldjianLehman Brothers

Stephanie Reiter J.P. Morgan and Co., Inc.

Michael RichterCitibank, N.A.

Marlene WisemanBankers Trust Company

Acknowledgments

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

The task force for the 2003 revision included:

Charles LeBrun (Chair)Bank One, NA

Kimberly Agostinelli**Bank One, NA

Andy BurtonJP Morgan Chase

Paul GinsbergEBS Dealing Resources, Inc.

Mel GunewardenaGoldman Sachs & Co.

Tony HamabletDeutsche Bank AG

Pamela Hutson*Bank One, NA

Cynthia Ingram(Coordinator)Bank One, NA

Erik JohnsenFleetBoston Financial

Keith McDonaldCredit Suisse First Boston

Arthur Magnus**JP Morgan Chase

Angela MeyerForeign ExchangeCommittee

Joe PalamaraWachovia Bank

Rick Rua***Mellon Bank, N.A.

Phillip ScottBank of New York

Gary Sims*Bank of New York

Julie SeifertFleetBoston Financial

Robert White***Standard Chartered Bank

Robert EbyLehman Brothers

FOREIGN EXCHANGE COMMITTEE50

* Financial Markets Lawyers Group representative** Guest participant

*** Foreign Exchange Committee representative

Works Consulted

Bank for International Settlements. Basel Committeeon Banking Supervision. Operational RiskSupporting Documentation to the New Basel CapitalAccord. Basel: BIS, 2002.

Triennial Central Bank Survey of Foreign Exchangeand Derivatives Market Activity 2004. Basel: BIS,2004.

Board of Governors of the Federal Reserve System.“Evaluating the Risk Management and InternalControls of Securities and Derivative ContractsUsed in Non-trading Activities.” SR 95-17.Washington, D.C.: GPO, 1995.

Financial Accounting Standards Board.“Disclosure of Information about FinancialInstruments with Off-Balance-Sheet Risk andFinancial Instruments with Concentrations ofCredit Risk.” In FASB Statement No. 105. FASB,March 1990.

———. “Offsetting of Amounts Related to CertainContracts: An Interpretation of APB OpinionNo. 10 and FASB Statement No. 105.” In FASBInterpretation No. 39. FASB, March 1992.

Foreign Exchange Committee. “Defining andMeasuring FX Settlement Exposure.” In TheForeign Exchange Committee 1995 Annual Report.New York: Federal Reserve Bank of New York,1996.

———. “Guidelines for FX Settlement Netting.” In TheForeign Exchange Committee 1996 Annual Report.New York: Federal Reserve Bank of New York,1997.

———. “Guidelines for the Management of FXTrading Activities.” In The Foreign ExchangeCommittee 2000 Annual Report. New York:Federal Reserve Bank of New York, 2001.

———. “Reducing FX Settlement Risk.” In The ForeignExchange Committee 1994 Annual Report. NewYork: Federal Reserve Bank of New York, 1995.

———. “Standardizing the Confirmation Process.” InThe Foreign Exchange Committee 1995 AnnualReport. New York: Federal Reserve Bank of NewYork, 1996.

———. “Supplementary Guidance on ElectronicValidations and Confirmation Messaging.” InThe Foreign Exchange Committee 2001 AnnualReport. New York: Federal Reserve Bank of NewYork, 2002.

Group of Thirty. Global Derivatives Study Group.Derivatives: Practices and Principles. Washington,D.C.: Group of Thirty, 1993.

U.S. Comptroller of the Currency. Banking Circular277. Washington, D.C.: GPO, 1993.


52 FOREIGN EXCHANGE COMMITTEE 2003 ANNUAL REPORT

Best Practices Map to 1996 Version and Checklist

Checklist 2003 Version 1996 Version

Pre-Trade Preparation andDocumentationProcess 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 andOperational Practices

BP no. 5: Agree upon and DocumentSpecial 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 Processingof Transactions

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

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

BP no. 10: Operations Should Be BP no. 6: Operations ResponsibilityResponsible 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 Paymentsand Deep-in-the-Money OptionTransactions



Confirmation

BP no. 13: Confirm and Affirm Trades BP no. 9: Timely Confirmation/Affirmationin a Timely Manner BP no. 14: Timely Resolution

of Confirmation Exceptions

BP no. 14: Be Diligent WhenConfirming by Nonsecure Means

BP no. 15: Be Diligent When ConfirmingStructured or Nonstandard Trades

BP no. 16: Be Diligent When Confirmingby Telephone

BP no. 17: Institute Controls for TradesTransacted through Electronic TradingPlatforms

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

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

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

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

BP no. 24: Establish Exception Processing BP no. 17: Escalation Procedures/and Escalation Procedures Non-confirming Counterparties



Netting

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

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

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

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

Settlement

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

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

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

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

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

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

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

Nostro Reconciliation

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



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

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

BP no. 39: Establish Operational BP no. 34: Operational StandardsStandards for Nostro Account Users for Nostro Account Users

Accounting/Financial Control

BP no. 40: Conduct Daily General BP no. 35: Daily General LedgerLedger Reconciliation Reconciliation

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

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

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

BP no. 44: Use Straight-Through BP no. 39: Straight-Through ProcessingProcessing of Rates and Prices of Rates and Prices

Unique Features of Foreign ExchangeOptions and Non-Deliverable Forwards

BP no. 45: Establish Clear Policies andProcedures for the Exercise of Options

BP no. 46: Obtain Appropriate Fixingsfor Nonstandard Transactions

BP no. 47: Closely Monitor OptionSettlements

General Best Practices

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



BP no. 49: Ensure That Staff UnderstandBusiness and Operational Roles

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

BP no. 42: Understand Operational Risks

BP no. 51: Identify Procedures for BP no. 43: Procedures for IntroducingIntroducing New Products, New ProductsNew Customer Types, orNew Trading Strategies

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

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

BP no. 54: Establish Strong Independent BP no. 48: Strong Independent AuditAudit/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 ServiceOutsourcing Conforms to IndustryStandards and Best Practices

BP no. 57: Implement GloballyConsistent Processing Standards

BP no. 58: Maintain Records of BP no. 47: Taped Conversations betweenDeal Execution and Confirmation Counterparties

BP no. 59: Maintain Procedures BP no. 49: Responsibility for Recordfor Retaining Transaction Records Retention

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

management of operational risk in foreign exchange

Documents