Overview of Risk Management in Trading Activities Section 2000.1

Risk is an inevitable component of intermedia- must determine that the computer system, man- tion and trading activity. Given the fundamental agement information reports, and other forms of trade-off between risks and returns, the objec- communication are adequate and accurate for tive of regulators is to determine when risk the level of business activity of the institution. exposures either become excessive relative to the financial institution’s capital position and financial condition or have not been identified to the extent that the situation represents an unsafe GLOBAL RISK-MANAGEMENT and unsound banking practice. FRAMEWORK Determination of whether the institution’s risk-management system can measure and con- The primary goal of risk management is to trol its risks is of particular importance. The ensure that a financial institution’s trading, primary components of a sound risk-management position-taking, credit extension, and opera- process are a comprehensive risk-measurement tional activities do not expose it to losses that approach; a detailed structure of limits, guide- could threaten the viability of the firm. Global lines, and other parameters used to govern risk risk management is ultimately the responsibility taking; and a strong management information of senior management and the board of direc- system for monitoring and reporting risks. These tors; it involves setting the strategic direction of components are fundamental to both trading and the firm and determining the firm’s tolerance for nontrading activities. Moreover, the underlying risk. The examiner should verify that the risk risks associated with these activities, such as management of capital-markets and trading market, credit, liquidity, operations, and legal activities is embedded in a strong global (firm- risks, are not new to banking, although their wide) risk-management system, and that senior measurement can be more complex for trading management and the directors are actively in- activities than for lending activities. Accord- volved in overseeing the risk management of ingly, the process of risk management for capital- capital-markets products. markets and trading activities should be inte- grated into the institution’s overall risk- management system to the fullest extent possible Role of Senior Management using a conceptual framework common to the and the Board of Directors financial institution’s other business activities. Such a common framework enables the institu- Senior management and the board of directors tion to consolidate risk exposure more effec- have a responsibility to fully understand the tively, especially since the various individual risks involved in the institution’s activities, risks involved in capital-markets and trading question line management about the nature and activities can be interconnected and may tran- management of those risks, set high standards scend specific markets. for prompt and open discussion of internal The examiner must apply a multitude of control problems and losses, and engage man- analyses to appropriately assess the risk- agement in discussions regarding the events or management system of an institution. The developments that could expose the firm to assessment of risk-management systems and substantial loss. The commitment to risk man- controls may be performed in consideration of agement in any organization should be clearly the type of risk, the type of instrument, or by delineated in practice and codified in written function or activity. The examiner must become policies and procedures approved by the board familiar with the institution’s range of business of directors. These policies should be consistent activities, global risk-management framework, with the financial institution’s broader business risk-measurement models, and system of inter- strategies and overall willingness to take risk. nal controls. Furthermore, the examiner must Accordingly, the board of directors should be assess the qualitative and quantitative assump- informed regularly of the risk exposure of the tions implicit in the risk-management system institution and should regularly reevaluate the as well as the effectiveness of the institution’s organization’s exposure and its risk tolerance approach to controlling risks. The examiner regarding these activities. Middle and senior

Trading and Capital-Markets Activities Manual February 1998 Page 1 2000.1 Overview of Risk Management in Trading Activities management, including trading and control staff, adequately identifies the major risks to which should be well versed in the risk-measurement the institution is exposed. The global risk- and risk-management methodology of the finan- management system should cover all areas of cial institution. the institution, including ‘‘special portfolios’’ Senior management is responsible for ensur- such as exotic currency and interest-rate options ing that adequate policies and procedures for or specially structured derivatives. At a mini- conducting long-term and day-to-day activities mum, the global risk-management system should are in place. This responsibility includes ensur- provide for the separate institution-wide mea- ing clear delineations of responsibility for man- surement and management of credit, market, aging risk, adequate systems for measuring risk, liquidity, legal, and operational risk. appropriately structured limits on risk taking, The evaluation of the firm’s institution-wide effective internal controls, and a comprehensive risk relative to the firm’s capital, earnings risk-reporting process. capacity, market liquidity, and professional and The risk-management mandate from senior technological resources is an essential responsi- management and the board of directors should bility of senior management. The examiner include— should also verify that senior management over- sees each of the major risk categories (credit, • identifying and assessing risks market, liquidity, operational, and legal risk). • establishing policies, procedures, and risk Examiners should ascertain whether the finan- limits cial institution has an effective process to evalu- • monitoring and reporting compliance with ate and review the risks involved in products limits that are (1) either new to the firm or new to the • delineating capital allocation and portfolio marketplace and (2) of potential interest to the management firm. In general, a bank should not trade a • developing guidelines for new products and product until senior management and all rele- including new exposures within the current vant personnel (including those in risk manage- framework ment, internal control, legal, accounting, and • applying new measurement methods to exist- audit) understand the product and are able to ing products integrate the product into the financial institu- tion’s risk-measurement and control systems. The limit structure should reflect the risk- Examiners should determine whether the finan- measurement system in place, as well as the cial institution has a formal process for review- financial institution’s tolerance for risk, given its ing new products and whether it introduces new risk profile, activities, and management’s objec- products in a manner that adequately limits tives. The limit structure should also be consis- potential losses. tent with management’s experience and the Financial institutions active in the derivatives overall financial strength of the institution. markets generate many new products that are In addition, senior management and the board variants of existing instruments they offer. In of directors are responsible for maintaining the evaluating whether these products should be institution’s activities with adequate financial subject to the new-product-evaluation process, support and staffing to manage and control the examiners should consider whether the firm has risks of its activities. Highly qualified personnel adequately identified and aggregated all signifi- must staff not only front-office positions such as cant risks. In general, all significant structural trading desks, relationship or account officers, variations in options products should receive and sales, but also all back-office functions some form of new-product review, even when responsible for risk management and internal the firm is dealing in similar products. control.

