Non Dealer Guidelines

8/3/2019 Non Dealer Guidelines

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Nondealer Participants

for

Foreign Exchange Transaction Processing:

Execution-to-Settlement

Recommendations



Introduction .....................................3

The Foreign Exchange Market...........................3The Changing Marketplace...............................3What Is the Foreign Exchange Committee

and What Are the Best Practices? ..................4How to Use This Document.............................4

Pre-Trade Preparationand Documentation...........................5

Process Description ..........................................5Recommendation No. 1: Determine Foreign

Exchange Needs and DevelopAppropriate Infrastructure..............................5

Recommendation No. 2: EnsureSegregation of Duties.....................................6

Recommendation No. 3: DetermineAppropriate Documentation.........................6

Trade Execution and Capture ............8Process Description..........................................8Recommendation No. 4: Establish

Appropriate Trading Policiesand Procedures...............................................8

Recommendation No. 5 : Clearly IdentifyCounterparties................................................9

Recommendation No. 6: Establishand Control System Access ..........................10

Recommendation No. 7 : Enter Tradesin a Timely Manner .......................................10

Confirmation ...................................11

Process Description ..............................................11Recommendation No. 8: Confirm Trades

in a Timely Manner ........................................11Recommendation No. 9: Block Trades

Should Be Confirmed in a Timely Manner.....12Recommendation No. 10: Resolve

Confirmation Discrepanciesin a Timely Manner........................................12

Recommendation No. 11: Unique Featuresof Foreign Exchange Options........................13

Recommendation No. 12: Unique Featuresof Non-deliverable Forwards........................14

Netting and Settlement....................

Process Description........................................Recommendation No. 13: Net Payments

and Confirm Bilateral Amounts....................Recommendation No. 14: Provide Accurate

and Complete Settlement Instructions .......Recommendation No. 15 : Use Standing

Settlement Instructions.................................Recommendation No. 16: Understand Risks

Associated with Third-Party Payments.........

Account Reconciliation ....................Process Description........................................Recommendation No. 17 : Perform Timely

Account Reconciliation ...............................Recommendation No. 18: Identify

Nonreceipt of Payments and SubmitCompensation Claims in a Timely Manner...

Accounting and Control ...................Process Description........................................Recommendation No. 19: Conduct Daily

General Ledger, Position, and P&LReconciliation...............................................

Recommendation No. 20: Conduct DailyPosition Valuation.........................................

Other ..............................................2Recommendation No. 21: Develop and Test

Contingency Plans........................................Recommendation No. 22: Ensure Service

Outsourcing Conforms to Best Practices.....

Acknowledgments ...........................

Recommended Readings...................2

2 FOREIGN EXCHANGE COMMITTEE 2004 ANNUAL REPORT2

Table of Contents



Execution-to-SettlementForeign Exchange Transaction Processing:

Introduction

The Foreign Exchange Market

The foreign exchange (FX) market is the largest and most liquid sector of the globalfinancial system. According to the Bank for International Settlements’ Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity 2004, FXturnover averages USD 1.9 trillion per day in the cash exchange market and an addi-

tional USD 1.2 trillion per day in the over-the-counter (OTC) FX and interest ratederivatives market.1 The FX market serves as the primary mechanism for makingpayments across borders, transferring funds, and determining exchange ratesbetween different national currencies.

The Changing Marketplace

Over the past decade, the FX market has grown in terms of both volume and diversityof participants and products. Although commercial banks have historically domi-nated the market, today’s participants also include investment banks, brokeragecompanies, multinational corporations, money managers, commodity trading advisors,

insurance companies, governments, central banks, and pension and hedge funds.In addition, the size of the FX market has grown as the economy has continued toglobalize. The value of transactions that are settled globally each day has risenexponentially—from USD 1 billion in 1974 to USD 1.9 trillion in 2004.

Nondealer Participants

forRecommendations



4 FOREIGN EXCHANGE COMMITTEE 2004 ANNUAL REPORT

What Is the Foreign Exchange

Committee and What Are the Best

Practices?

The Foreign Exchange Committee is an industrygroup sponsored by the Federal Reserve Bank

of New York that has been providing guid-ance and leadership to the global FX marketsince its founding in 1978. In all its work, theCommittee seeks to improve the efficienciesof the FX market, to encourage steps toreduce settlement risk, and to supportactions that enhance the legal certainty of FXcontracts.

In 1998, the Committee recognized the

need for a checklist of best practices thatcould help nondealer participants enteringthe FX market to develop internal guidelinesand procedures for managing risk. Theoriginal version of Foreign ExchangeTransaction Processing: Execution-to-Settlement Recommendations for Nondealer Participantswas published in 1999 by the Committee’sOperations Managers Working Group toserve as a resource for market participants as

they evaluate their policies and proceduresregarding FX transactions. This 2004 updatetakes into account market practices that haveevolved since the paper’s original publicationand supersedes previous recommendationsby the Committee regarding nondealerparticipants.

The purpose of this paper is to share theexperiences of financial institutions that are

active in the growing FX market with non-dealer participants that may participate in the

FX market on a more occasional basis. Ttwenty-two issues highlighted are meant promote risk awareness and provide “bepractice” recommendations for nondealeParticipants in prime brokerage or simiarrangements should also be familiar wthese recommendations. The implementatioof these practices may mitigate some of ttrading and operational risks that are specificthe FX industry. It may also help limit potentfinancial losses and reduce operational costs

This document is primarily oriented towanondealer participants with moderate activities. However, those nondealer par

cipants that are particularly active in the market are encouraged to review thCommittee’s guidance to other markparticipants, specifically the Guidelines fForeign Exchange Trading Activities and t Management of Operational Risk in ForeiExchange. These documents provide a modetailed discussion of the business practicand operational guidelines appropriate institutions with larger or more complex

activities. Copies of these papers aavailable on the Committee’s website <www.newyorkfed.org/fxc>.