ORGANIZATIONAL STRUCTURE Comprehensiveness of the OF RISK MANAGEMENT Risk-Management System Examiners should evaluate the company’s orga- The examiner should verify that the global risk- nizational structure and job descriptions to make management system is comprehensive and sure that there is a clear understanding of the

February 1998 Trading and Capital-Markets Activities Manual Page 2 Overview of Risk Management in Trading Activities 2000.1 appropriate personnel interaction required to occur in the normal course of business can be control risk. In particular, measuring and setting accomplished through either centralized or parameters for the total amount of various risks decentralized structures. The choice of approach facing the institution are distinct functions that should reflect the organization’s risk profile, should be clearly separated from the day-to-day trading philosophy, and strategy. In a highly management of risks associated with the normal decentralized structure, examiners should ascer- flow of business. Normally, these parameters tain that adequate controls are in place to ensure should be managed independently by senior the integrity of the aggregate information pro- management, with approval from the institu- vided to senior management and the board of tion’s board of directors. directors. The trading-risk-management role within an Trading positions must be accurately trans- organization includes defining trading-risk- mitted to the risk-measurement systems. The management policies, setting uniform standards appropriate reconciliations should be performed of risk assessment and capital allocation, pro- to ensure data integrity across the full range of viding senior management with global risk products, including new products that may be reporting and evaluation, monitoring compli- monitored apart from the main processing net- ance with limits, and assisting in strategic plan- works. Management reports should be reviewed ning related to risk management. to determine the frequency and magnitude of In some organizations, risk management has a limit excesses over time. Traders, risk manag- control or policing function; in others, it is a ers, and senior management should be able to counselor to the trading-operations area. Regard- define constraints on trading and justify identi- less of how it is implemented, the risk- fied excesses. The integrity of the management management function should have reporting lines information system is especially important in that are fully independent of the trading groups. this regard (See section 2040.1, ‘‘Operations When defining an institution’s exposures, risk and Systems Risk (Management Information managers must address all risks, those that are Systems)’’.) Examiners should also review and easily quantifiable and those that are not. Many assess the compensation arrangements of risk- trading risks lend themselves to common management staff to ensure that there are no financial-estimation methods. Quantifiable risks incentives which may conflict with maintaining related to price changes should be applied con- the integrity of the risk-control system. sistently to derive realistic estimates of market exposure. Consequently, examiners must subjec- tively and pragmatically evaluate an institu- tion’s risk related to capital-markets and trading Measurement of Risks activities. The risk measurement and management of an The increasing globalization and complexity of institution will only be as strong as its internal capital markets and the expanding range of control system. Effective internal control mecha- esoteric financial instruments have made trading- nisms for monitoring risk require that risk man- risk management more difficult to accomplish agers maintain a level of independence from the and evaluate. Fortunately, a number of com- trading and marketing functions—a requirement monly used risk-measurement systems have been not only for the development of the conceptual developed to assist financial institutions in evalu- framework applied but for determining the appli- ating their unique combinations of risk expo- cable parameters used in daily evaluations of sures. These systems all aim to identify the risks market risks. This function would be respon- associated with particular business activities and sible for measuring risk, setting risk parameters, group them into generic components, resulting identifying risk vulnerabilities, monitoring risk in a single measure for each type of risk. These limits, and evaluating or validating pricing and systems also allow institutions to manage risks valuation models. Examiners should ascertain on a portfolio basis and to consider exposures in that the financial institution has some form of relation to the institution’s global strategy and independent risk management and that manage- risk profile. ment information is comprehensive and reported Managing the residual exposure or net posi- to senior management on a frequency commen- tion of a portfolio, instead of separate transac- surate with the level of trading activity. tions and positions, provides two important The day-to-day management of risks that benefits: a better understanding of the port-

Trading and Capital-Markets Activities Manual February 1998 Page 3 2000.1 Overview of Risk Management in Trading Activities folio’s exposure and more efficient hedging. A often lead to improvements in procedures, data market maker’s portfolio benefits from econo- processing systems, and contingency plans that mies of scale in market-risk management significantly reduce operational risk. because large portfolios tend to contain natu- Examiners should ascertain whether manage- rally offsetting positions, which may signifi- ment has considered the largest losses which cantly reduce the overall market risk. Hedging might arise during adverse events, even sce- the residual risk of the net portfolio position narios which the financial institution may con- rather than individual transactions greatly sider fairly remote possibilities. The evaluation reduces transactions costs. A portfolio-focused of worst-case scenarios does not suggest that the management approach reduces the complexity limits themselves must reflect the outcomes of a of position tracking and management. worst-case scenario or that the financial institu- All major risks should be measured explicitly tion would be imprudent to assume risk posi- and consistently and integrated into the firm- tions that involve large losses if remote events wide risk-management system. Systems and were to occur. However, financial institutions procedures should recognize that measurement should have a sense of how large this type of of some types of risk is an approximation and risk might be and how the institution would that some risks, such as the market liquidity of a manage its positions if such an event occured. marketable instrument, can be very difficult to Evaluation of such scenarios is crucial to risk quantify and can vary with economic and mar- management since significant deviations from ket conditions. Nevertheless, at a minimum, the past experience do occur, such as the breakdown vulnerabilities of the firm to these risks should in 1992 and 1993 of the traditionally high be explicitly assessed on an ongoing basis in correlation of the movements of the dollar and response to changing circumstances. other European currencies of the European Sound risk-measurement practices include the monetary system. careful and continuous identification of possible An institution’s exposures should be moni- events or changes in market behavior that could tored against limits by control staff who are fully have a detrimental impact on the financial insti- independent of the trading function. The process tution. The financial institution’s ability to with- for approving limit excesses should require that, stand economic and market shocks points to the before exceeding limits, trading personnel desirability of developing comprehensive and obtain at least oral approval from senior man- flexible data-management systems. agement independent of the trading area. The organization should require written approval of limit excesses and maintenance of such docu- Risk Limits mentation. Limits need not be absolute; how- ever, appropriate dialogue with nontrading senior The risk-management system should include a management should take place before limits are sound system of integrated institution-wide risk exceeded. Finally, senior management should limits that should be developed under the direc- properly address repeated limit excesses and tion of and approved by senior management and divergences from approved trading strategies. the board of directors. The established limits Procedures should address the frequency of structure should apply to all risks arising from limit review, method of approval, and authority an institution’s activities. For credit and market required to change limits. Relevant management risk, in particular, limits on derivatives should reports and their routing through the organiza- be directly integrated with institution-wide lim- tion should be delineated. its on those risks as they arise in all other activities of the firm. When risks are not quan- tifiable, management should demonstrate an Maintenance Issues awareness of their potential impact. In addition to credit risk and market risk, Complex instruments require sound analytical limits or firm guidelines should be established to tools to assess their risk. These tools are address liquidity and funding risk, operational grounded in rigorous financial theory and math- risk, and legal risk. Careful assessment of ematics. As an institution commits more resources operational risk by the financial institution is to structured products, complex cash instru- especially important, since the identification of ments, or derivatives, existing staff will be vulnerabilities in the operational process can required to develop an understanding of the

February 1998 Trading and Capital-Markets Activities Manual Page 4 Overview of Risk Management in Trading Activities 2000.1 methodologies applied. Institutions should not plex products. Internal auditors should also create an environment in which only trading test compliance with risk limits and evaluate staff can evaluate market risk; information on the reliability and timeliness of information new products and their attendant risks should be reported to the financial institution’s senior man- widely disseminated. agement and the board of directors. Internal Concurrent with the review of the existing auditors are also expected to evaluate the inde- risk-management framework, the resources pro- pendence and overall effectiveness of the finan- vided to maintain the integrity of the risk- cial institution’s risk-management functions. measurement system should be evaluated. The level of confidence that examiners place Limits should be reviewed at least annually. in the audit work, the nature of the audit Assumptions underlying the established limits findings, and management’s response to those should be reviewed in the context of changes in findings will influence the scope of the current strategy, the risk tolerance of the institution, or examination. Even when the audit process and market conditions. Automated systems should findings are satisfactory, examiners should test be upgraded to accommodate increased volumes critical internal controls, including the revalua- and added financial complexity, either in apply- tion process, the credit-approval process, and ing new valuation methodologies or implement- adherence to established limits. Significant ing tools to evaluate new products. Products changes in product lines; modeling; or risk- that are recorded ‘‘off-line,’’ that is, not on the management methodologies, limits, and internal mainframe or LAN (linked personal computers), controls should receive special attention. Sub- should provide automated data feeds to the stantial changes in earnings from capital-markets risk-measurement systems to reduce the inci- and trading activities, in the size of positions, or dence of manual error. the value-at-risk associated with these activities should also be investigated during the examina- tion. These findings and evaluations and other Internal Controls and Audits factors, as appropriate, should be the basis for decisions to dedicate greater resources to exam- A review of internal controls has long been ining the trading functions. central to the examination of capital-markets and trading activities. The examiner should review the system of internal controls to ensure SOUND PRACTICES that they promote effective and efficient opera- tions; reliable financial and regulatory reporting; Capital-markets and trading operations vary sig- and compliance with relevant laws and regu- nificantly among financial institutions, depend- lations, safe and sound banking practices, and ing on the size of the trading operation, trading policies of the board of directors and manage- and management expertise, organizational struc- ment. Evaluating the ability of internal controls tures, the sophistication of computer systems, to achieve these objectives involves understand- the institution’s focus and strategy, historical ing and documenting adherence to control and expected income, past problems and losses, activities such as approvals, verifications, and risks, and types and sophistication of the trading reconciliations. products and activities. As a result, the risk- When evaluating internal controls, examiners management practices, policies, and procedures should consider the frequency, scope, and find- expected in one institution may not be necessary ings of internal and external audits and the in another. With these caveats in mind, a list of ability of those auditors to review the capital- sound practices for financial institutions actively markets and trading activities. Internal auditors engaged in capital-markets and trading opera- should audit and test the risk-management pro- tions follows: cess and internal controls periodically, with the frequency based on a careful risk assessment. • Every organization should have a risk- Adequate test work should be conducted to management function that is independent of re-create summary risk factors in management its trading staff. reports from exposures in the trading position. • Every organization should have a risk- This may include validation of risk-measurement management policy that is approved by the algorithms independent of the trading or control board of directors annually. The policy should functions with special emphasis on new, com- outline products traded, parameters for risk