How to Use This Document

This document is divided into sections baseon the five steps of the FX trade process flo1) pre-trade preparation, 2) trade executioand capture, 3) confirmation, 4) netting a

settlement, and 5) account reconciliation aaccounting/financial control processes. Ho

1 Bank for International Settlements, Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity 2004 (Basel: Bank forInternational Settlements, 2004).



FOREIGN EXCHANGE TRANSACTION PROCESSING

each of these individual phases integrateswith the others in the FX process flow is out-lined in Figure 1 above. Each section of thispaper provides a process description, fol-lowed by a list of best practices specific to thatphase. The paper concludes with general bestpractices that apply to overall risk manage-ment, including guidance for contingencyplanning and service outsourcing.

Pre-Trade Preparation

and Documentation

Process Description

The pre-trade preparation and documenta-tion process initiates the business relationshipbetween two parties. During this process,both parties’ needs and business practices

should be established. An understanding of each counterparty’s trading characteristicsand level of technical sophistication shouldalso develop. In summary, the pre-tradeprocess allows the two parties to agree upon

procedures and practices for ensuring thesafe and sound conduct of business.

Recommendation No. 1:Determine Foreign Exchange Needs

and Develop Appropriate

Infrastructure

It is critical for each firm to determine its underlyingFX requirements and establish the appropriate

infrastructure to support its activities.

Before initiating activities in the FX market,a company should perform a thoroughassessment of its FX needs within the contextof its business and financial strategy. The risksassociated with engaging in FX activities—including market, liquidity, credit, legal,operational, and settlement risk—need to beidentified, quantified, and managed. Clear

policies and procedures governing all aspectsof FX trading and processing should beestablished, documented, and maintained.Because the nature of a firm’s participation inthe FX market may continually change and

Figure 1

The Foreign Exchange Process Flow

Accounting and Financial Control

AccountReconciliation

Netting andSettlementConfirmation

Trade Executionand Capture

Pre-TradePreparation

Problem Identification, Investigation, and Resolution

ManagementManagement and Exception Reports



evolve, policies and procedures should beperiodically reviewed and updated.

All market participants should ensure thatthey engage sufficient experienced personnel

to execute the firm’s FX mandate. Each groupor individual playing a role in the FX processflow should have a complete understandingof how FX trades are initiated, recorded,confirmed, settled, and accounted for.Insufficient knowledge of the overall FXprocess, or the role played by each individualor group, can lead to an improper segregationof duties, inadequate controls, and increasedrisk. All market participants should provide

ongoing employee education regardingbusiness strategies, roles, responsibilities, andpolicies and procedures.

A clear policy on ethics should beestablished, such as a code of conduct thatconforms to applicable laws, good convention,and corporate policies. In particular, theguidelines should address the issue of thereceipt of entertainment and gifts on the part

of trading staff and others in a position toinfluence the firm’s choice of counterparties.Senior management should ensure that thepolicies are well circulated, understood, andperiodically reviewed by all personnel. Suchpolicies should be updated regularly toensure they cover new business initiatives andmarket developments.

Recommendation No. 2:Ensure Segregation of Duties

Nondealer participants should preclude individuals from having concurrent trading, confirmation, payment, and general ledger reconciliation

responsibilities. Reporting lines for trading aoperational personnel should be independeand management should ensure that appropria segregation of duties exists between operatioand other business lines and within operations.

Responsibility for trade execution, trad

confirmation, payments, and general ledg

reconciliation should be segregated to t

greatest extent possible. At a minimum

responsibility for trade execution should b

segregated from responsibility for subseque

processing steps. When such duties are n

segregated, the potential for fraud mig

increase. An individual may be able

complete unauthorized trades and hide a

resultant losses.

Individuals responsible for confirmatio

settlement, and reconciliation must be able

report any and all issues to manageme

independent of the trading function. To do s

operations staff must have a reporting line th

is not subject to an organizational hierarc

that could lead to a compromise of contrFirms with small treasury staffs and an overl

in employee responsibilities should establi

and document workflows and systems

prevent unauthorized activities. Such arrang

ments should be periodically verified by

independent audit function.

Recommendation No. 3:Determine Appropriate

Documentation

An institution should determine its documentatirequirements and know whether those requirments have been met prior to trading.




An institution should begin FX tradingactivities only if it has the proper documen-tation in place. The use of industry standarddocuments is strongly encouraged to provide asound mutual basis for conducting financialmarket transactions. A variety of documentsensure the smooth functioning of the marketsand protect participants in these markets:

Authority documents address capacity—the right of an institution to enter into atransaction—and authority—permissionfor an individual to act on the institution’sbehalf.

Confirmations summarize the significant

trade terms and conditions agreed uponby the parties.

Master agreements contain terms thatapply to broad classes of transactions,expressions of market practice andconvention, and terms for netting, termi-nation, and liquidation.2

Standard settlement instructions providefor the exchange of payment instructionsin a standardized, secure, and authenti-

cated format.

Each institution is responsible for ensuringthat it has the capacity to enter into a trans-action, as well as to monitor and enforcecompliance with its internal proceduresregarding any limitations there may be on the

trading authority of its employees or thirdparties acting on its behalf. Thus, providing todealing firms documentation that includes anumber of investment limitations and restric-tions affecting a participant’s ability to trade andinvest is not consistent with best marketpractice.3

Before executing a master agreement with acounterparty, an institution should alsoestablish a policy on whether or not it willtrade and in what circumstances. It should alsobe noted that electronic trading often requiresadditional or different documentation.Specifically, customer and user identification

procedures, as well as security procedures,should be documented.