Trading and Capital-Markets Activities Manual February 1998 Page 5 2000.1 Overview of Risk Management in Trading Activities

activities, the limit structure, over-limit- • Counterparty credit exposure on derivative approval procedures, and frequency of review. transactions should be measured on a In addition, every organization should have a replacement-cost and potential-exposure basis. process to periodically review limit policies, Every organization should perform a periodic pricing assumptions, and model inputs under assessment of credit exposure to redefine changing market conditions. In some markets, statistical parameters used to derive potential frequent, high-level review of such factors exposure. may be warranted. • With regard to credit risk, any organization • Every organization should have a new-product that employs netting should have a policy policy that requires review and approval by all related to netting agreements. Appropriate operational areas affected by such transactions legal inquiry should be conducted to deter- (for example, risk management, credit man- mine enforceability by jurisdiction and coun- agement, trading, accounting, regulatory terparty type. Netting should be implemented reporting, back office, audit, compliance, and only when legally enforceable. legal). This policy should be evidenced by an • Every organization should have middle and audit trail of approvals before a new product is senior management inside and outside the introduced. trading room who are familiar with the stated • Every organization should be able to aggre- philosophy on market and credit risk. Also, gate each major type of risk on a single pricing methods employed by the traders common basis, including market, credit, and should be well understood. operational risks. Ideally, risks would be evalu- • Every organization should be cognizant of ated within a value-at-risk framework to deter- nonquantifiable risks (such as operational mine the overall level of risk to the institution. risks), have an approach to assessing them, The risk-measurement system should also per- and have guidelines and trading practices to mit disaggregation of risk by type and by control them. customer, instrument, or business unit to • Every organization with a high level of trad- effectively support the management and con- ing activity should be able to demonstrate that trol of risks. it can adjust strategies and positions under • Every organization should have a methodol- rapidly changing market conditions and crisis ogy to stress test the institution’s portfolios situations on a timely basis. with respect to key variables or events to • For business lines with high levels of activity, create plausible worst-case scenarios for risk management should be able to review review by senior management. The limit struc- exposures on an intraday basis. ture of the institution should consider the • Management information systems should pro- results of the stress tests. vide sufficient reporting for decision making • Every organization should have an integrated on market and credit risks, as well as opera- management information system that controls tional data including profitability, unsettled market risks and provides comprehensive items, and payments. reporting. The sophistication of the system • A periodic compliance review should be con- should match the level of risk and complexity ducted to ensure conformity with federal, of trading activity. Every institution should state, and foreign securities laws and regula- have adequate financial applications in place tory guidelines. to quantify and monitor risk positions and to • Every institution should have a compensation process the variety of instruments currently system that does not create incentives which in use. A minimum of manual intervention may conflict with maintaining the integrity of should be required to process and monitor the risk-control system. transactions. • Auditors should perform a comprehensive • Risk management or the control function review of risk management annually, empha- should be able to produce a risk-management sizing segregation of duties and validation of report that highlights positions, limits, and data integrity. Additional test work should be excesses on a basis commensurate with trad- performed when numerous new products or ing activity. This report should be sent to models are introduced. Models used by both senior management, reviewed, signed, and the front and back offices should be reassessed returned to control staff. periodically to ensure sound results.

February 1998 Trading and Capital-Markets Activities Manual Page 6 Market Risk Section 2010.1

Market risk is the potential that changes in the tional elements such as stop-loss limits and market prices of an institution’s holdings may other trading guidelines that may play an impor- have an adverse effect on its financial condition. tant role in controlling risk at the trader and The four most common market-risk factors are business-unit level. All limits should be appro- interest rates, foreign-exchange rates, equity priately enforced and adequate internal controls prices, and commodity prices. The market risk should exist to ensure that any exceptions to of both individual financial instruments and limits are detected and adequately addressed by portfolios of instruments can be a function of management. one, several, or all of these basic factors and, in many cases, can be significantly complex. The market risks arising from positions with options, TYPES OF MARKET RISKS either explicit or embedded in other instruments, can be especially complex and difficult to man- age. Institutions should ensure that they ade- Interest-Rate Risk quately measure, monitor, and control the mar- ket risks involved in their trading activities. Interest-rate risk is the potential that changes in interest rates may adversely affect the value of a The measurement of market risk should take financial instrument or portfolio, or the condi- due account of hedging and diversification effects tion of the institution as a whole. Although and should recognize generally accepted mea- interest-rate risk arises in all types of financial surement techniques and concepts. Although instruments, it is most pronouced in debt instru- several types of approaches are available for ments, derivatives that have debt instruments measuring market risk, institutions have increas- as their underlying reference asset, and other ingly adopted the ‘‘value-at-risk’’ approach for derivatives whose values are linked to market their trading operations. Regardless of the spe- interest rates. In general, the values of longer- cific approach used, risk measures should be term instruments are often more sensitive to sufficiently accurate and rigorous to adequately interest-rate changes than the values of shorter- reflect all of an institution’s meaningful market- term instruments. risk exposure and should be adequately incor- Risk in trading activities arises from open or porated into the risk-management process. unhedged positions and from imperfect correla- Risk monitoring is the foundation of an effec- tions between offsetting positions. With regard tive risk-management process. Accordingly, in- to interest-rate risk, open positions arise most stitutions should ensure that they have adequate often from differences in the maturities or internal reporting systems that address their repricing dates of positions and cash flows that market-risk exposures. Regular reports with are asset-like (i.e., ‘‘longs’’) and those that are appropriate detail and frequency should be pro- liability-like (i.e., ‘‘shorts’’). The exposure that vided to the various levels of trading operations such ‘‘mismatches’’ represent to an institution and senior management, from individual traders depends not only on each instrument’s or posi- and trading desks to business-line management tion’s sensitivity to interest-rate changes and the and senior management and, ultimately, the amount held, but also on how these sensitivities board of directors. are correlated within portfolios and, more A well-constructed system of limits and poli- broadly, across trading desks and business lines. cies on acceptable levels of risk exposure is a In sum, the overall level of interest-rate risk in particularly important element of risk control in an open portfolio is determined by the extent to trading operations. Financial institutions should which the risk characteristics of the instruments establish limits for market risk that relate to their in that portfolio interact. risk measures and are consistent with maximum Imperfect correlations in the behavior of off- exposures authorized by their senior manage- setting or hedged instruments in response to ment and board of directors. These limits can changes in interest rates—both across the yield be allocated to business units, product lines, or curve and within the same maturity or repricing other appropriate organizational units and should category—can allow for significant interest-rate be clearly understood by all relevant parties. In risk exposure. Offsetting positions with different practice, some limit systems often include addi- maturities, although theoretically weighted to