Nondealer participants should be aware thatdealers are likely to be subject to statutory,regulatory, and supervisory requirements for“knowing” their customers. Dealers need toknow the identity of their counterparties, theactivities they intend to undertake with thedealer, and why they are undertaking those

activities. While each dealer may havedifferent procedures for implementing theserequirements, nondealer participants shouldcooperate in providing the information thatallows dealers to fulfill these obligations.


2 The Financial Markets Lawyers Group (FMLG), an industry organization of lawyers representing major financial institutions sponsored bythe Federal Reserve Bank of New York, has helped draft documentation for FX activities, including the International Foreign ExchangeMaster Agreement, the International Foreign Exchange and Options Master Agreement, the International Currency Options MarketMaster Agreement, and the International Foreign Exchange and Currency Options Master Agreement. These documents, endorsed bythe Committee, are available on the FMLG’s and the Committee’s websites, <www.newyorkfed.org/fmlg> and<www.newyorkfed.org/fxc>, respectively.

3 For related guidance on this issue, see the letter to market participants on the Committee’s website.



Trade Execution

and Capture

Process Description

The trade execution and capture function is

the second phase of the FX processing flow.Deals may be transacted directly over a

recorded phone line or through Internet-

based systems (for example, proprietary trading

systems or multidealer trading platforms).

Trade information captured typically includes

trade date, time of execution, settlement

date, counterparty, financial instrument traded,

amount transacted, price or rate, and may

also include settlement instructions.

Recommendation No. 4:Establish Appropriate Trading

Policies and Procedures

Firms should endeavor to execute transactions in a

manner that reduces the possibility of misunder-

standings, errors, or unauthorized dealing. Once

completed, FX trades constitute binding obligations

for both parties. Although subsequent processing

steps (for example, confirmation) may uncover problems, the best protection from unanticipated

loss is to avoid problems from the outset.

Transactions should be executed only byinternally authorized staff who are fullyconversant with market practice andterminology. Firms should avoid the use of obscure market jargon that may lead toconfusion or miscommunication. When

trades are verbally executed, traders should

carefully reconfirm key terms with thcounterparty before ending the call.

Firms should ensure that all trading conducted at current market rates. Trad

executed at off-market rates can concelosses, facilitate accounting misstatements, mask other illegitimate activities. Off-marktrades also involve the extension of crefrom one party to the other. Nondealparticipants should establish controls detect off-market dealing, such as compariactual trade rates against daily market rangand reviewing position revaluation results funreasonable gains or losses.

In certain cases, valid business purposmay exist for completing off-market tradeFirms intending to complete off-market tradeincluding historical rate rollovers, shouprovide counterparties such additioninformation as is necessary to establish underlying business purpose, as well evidence that such dealing has been reporteto and approved by senior managemen

Responsibilities regarding monitoring anreporting off-market transactions should clearly defined.

Firms electing to leave orders with dealers should establish a clear mutuunderstanding of how such orders will handled, particularly with respect to fast discontinuous markets or more seriomarket disruptions. Firms should clearly agr

on the specific terms of the order, particula


4 The Committee’s letter on historical rate rollovers, first published in December 1991, continues to offer sound advice to those who neeto execute these transactions. The letter, reprinted in the Committee’s 1995 Annual Report, is available on the Committee’s website,<www.newyorkfed.org/fxc>.



when such orders are activated, canceled, ormodified by the occurrence of subsequentevents. If certain aspects of an order arecontingent upon the achievement of specificmarket levels, firms should agree in advanceupon the rate or price sources to be used insuch determination.

Given the twenty-four-hour nature of theFX market, nondealer participants shouldhave a clear policy on dealing off thepremises or during off-hours. Firms allowingsuch activity should consider institutingprocedures to ensure that trades executedduring off-hours are promptly reported to

others in a prearranged manner (for example,e-mail, voicemail).

Recommendation No. 5:Clearly Identify Counterparties

All participants should clearly identify the legal entity on whose behalf they are undertaking atransaction. Trading on an unnamed basis iscontrary to best market practice.

Each counterparty to a transaction shouldensure that its organization recognizes theimportance of clearly and accurately identifyingthe legal entities involved in the transaction.Additionally, firms should encourage staff toprovide their names and affiliation in allcounterparty communication. The benefits of clear counterparty identification are particularlyevident when:

the organization has multiple legal entities(subsidiaries, branches, offices, and affili-ates) that are trading in the FX market;

the organization has been involved inacquisition, divestiture, or restructuringactivity that has led to name changes; and

participants are transacting in an agency

capacity.

Identification failure raises a number of potential risks, including:

incorrect assessment of counterparty per-formance risk;

erroneous bookings and/or misdirectedsettlements, creating potential losses foreither counterparty to the transaction;

misallocation of collateral; or

disclosure of transaction information toincorrect entities.

The practice of trading FX on an unnamedbasis—also referred to as undisclosed principaltrading—presents an adverse risk to bothindividual market participants and thebroader financial market. Such practices

constrain a dealer’s ability to assess thecreditworthiness of its counterparties and tocomply with “know your customer” and anti-money-laundering rules and regulations—exposing dealers to clear and significant legal,compliance, credit, and reputational risks aswell as heightening the risk of fraud. It isrecommended that investment advisors anddealers alike implement measures toeliminate the practice of trading on an

unnamed basis. Specifically, investmentadvisors and FX intermediaries should developa process to disclose client names to a dealer’scredit, legal, and compliance functions beforethe execution of FX trades.




Recommendation No. 6:Establish and Control System Access

As alternative technologies continue to emerge inthe FX trading and processing environments,rigorous controls need to be implemented and

monitored to ensure that data integrity and security are not undermined. Each system should haveaccess controls that allow only authorized individ-uals to alter the system and/or gain user access.

The use of electronic interfaces among FXmarket participants—such as electroniccommunications networks (ECNs) andautomated trading systems (ATSs)—hasincreased significantly in recent years. Use

of robust electronic interfaces is encouragedas it reduces trading- and operations-relatederrors, particularly when trade data flowdirectly from the electronic trading platformto the front-end trading system and to theoperations system books and records in orderto achieve straight-through processing.

To maximize the benefits of thesedevelopments, access to production systems

should be allowed only for those individualswho require such access to perform their jobfunction. Lack of adequate access controlsand related monitoring can result inunauthorized trading activity. Without properaccess control, the flow of data between theelectronic trading platform and the tradingsystems or back-office books and records canbe altered, compromising data integrity andsubjecting the firm to the risk of financial loss.

System access and entitlements should beperiodically reviewed, and users who nolonger require access to a system should have

their access revoked. Under no circumstanshould operations or trading functions hathe ability to modify a production systemthey are not authorized.

Recommendation No. 7:Enter Trades in a Timely Manner

All trades should be entered immediately inappropriate systems and be accessible for botrading and operations processing as soon they are executed.

It is crucial that all trades are entered immdiately so that all systems and processes hatimely, updated information. Front-end systemthat capture deal information may interfawith other systems that monitor and updacredit limit usage, intraday profit and loss (P&trader positions, confirmation status, settlment instructions, and general ledger activity

An institution’s ability to manage risk may adversely affected if it does not have accuratransaction updates in each of the abovmentioned areas. The failure to reco

trades promptly misrepresents contractupositions and can result in:

inaccurate accounting records,

mismanagement of market risk,

misdirected or failed settlement, and

the failure of a trade to be booked at al




Confirmation

Process Description

The transaction confirmation is evidence of the terms of an FX or a currency derivative

transaction. Therefore, proper management of the confirmation process is an essential control.This process is handled in many ways within FXmarkets. For spot, forward FX, or vanilla cur-rency option transactions, counterpartiesexchange electronic or paper confirmationsthat identify transaction details and provideother relevant information. For structured andnonstandard transactions (for example, non-deliverable forwards [NDFs] and exotic cur-

rency option transactions), documents areprepared and 1) exchanged and matched byboth counterparties, in the case of most dealers,or 2) signed and returned in the case of certaincounterparties.5

All confirmations should be subject eitherto the 1998 FX and Currency Option Definitionsissued by the Committee, EMTA, and the Inter-national Swaps and Derivatives Association

(ISDA) or to other appropriate guidelines.

Recommendation No. 8:Confirm Trades in a Timely Manner

Both parties should make every effort to send confirmations or positively affirm trades withintwo hours after execution and in no event later than the end of the day.

Prompt confirmations are key to the

orderly functioning of the marketplacebecause they reduce market risk andminimize losses due to settlement errors. In

the absence of timely confirmation, tradediscrepancies may go undetected, which canlead to disputes, disrupting the settlementprocess and increasing processing costs. Suchdiscrepancies can also result in failed tradesor inaccurate accounting records and canadversely affect any underlying securitysettlement. The incidence of error tends toincrease when non-automated or verbalconfirmations are not followed up withwritten or electronic confirmation. Given thesignificance of the confirmation process, it isimportant that the process is handledindependently of the trading function.

Counterparties should have an under-standing regarding confirmation practices,that is, whether they will both send out theirown confirmations, or whether one counter-party will sign and return (affirm) incomingconfirmations. It is not recommended thateither party simply accept receipt of thecounterparty confirmation as completion of the confirmation process.

Confirmations should be transmitted in asecure manner whenever possible. In themost developed markets, confirmations aregenerally sent via electronic message througha secure network. Automated confirmationmatches one party’s trade details to itscounterparty’s trade details. It minimizesmanual error and is the most timely andefficient method because it requires nosubsequent confirmation or manual check.

While a significant number of transactionconfirmations are also sent via mail, e-mail, or


5 Typically, the price maker prepares the confirmation and the price taker signs the confirmation.



fax, it is important to note that when theseopen communication methods are usedthere is a greater risk of human error orfraudulent correspondence. When sendingconfirmations by fax or e-mail, or whenconfirming by telephone, counterparties mayagree to take additional steps to ensure receiptby the correct counterparty. Telephoneconfirmations should be used when no othermethod is available. Following the telephoneconfirmation, both parties should exchangeand match written or electronic confirmations.With verbal confirmations, most dealersemploy recorded telephone lines. Non-dealer participants may want to consideradopting this practice.

Data included in the confirmation shouldcontain the following: the counterparty to theFX transaction, the office through which it isacting, the transaction date (or trade date),the value date (or settlement date), the amountsof the currencies being bought and sold, thebuying and selling parties, and settlementinstructions. Amended confirmations should

be sent promptly when necessary. Settle-ment instructions for forward transactionsshould be reconfirmed two days before thesettlement date.

Once a trade between counterparties hasbeen confirmed, such trades may be thesubject of novation or other similar agreements,which should be confirmed in a similarlyvigorous manner.