Trading and Capital-Markets Activities Manual February 1998 Page 1 2010.1 Market Risk create hedged positions, may be exposed to markets pose particular challenges to the effec- imperfect correlations in the underlying refer- tiveness of foreign-currency hedging strategies. ence rates. Such ‘‘yield curve’’ risk can arise in portfolios in which long and short positions of different maturities are well hedged against a Equity-Price Risk change in the overall level of interest rates, but not against a change in the shape of the yield Equity-price risk is the potential for adverse curve when interest rates of different maturities changes in the value of an institution’s equity- change by varying amounts. related holdings. Price risks associated with Imperfect correlation in rates and values of equities are often classified into two categories: offsetting positions within a maturity or repric- general (or undiversifiable) equity risk and spe- ing category can also be a source of significant cific (or diversifiable) equity risk. risk. This ‘‘basis’’ risk exists when offseting ‘‘General equity-price risk’’ refers to the sen- positions have different and less than perfectly sitivity of an instrument’s or portfolio’s value to correlated coupon or reference rates. For exam- changes in the overall level of equity prices. As ple, three-month interbank deposits, three- such, general risk cannot be reduced by diver- month Eurodollars, and three-month Treasury sifying one’s holdings of equity intruments. bills all pay three-month interest rates. However, Many broad equity indexes, for example, prima- these three-month rates are not perfectly corre- rily involve general market risk. lated with each other, and spreads between their Specific equity-price risk refers to that portion yields may vary over time. As a result, three- of an individual equity instrument’s price vola- month Treasury bills, for example, funded by tility that is determined by the firm-specific three-month Eurodollar deposits, represent an characteristics. This risk is distinct from market- imperfectly offset or hedged position. One vari- wide price fluctuations and can be reduced by ant of basis risk that is central to the manage- diversification across other equity instruments. ment of global trading risk is ‘‘cross-currency By assembling a portfolio with a sufficiently interest-rate risk,’’ that is, the risk that compa- large number of different securities, specific risk rable interest rates in different currency markets can be greatly reduced because the unique may not move in tandem. fluctuations in the price of any single equity will tend to be canceled out by fluctuations in the opposite direction of prices of other securities, Foreign-Exchange Risk leaving only general-equity risk.

Foreign-exchange risk is the potential that move- ments in exchange rates may adversely affect Commodity-Price Risk the value of an institution’s holdings and, thus, its financial condition. Foreign-exchange rates Commodity-price risk is the potential for ad- can be subject to large and sudden swings, and verse changes in the value of an institution’s understanding and managing the risk associated commodity-related holdings. Price risks associ- with exchange-rate volatility can be especially ated with commodities differ considerably from complex. Although it is important to acknowl- interest-rate and foreign-exchange-rate risk and edge exchange rates as a distinct market-risk require even more careful monitoring and man- factor, the valuation of foreign-exchange instru- agement. Most commodities are traded in mar- ments generally requires knowledge of the be- kets in which the concentration of supply can havior of both spot exchange rates and interest magnify price volatility. Moreover, fluctuations rates. Any forward premium or discount in the in market liquidity often accompany high price value of a foreign currency relative to the volatility. Therefore, commodity prices gener- domestic currency is determined largely by ally have higher volatilities and larger price relative interest rates in the two national discontinuities than most commonly traded markets. financial assets. An evaluation of commodity- As with all market risks, foreign-exchange price risk should be performed on a market-by- risk arises from both open or imperfectly offset market basis and include not only an analysis of or hedged positions. Imperfect correlations historical price behavior, but also an assessment across currencies and international interest-rate of the structure of supply and demand in the

February 1998 Trading and Capital-Markets Activities Manual Page 2 Market Risk 2010.1 marketplace to evaluate the potential for unusu- Adequate controls should be imposed on all ally large price movements. elements of the process for market-risk measure- ment and monitoring, including the gathering and transmission of data on positions, market factors and market conditions, key assumptions OPTIONS and parameters, the calculation of the risk mea- sures, and the reporting of risk exposures through Exposure to any and all of the various types of appropriate chains of authority and responsibil- market risk can be significantly magnified by the ity. Moreover, all of these elements should be presence of explicit or embedded options in subject to internal validation and independent instruments and portfolios. Moreover, assessing review. the true risk profile of options can be complex. In most institutions, computer models are Under certain conditions, the significant lever- used to measure market risk. Even within a age involved in many options can translate small single organization, a large number of models changes in the underlying reference instrument may be used, often serving different purposes. into large changes in the value of the option. For example, individual traders or desks may Moreover, an option’s value is, in part, highly use ‘‘quick and dirty’’ models that allow speedy dependent on the likelihood or probability that it evaluation of opportunities and risks, while may become profitable to exercise in the future. more sophisticated and precise models are In turn, this probability can be affected by needed for daily portfolio revaluation and for several factors including the time to expiration systematically evaluating the overall risk of the of the option and the volatility of the underlying institution and its performance against risk lim- reference instrument. Accordingly, factors other its. Models used in the risk-measurement and than changes in the underlying reference instru- front- and back-office control functions should ment can lead to changes in the value of the be independently validated by risk-management option. For example, as the price variability of staff or by internal or outside auditors. the reference instrument increases, the probabil- Examiners should ensure that institutions have ity that the option becomes profitable increases. internal controls to check the adequacy of the Therefore, a change in the market’s assessment valuation parameters, algorithms, and assump- of volatility can affect the value of an option tions used in market-risk models. Specific con- even without any change in the current price of siderations with regard to the oversight of mod- the underlying asset. els used in trading operations and the adequacy The presence of option characteristics is a of reporting systems are discussed in sections major complicating factor in managing the mar- 2100 and 2110, ‘‘Financial Performance’’ and ket risks of trading activities. Institutions should ‘‘Capital Adequacy of Trading Activities,’’ ensure that they fully understand, measure, and respectively. control the various sources of optionality influ- encing their market-risk exposures. Measure- ment issues arising from the presence of options Basic Measures of Market Risk are addressed more fully in the instrument profile on options (section 4330.1). Nominal Measures

Nominal or notional measurements are the most basic methodologies used in market-risk man- MARKET-RISK MEASUREMENT agement. They represent risk positions based on the nominal amount of transactions and hold- There are a number of methods for measuring ings. Typical nominal measurement methods the various market risks encountered in trading may summarize net risk positions or gross risk operations. All require adequate information on positions. Nominal measurements may also be current positions, market conditions, and instru- used in conjunction with other risk-measurement ment characteristics. Regardless of the methods methodologies. For example, an institution may used, the scope and sophistication of an institu- use nominal measurements to control market tion’s measurement systems should be commen- risks arising from foreign-exchange trading while surate with the scale, complexity, and nature of using duration measurements to control interest- its trading activities and positions held. rate risks.

Trading and Capital-Markets Activities Manual February 1998 Page 3 2010.1 Market Risk

For certain institutions with limited, noncom- U.S. Treasury security. The institution can then plex risk profiles, nominal measures and con- aggregate the instruments and evaluate the risk trols based on them may be sufficient to ade- as if the instruments were a single position in the quately control risk. In addition, the ease of common base. computation in a nominal measurement system While basic factor-sensitivity measures can may provide more timely results. However, provide useful insights, they do have certain nominal measures have several limitations. limitations—especially in measuring the expo- Often, the nominal size of an exposure is an sure of complex instruments and portfolios. For inaccurate measure of risk since it does not example, they do not assess an instrument’s reflect price sensitivity or price volatility. This is convexity or volatility and can be difficult to especially the case with derivative instruments. understand outside of the context of market Also, for sophisticated institutions, nominal mea- events. Examiners should ensure that factor- sures often do not allow an accurate aggregation sensitivity measures are used appropriately and, of risks across instruments and trading desks. where necessary, supported with more sophisti- cated measures of market-risk exposure.

Factor-Sensitivity Measures

Basic factor-sensitivity measures offer a some- Basic Measures of Optionality what higher level of measurement sophistication than nominal measures. As the name implies, At its most basic level, the value of an option these measures gauge the sensitivity of the value can generally be viewed as a function of the of an instrument or portfolio to changes in a price of the underlying instrument or reference primary risk factor. For example, the price value rate relative to the exercise price of the option, of a basis point change in yield and the concept the volatility of the underlying instrument or of duration are often used as factor-sensitivity reference rate, the option contract’s time to measures in assessing the interest-rate risk of expiration, and the level of market interest rates. fixed-income instruments and portfolios. Beta, Institutions may use simple measures of each of or the measure of the systematic risk of equities, these elements to identify and manage the mar- is often considered a first-order sensitivity mea- ket risks of their option positions, including the sure of the change in an equity-related instru- following: ment or portfolio to changes in broad equity indexes. • ‘‘Delta’’ measures the degree to which the Duration provides a useful illustration of a option’s value will be affected by a (small) factor-sensitivity measure. Duration measures change in the price of the underlying the sensitivity of the present value or price of a instrument. financial instrument with respect to a change in • ‘‘Gamma’’ measures the degree to which the interest rates. By calculating the weighted aver- option’s delta will change as the instrument’s age duration of the instruments held in a port- price changes; a higher gamma typically folio, the price sensitivity of different instru- implies that the option has greater value to its ments can be aggregated using a single basis holder. that converts nominal positions into an overall • ‘‘Vega’’ measures the sensitivity of the option price sensitivity for that portfolio. These port- value to changes in the market’s expectations folio durations can then be used as the primary for the volatility of the underlying instrument; measure of interest-rate risk exposure. a higher vega typically increases the value of Alternatively, institutions can express the basic the option to its holder. price sensitivities of their holdings in terms of • ‘‘Theta’’ measures how much an option’s one representative instrument. Continuing the value changes as the option moves closer to its example using duration, an institution may con- expiration date; a higher theta is typically vert its positions into the duration equivalents of associated with a higher option value to its one reference instrument such as a four-year holder. U.S. Treasury, three-month Eurodollar, or some • ‘‘Rho’’ measures how an option’s value other common financial instrument. For exam- changes in response to a change in short-term ple, all interest-rate risk exposures might be interest rates; a higher rho typically is associ- converted into a dollar amount of a ‘‘two-year’’ ated with a lower option value to its holder.