Recommendation No. 9:Block Trades Should Be Confirmed

a Timely Manner

The full amount of block trades transacted agents should be confirmed as soon as possib

but always within two hours of the trade executio

Investment managers or others acting as agent may undertake “block” or “bundletrades on behalf of multiple counterpartieSuch trades are subsequently split into smalamounts and apportioned to specific undelying funds or counterparties. The failure allocate a block trade on a timely basis couresult in increased credit, legal, and operation

risk. Specifically, a delay in allocation hampethe allocation and management of creexposure. Trade confirmation will also delayed, which in turn may interrupt tsettlement process and, in extreme cases, caupayment failures.

The full amount of block trades should confirmed as soon as possible but always withtwo hours of trade execution. Allocations a

confirmations to individual obligor accounshould be completed within four hours anno later than the end of the day on the tradate. To minimize errors caused by manuintervention, trade allocations should, possible, be provided to the counterpaelectronically, either through a secunetwork or through authenticated means.

Recommendation No. 10:Resolve Confirmation Discrepanciesin a Timely Manner

Discrepancies between a confirmation receiv from a counterparty and a firm’s own reco should be brought to the counterparty’s attentio




immediately. Escalation procedures should beestablished to resolve any unconfirmed or dis- puted deals.

When trade discrepancies exist,

unintended exposure to market risk mayarise. Trade discrepancies may also lead toincreased processing costs, inaccurateaccounting records, failed settlements(including underlying transactions), andfinancial loss. Unconfirmed trades may resultfrom simple trade entry errors or more seriousdisagreements between counterparties withrespect to the agreed-upon transaction terms.

To mitigate this risk, confirmation discre-pancies should be brought to the counterparty’sattention immediately and resolved as quicklyas possible. Additionally, procedures should beestablished to escalate unresolved discre-pancies to increasingly higher levels of management within established time frames.Automated trade confirmation systems arestrongly recommended; these systems canhighlight discrepancies and mitigate potential

problems. Processes should be in place todetect chronic discrepancies.

Recommendation No. 11:Unique Features of Foreign Exchange

Options

Market participants should establish clear policiesand procedures for the confirmation, exercise, and settlement of FX options and familiarize staff withthe additional terms and conditions associated

with options.

FX options are more complex productsthan spot and forward transactions. Optionsincorporate additional and often complex

contract terms (such as strike price, call or putindicator, premium price, and expiry date andtime). Their value is determined not only byspot and forward exchange rates but also byimplied volatilities and time remaining untilexpiration. Option values may change rapidlyand in a nonlinear manner. Those optionspossessing intrinsic value at expiration (strikerate more favorable than current market orindex rate) must be properly exercised if suchvalue is to be realized. The exercise of anoption generally creates a new position in theunderlying instrument (for example, spotdollar-yen) requiring further processing andsettlement.

Special attention should be paid to the saleof options (short positions), which generallyentail significantly higher levels of market risk.Similarly, management should be aware that“deep-in-the-money” option transactions bytheir nature involve unusual funding require-ments and related credit exposure. There maybe legitimate reasons for the sale of suchoptions—for example, the “sell back” of an

option or the implied delta within a separatederivatives product. However, it should berecognized that the sale of deep-in-the-moneyoptions can be used to exploit weaknesses in acounterparty’s revaluation or accountingprocess that could create erroneous results.Procedures should ensure an appropriate levelof review—if necessary, by senior tradingmanagement or risk management outside thesales and trading area—to guard against

potential legal, reputational, and other risks.

Management should clearly define rolesand responsibilities to ensure that the higherinherent risk of options is well controlled.




Operations staff should be fully versed inoptions terminology, contract provisions, andmarket practice. Transaction terms should beelectronically, or at least verbally, confirmedon the trade date and both parties should signa detailed confirmation. Certain exoticoptions may also require the collection of additional information or rates, depending onthe product.

Premium settlements should be closelymonitored to reduce the potential for out-trades.

Clear policies and procedures related to

the exercise of options should be establishedand, where possible, documents and systemsshould be designed to auto-exercise expiringin-the-money options. It is recommendedthat, whether or not auto-exercise applies,both parties independently monitor theiroption positions for internal market andoperational risk management purposes.

Recommendation No. 12:Unique Features of Non-deliverable

Forwards

Market participants should establish clear policiesand procedures for the confirmation and set-tlement of FX NDFs and familiarize staff withthe additional terms and conditions associated with NDFs in order to reduce operational risk.

NDFs are cash-settled FX instruments thatrequire a rate fixing to determine the amount

and direction of the cash settlement. NDlike options, have additional trade terms arequire additional handling and processinIn addition, they may be more susceptible market disruptions.

Counterparties should confirm NDtransaction terms electronically, or at leaverbally, on the trade date. In addition to tstandard transaction details (such as tcounterparties and the offices through whithey are acting, the transaction date, tnotional amount of the currencies, ansettlement instructions), NDFs involadditional trade terms that requ

confirmation, such as fixing source and datFollowing telephone confirmation, boparties must validate, review, sign, and retuthe long-form confirmation to cover nonfinancial information. Confirmatioshould be reviewed on the trade date determine the fixing source, and transactioshould be reviewed daily thereafter to ensuthat fixings are obtained as required in tconfirmation language.

When possible, counterparties are encouaged to use an addendum to an existing mastagreement, indicating a set fixing rate for eacurrency.6 On the fixing date, fixing advicthat reflect the fixing rate and cash settlemeamount should be generated and exchangeelectronically (when possible).


6 The Master Agreement Addendum for Non-deliverable Forwards is available online at the Committee’s public website.



Netting and Settlement

Process Description

Settlement is the exchange of payments betweencounterparties on the value date of the transaction.