February 1998 Trading and Capital-Markets Activities Manual Page 4 Market Risk 2010.1

Measurement issues arising from the presence term movements in the prices of many financial of options are addressed more fully in the instruments are not normally distributed, in instrument profile on options (section 4330.1). particular, that the probability of extreme move- ments is considerably higher than would be predicted by an application of the normal distri- bution. Accordingly, more sophisticated institu- Scenario Simulations tions use more complex volatility-measurement techniques to define appropriate scenarios. Another level of risk-exposure measurement is A particularly important consideration in con- the direct estimation of the potential change in ducting scenario simulations is the interactions the value of instruments and portfolios under and relationships between positions. These specified scenarios of changes in risk factors. On interrelationships are often identified explicitly a simple basis, changes in risk factors can be with the use of correlation coefficients. A cor- applied to factor-sensitivity measures such as relation coefficient is a quantitative measure of duration or the present value of a basis point the extent to which changes in one variable are to derive a change in value under the selected related to another. The magnitude of the coeffi- scenario. These scenarios can be arbitrarily cient measues the likelihood that the two vari- determined or statistically inferred either from ables will move together in a linear relationship. analyzing historical data on changes in the Two variables (that is, instrument prices) whose appropriate risk factor or from running multiple movements correspond closely would have a forecasts using a modeled or assumed stochastic correlation coefficient close to 1. In the case process that describes how a risk factor may of inversely related variables, the correlation behave under certain circumstances. In statisti- coefficient would be close to −1. cal inference, a scenario is selected based on the Conceptually, using correlation coefficients probability that it will occur over a selected time allows an institution to incorporate multiple risk horizon. A simple statistical measure used to factors into a single risk analysis. This is impor- infer such probabilities is the standard deviation. tant for instruments whose value is linked to Standard deviation is a summary measure of more than one risk factor, such as foreign- the dispersion or variability of a random vari- exchange derivatives, and for measuring the risk able such as the change in price of a financial of a trading portfolio. The use of correlations instrument. The size of the standard deviation, allows the institution to hedge positions—to combined with some knowledge of the type of partially offset long positions in a particular probability distribution governing the behavior currency/maturity bucket with short positions in of a random variable, allows an analyst to a different currency/maturity bucket—and to quantify risk by inferring the probability that a diversify price risk for the portfolio as a whole certain scenario may occur. For a random vari- in a unitary conceptual framework. The degree able with a normal distribution, 68 percent of the to which individual instruments and positions observed outcomes will fall within plus or are correlated determines the degree of risk minus one (±1) standard deviation of the aver- offset or diversification. By fully incorporating age change, 90 percent within 1.65 standard correlation, an institution may be able to express deviations, 95 percent within 1.96 standard all positions, across all risk factors, as a single deviations, and 99 percent within 2.58 standard risk figure. deviations. Assuming that changes in risk fac- tors are normally distributed, calculated stan- dard deviations of these changes can be used to specify a scenario that has a statistically inferred Value-at-Risk probability of occurrence (for example, a sce- nario that would be as severe as 95 percent or Value-at-risk (VAR) is the most common mea- 99 percent of all possible outcomes). An alter- surement technique used by trading institutions native to such statistical inference is to use to summarize their market-risk exposures. VAR directly observed historical scenarios and is defined as the estimated maximum loss on an assume that their future probability of occur- instrument or portfolio that can be expected over rence is the same as their historical frequency of a given time interval at a specified level of occurrence. probability. Two basic approaches are generally However, some technicians contend that short- used to forecast changes in risk factors for a