Bilateral settlement netting is the practice of combining all trades between two counterpartiesdue on a particular settlement date and calcu-lating a single net payment in each currency. For example, if an institution executes twenty-fivedollar-yen trades with the same counterparty, all of which settle on the same day, bilateral settle-ment netting will enable the institution to makeonly one or two netted payments.7 These netted payments will generally be much smaller than

the gross settlement amount due. The establish-ment of settlement netting agreements betweencounterparties can thus reduce settlement risk,operational risk, and clearing costs.

Various market utilities support multilateralsettlement netting, which involves combiningall trades between multiple counterpartiesand calculating a single net payment in eachcurrency.

For counterparties that do not settle on anet basis, payment instructions are sent tonostro banks for all the amounts owed—aswell as for expected receipts. Settlementinstructions are sent one day before settle-ment, or on the settlement date, dependingon the currency’s settlement requirements. If a settlement error occurs in the process, it is

typically quite costly. If a company fails tomake a payment, it must compensate itscounterparty, thus generating additionalexpense. Settlement errors may also cause aninstitution’s cash position to be different thanexpected.

In addition, settlement risk—the risk that acompany makes its payment but does notreceive the payment it expects—can cause alarge, even catastrophic, loss. This risk arises inFX trading because payment and receipt of payment often do not occur simultaneously. Aproperly managed settlement function reducesthis risk. Settlement risk is measured as the full

amount of the currency purchased and ispresent from the time a payment instruction forthe currency sold becomes irrevocable untilthe time the final receipt of the currencypurchased is confirmed.8 Sources of this riskinclude internal procedures, intramarketpayment patterns, finality rules of localpayments systems, and operating hours of thelocal payments systems when a counterpartydefaults.

Recommendation No. 13:Net Payments and Confirm Bilateral

Amounts

Transaction payments should be netted whenever possible. Legal agreements should provide for set-tlement netting as well as “close-out” netting in theevent transactions are terminated before maturity.


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

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



Settlement on a gross basis not onlyincreases the actual number of settlements thatare necessary but also increases the probabilityof settlement errors. An enforceable settlementnetting agreement has the benefit of entitlingparties to reduce the number and size of payments between themselves.

The operational process of settlementnetting should be supported by a legalagreement. Such an agreement may be a brief document that only supports settlementnetting or a settlement netting provision that isincluded in a master agreement. Thefollowing master agreements have been

developed as industry standard forms. Eachform includes provisions for settlementnetting (included as an optional term) andclose-out netting:

International Swaps and DerivativesAssociation (ISDA) Master Agreement,

International Foreign Exchange MasterAgreement (IFEMA) covering spot andforward currency transactions,

International Currency Options MarketMaster Agreement (ICOM) covering cur-rency options, and

International Foreign Exchange and

Options Master Agreement (FEOMA)

covering spot and forward currency trans-

actions and currency options.

Correct calculations of netted payments

are important to ensure accurate settlementamounts and enhance the efficiency of operations. All market participants areencouraged to automate the actual nettingcalculation so that errors introduced by

manual calculation are reduced. To proteagainst an improper settlement of a namount, counterparties should confirm tnet payment amount with each other at sompredetermined cutoff time before settlemeParties should establish the latest possibcutoff time for confirming bilateral nettamounts. Such a deadline will ensure that tparties agree on the transactions includedthe net amounts.

In addition to settlement netting, mastagreements may provide for close-onetting. Close-out netting clauses provide f1) appropriate events of default, includi

default upon insolvency or bankruptc2) close-out of all covered transactionand 3) the calculation of a single nobligation from unrealized gains and losseClose-out netting provisions providsignificant risk management benefits to boparties to a master agreement by providing fthe netting of all outstanding transactiounder an agreement. Master agreements wlegally enforceable close-out netting recei

bankruptcy and insolvency law protection ensure that the defaulting counterparemains responsible for all existing contracand transactions under the agreement anot just those it chooses. Thus, close-onetting provisions provide the legal basis fparties to measure counterparty exposure oa net rather than a gross basis.

Recommendation No. 14:Provide Accurate and Complete

Settlement Instructions

Market participants should always provide com plete and accurate settlement instructions intimely manner.




Settlement instructions should clearlyreference the following information:

the recipient’s account name, accountaddress, and account number;

the name of the receiving bank, a SWIFT/ISO address, and a branch identifier; and

the identity of any intermediary bank usedby the recipient.

Incomplete or inaccurate settlement

instructions heighten the risk of a disrupted

settlement process, thus inflating processing

and compensation costs. Failed FX settlements

may also disrupt completion of an underlyingtransaction.

Recommendation No. 15:Use Standing Settlement Instructions

Standing settlement instructions (SSIs) should be

exchanged whenever possible. Market partici-

pants should issue new SSIs, as well as changes

to SSIs, in a secure manner.

SSIs allow for complete trade details to be

entered quickly so that the confirmation

process can begin as soon as possible after

trade execution. By removing the need to

exchange settlement instructions solely on a

trade-by-trade basis, SSIs minimize the

potential that incorrect or incomplete

settlement instructions will be exchanged. SSIs

also contribute to improved risk management

and greater efficiency because the repeatedmanual inputting, formatting, and confirming of

settlement instructions increases the cost of

trade processing and heightens the opportunity

for errors in settlement.

Market participants should exchangestanding settlement instructions as soon aspossible. When an institution changes its SSIs,it should provide as much lead time aspossible—a minimum of two weeks’ notice—to its counterparties to allow them to updatetheir records before the new SSIs becomeeffective. Institutions should update theirrecords promptly when changes to SSIs arereceived from their counterparties.

All standing settlement instructions shouldbe delivered electronically, if possible, andpreferably through authenticated mediabecause electronic delivery minimizes

manual error and is the timeliest method of delivery. In addition, authenticated mediareduce the potential for fraud. Changes toSSIs that cannot be delivered electronicallyshould be delivered in writing and signed byan authorized individual.

Although SSIs are preferred, they are notalways available and may not be appropriatefor all trades. When SSIs are not used, the

settlement instructions may be recorded atthe time of trade execution. These exceptionsettlement instructions should be deliveredby the close of business on the trade date (if spot) or at least one day before settlement (if forward).

Recommendation No. 16:Understand Risks Associated with

Third-Party Payments

In cases where a dealer agrees to process a third- party payment, nondealer participants should provide the information necessary for the dealer to internally approve and accurately make the payment.




Third-party payments are the transfer of settlement funds for an FX transaction to theaccount of an entity other than the counter-party to the transaction. Third-party paymentsraise important issues that should beconsidered carefully by a firm requesting sucha practice.

Participants should recognize that third-partypayments may significantly increase operationalrisk and potentially expose all involved tomoney laundering or other fraudulent activity.The practice also heightens the risk of financialloss; if the third-party payment is directed to anincorrect beneficiary, the payment may be

delayed or even lost. Third-party payments mayalso create potential legal liability to the dealermaking the payment.

Both nondealers and dealers should beaware of the risks involved with thesetransactions and should establish clearprocedures beforehand for validating boththe authenticity and correctness of suchrequests. In addition, nondealer participantsshould provide dealers with any writteninformation required to screen, internallyreview and approve, and accurately make thethird-party payment. For example, writteninformation may include the third party’sreceiving bank name and address; the thirdparty’s account name, address, and number;and the nature of the third party’s affiliationwith the nondealer participant.

Also, third-party payment instructions

should be provided via authenticated means.Instructions otherwise provided—for example,by phone or fax—should be reconfirmed bystaff independent of those providing suchinstructions.

Account Reconciliation

Process Description

Account reconciliation occurs at the end the trade settlement process to ensure that

trade has settled properly and that all expectecash flows have occurred. An institutioshould begin reconciliation as soon as receives notification from its bank that paments are received. If possible, reconciliatishould be performed before the paymesystem associated with each currency closeEarly reconciliation enables an institution detect any problems in cash settlement anresolve them on the settlement date.

Recommendation No. 17:Perform Timely Account

Reconciliation

Account reconciliation—the process of compariexpected and actual cash movements—should performed as early as possible.

The main objective of the accoureconciliation function is to ensure th

expected cash movements agree with tactual cash movements in a firm’s currenaccounts. The cause for the difference might that wrong settlement or trade information wcaptured or that a payment error occurred.

Failure to reconcile expected and actual camovements could result in the inability recognize the underfunding of a transactiand/or an overdraft to the cash account. Wh

cash is used to overfund a position, opportuncosts arise because cash often cannot invested. When positions are underfundeoverdraft charges may be imposeunknowingly. Account reconciliation al




serves as a main line of defense in detectingfraudulent activity.

All market participants are encouraged toreconcile expected cash flows against actual

cash flows in a timely manner. The soonerreconciliations are performed, the sooner aninstitution can take appropriate actions toensure that its accounts are properly funded.

Recommendation No. 18:Identify Nonreceipt of Payments and

Submit Compensation Claims in a

Timely Manner

Management should establish procedures for

detecting nonreceipt of payments and for notify-ing appropriate parties of these occurrences.Escalation procedures should be in place for dealing with counterparties that fail to make payments. Parties that have failed to make a pay-ment on a settlement date should arrange for the proper value to be applied and pay compensa-tion costs promptly.

An institution should attempt to identify, as

early in the process as possible, any expectedpayments that are not received. Failure tonotify counterparties of problems in a timelymanner may lead them to dismiss claims thatare over a certain age, causing the institutionto absorb overdraft costs.

All instances of nonreceipt of paymentshould be reported immediately to thecounterparty’s operations and/or trading

units. When necessary, escalation proceduresshould be followed. Management may wishto consider a limited dealing relationship withcounterparties that have a history of settle-ment problems. The counterparty that has not

received payment generally incurs the costsassociated with nonreceipt, including thoseassociated with obtaining alternative fundingon the settlement date, processing theexception, and administering payment. As aresult, the counterparty may commence legalaction to recover these costs. Compensationclaims for nonreceipt or late receipt of payment should be agreed upon and paidexpeditiously.

Accounting and Control

Process Description

The accounting function ensures that FXtransactions are properly recorded on thebalance sheet and income statement. If transaction information is not recorded cor-rectly, a company’s reputation may be tarnishedif material restatements of financial accountsare necessary.

Accounting entries are first booked

following the initiation of a trade. At the end

of each trade day, all sub-ledger accountsflow through to the general ledger. Any

discrepancies should be investigated as soon

as possible to ensure that the institution’s

books and records reflect accurate infor-

mation. The accounting area should ensure

that outstanding positions are continually

marked to market until close-out—after

which realized gains and losses are

calculated and reported.

Cash flow movements that take place on

settlement date are also posted to the general

ledger in accordance with accepted accounting

procedures. The receipt and payment of




expected cash flows at settlement are

calculated in an institution’s operations system.

Recommendation No. 19:

Conduct Daily General Ledger,Position, and P&L Reconciliation

Systematic reconciliations of both the general ledger to the operations system and the trading systems to the operations systems should bedone 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 toreview and update control procedures asneeded.

Position reconciliations allow an institution

to ensure that all managed positions are thesame as those settled by operations. Thiscontrol is imperative when all deal entries andadjustments are not passed electronicallybetween trading and operations. Whenstraight-through processing is in place, thereconciliation ensures that all deals weresuccessfully processed from trading tooperations, along with all amendments.Because a discrepancy in P&L between trading

and operations can indicate a difference inpositions or market parameters (that is, rates orprices) all differences should be reported,investigated, and resolved in a timely manner.

Recommendation No. 20:Conduct Daily Position Valuation

Using independent price sources, staff independeof the trading function should revalue outstaning positions to market daily. This is particular

important for market participants that are actiin less liquid forward markets or in exotic optiomarkets. Both trading and operations sta should be familiar with the procedures used f position valuation.

The daily revaluation of outstandipositions is an integral part of the contprocess. The end-of-day rates and prices thare used to create the position valuatio

should be periodically checked by independent source. Staff independent of ttrading function should ensure that the ratand prices used for end-of-day valuatiorepresent market rates. Position valuatioshould be verified using independent sourcsuch as market rate screens or broker/deaquotations.

Illiquid markets present additional risk

an institution because illiquid instruments atraded infrequently, making them difficult price. Often, it is difficult to obtain markquotes, thereby preventing timely anconsistent position monitoring. Valuations mbe distorted, causing improper managemeof risk. In such instances, a company shouseek to obtain quotes from other counteparties active in the market. Managemeshould be aware of these procedures so tha

may effectively manage and evaluate illiqumarket positions. These procedures allow institution to mark to market its positions anto evaluate associated risks.




Marking to market reflects the current value

of FX cash flows to be managed and provides

information about market risk.9 Senior

management will be able to better manage and

evaluate market positions when it knows

positions are accurately valued on a daily basis.

Other

Recommendation No. 21:Develop and Test Contingency Plans

Participants should develop plans for operating

in the event of an emergency. Contingency plans

should be periodically reviewed, updated, and

tested.

In the event of a major disaster, a market

participant may not be able to meet itsobligation to monitor its market positions. It

may also fail to meet its obligation to settle

and confirm transactions. Inability to trade orsettle transactions could subject the market

participant to severe financial and reputational

repercussions.

Firms should identify various types of

potential disasters and examine how they may

disrupt the participant’s ability to satisfy its

obligations (that is, issuing and receiving

confirmations, performing settlements, and

completing daily trading). Disaster recovery

plans should identify requisite systems and

procedural backups, management objectives,

staffing plans, and the methodology for

dealing with each type of disaster. Plansshould be reviewed and tested periodically.

Backup sites that can accommodate theessential staff and systems should be estab-lished, maintained, and tested on a regularbasis. Particularly for operations, marketparticipants should consider developing abackup site that relies on a separate infra-structure (electricity, telecommunications, andso forth).

Additionally, all market participants shouldidentify alternative methods of confirmationand settlement communication and practicethese methods with counterparties. Suchmethods may require the use of fax or telex toensure proper processing. During a disaster, a

firm should notify its counterparties of potential processing changes. It should alsoprovide counterparties with current contactinformation for key personnel to ensure thatcounterparties can contact the firm in anemergency.

Recommendation No. 22:Ensure Service Outsourcing

Conforms to Best Practices

If an institution chooses to outsource a portion or all of its operational functions, it should ensurethat its internal controls and industry standardsare met. A firm that outsources should have ade-quate operational controls in place to monitor the outsourcer and to ensure that functions arebeing performed according to agreed-upon standards and industry best practices.

An institution may choose to outsource

some or all of its operations functions.However, outsourcing should neither


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




compromise a firm’s internal standards forconfirmations, settlement, and payments nordiminish the responsibility of the firm toensure settlement performance.

Controls should be in place to monitorvendors to ensure that internal standards aremet. For example, trades should still beconfirmed in a timely manner and properescalation and notification procedures muststill be followed.

Participants should establish procedures toperiodically monitor service providers toensure that they are performing functions

according to agreed-upon standards andindustry best practices. A service levelagreement should be in place to clearlyidentify responsibility in case of failure tomeet obligations.




Charles LeBrunBank One Philip ScottBank of New York Kathryn WheadonBank of America

AcknowledgmentsThis document was originally prepared in 1998 by a task force composed of members of the ForeignExchange Committee and the Operations Managers Working Group. The task force included:

The task force for the 2004 revision included:

Joe DemetrioBank of New York

Laura HuiziFederal Reserve Bank

of New York

Sandra GalarzaBank of New York

Barry McCarraherHSBC

Keith McDonaldCSFB

Michael NelsonFederal Reserve Bank

of New York

Nancy RiyadHSBC

Richard RuaMellon Bank

Daniel RupertoGoldman Sachs & Co.

Robert ToomeyFederal Reserve Bank

of New York

Diane VirzeraFederal Reserve Bankof New York



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

———. “Guidelines for the Management of FX TradingActivities.” In Foreign Exchange Committee 2000

Annual Report . New York: Federal Reserve Bankof New York, 2001.

———. “Management of Operational Risk in ForeiExchange.” In Foreign Exchange Committee 20

Annual Report . New York: Federal Reserve BankNew York, 2004.

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

———. “Standardizing the Confirmation ProcesIn Foreign Exchange Committee 1995 AnnuReport . New York: Federal Reserve Bank of NeYork, 1996.

———. “Supplementary Guidance on ElectronValidations and Confirmation Messaging.”

Foreign Exchange Committee 2001 Annual RepoNew York: Federal Reserve Bank of New Yo2002.

Foreign Exchange Committee and FinancMarkets Lawyers Group. “Guide for TransactioInvolving Intermediaries.” 1998.

Recommended Readings

Non Dealer Guidelines

Documents