Trading and Capital-Markets Activities Manual February 1998 Page 5 2010.1 Market Risk desired probability or confidence interval. One closing out or hedging positions may be impos- involves direct specification of how market sible except at extremely unfavorable prices, in factors will act using a defined stochastic pro- which case positions may be held for longer cess and Monte Carlo techniques to simulate than envisioned. This unexpected lengthening of multiple possible outcomes. Statistical inference the holding period will cause a portfolio’s risk from these multiple outcomes provides expected profile to be much greater than expected because values at some confidence interval. An alter- the likelihood of a large price change increases native approach involves the use of historical with time (holding period), and the risk profile changes in risk factors and parameters observed of some instruments, such as options, changes over some defined sample period. Under this substantially as their remaining time to maturity alternative approach, forecasts can be derived decreases. using either variance-covariance or historical- simulation methodologies. Variance-covariance estimation uses standard deviations and corre- Stress Testing lations of risk factors to statistically infer the probability of possible scenarios, while the The underlying statistical methods used in daily historical-simulation method uses actual distri- risk measurements summarize exposures that butions of historical changes in risk factors to reflect the most probable market conditions. estimate VAR at the desired confidence interval. Market participants should periodically perform Some organizations allocate capital to various simulations to determine how their portfolios divisions based on an internal transfer-pricing will perform under exceptional conditions. The process using measures of value-at-risk. Rates framework of this stress testing should be of return from each business unit are measured detailed in the risk-management policy state- against this capital to assess the unit’s efficiency ment, and senior management should be regu- as well as to determine future strategies and larly apprised of the findings. Assumptions commitments to various business lines. In addi- should be critically questioned and input tion, as explained in the section on capital parameters altered to reflect changing market adequacy, the internal value-at-risk models are conditions. used for risk-based capital purposes. The examiner should review available simu- Assumptions about market liquidity are likely lations to determine the base case, as well as to have a critical effect on the severity of review comparable scenarios to determine conditions used to estimate risk. Some institu- whether the resulting ‘‘worst case’’ is suffi- tions may estimate exposure under the assump- ciently conservative. Similar analyses should be tion that dynamic hedging or other rapid port- conducted to derive worst-case credit exposures. folio adjustments will keep risk within a given Nonquantifiable risks, such as operational and range even when significant changes in market legal risks, constraints on market or product prices occur. Dynamic hedging depends on liquidity, and the probability of discontinuities the existence of sufficient market liquidity to in various trading markets, are important execute the desired transactions at reasonable considerations in the review process. Concerns costs as underlying prices change. If a market- include unanticipated political and economic liquidity disruption were to occur, the difficulty events which may result in market disruptions or of executing transactions would cause the actual distortions. This overall evaluation should include market risk to be higher than anticipated. an assessment of the institution’s ability to alter To recognize the importance of market- hedge strategies or liquidate positions. Addi- liquidity assumptions, measures such as value- tional attention should be committed to evaluat- at-risk should be estimated over a number of ing the frequency of stress tests. different time horizons. The use of a short time horizon, such as a day, may be useful for day-to-day risk management. However, prudent managers will also estimate risk over longer MARKET-RISK LIMITS horizons, since the use of a short horizon relies on an assumption that market liquidity will Market-risk limits are one of the most funda- always be sufficient to allow positions to be mental controls over the risks inherent in an closed out at minimal losses. In a crisis, the institution’s trading activities. Banks should firm’s access to markets may be so impaired that establish limits for market risk that relate to their

February 1998 Trading and Capital-Markets Activities Manual Page 6 Market Risk 2010.1 risk measures and are consistent with maximum tion of excessive losses in a position. Typi- exposures authorized by their senior manage- cally, if these limits are reached, a senior ment and board of directors. These limits should management response is required to hedge or be allocated to business units and individual liquidate a position. These limits are usually traders and be clearly understood by all relevant more restrictive than overall position limits. parties. Internal controls should ensure that Typical stop-loss limits are retrospective and exceptions to limits are detected and adequately cover cumulative losses for a day, week, or addressed by management. In practice, some month. limit systems include additional elements, such • Value-at-risk limits. Management may place as stop-loss limits and trading guidelines, that limits on the extent to which the value of a may play an important role in controlling risk at portfolio is affected by changes in underlying the trader and business-unit level. Examiners risk factors. Limits can be specified as the should include these elements in their review of maximum loss for a specified scenario (for the limit system. Other institutions may have example, a 100 basis point change in rates) or several levels of limits informally allocated by for scenarios defined at some specified confi- product or by staff. For example, policy guide- dence level derived from internal VAR mea- lines may give head traders substantial discre- sures (for example, 99 percent of possible tion in allocating limits among staff. Some occurrences over a one-day time horizon). institutions that permit traders to take positions Generally, measures of sensitivity are based in multiple instruments may apply limits broadly on historical volatilities of risk. across the organization, with sublevels of advi- • Maturity gap limits. These limits enable an sory limits when gross exposures exceed a given institution to control the risk of adverse percentage, such as 75 percent, of overall levels. changes in rates for the periods designated in When analyzing an institution’s limits, exam- the institution’s planning time horizon. Limits iners should evaluate the size of limits against might range from stated absolute amounts for the institution’s financial strength. The risks each time frame to weighted limits that em- resulting from full utilization of an institution’s phasize increasing rate-movement exposure limits should not compromise its safety and applicable to the relative distance into the soundness. Examiners should also evaluate the future in which the gap appears. In addition, percentage of limit use over time. Excessively these limits should specify the maximum large limits may circumvent normal reporting maturity of the specific instrument or combi- lines; an increase in activity or position may not nation of instruments. Typically, institutions be properly highlighted to senior management. employ maturity gap limits to control risks Conversely, overly restrictive limits which are arising from nonparallel shifts in yield curves frequently exceeded may undermine the disci- and forward curves. pline of the limit structure in place. Finally, examiners should evaluate profitability along • Limits on options positions. An institution with position taking. Institutions should be able should place unique limits on options posi- to explain abnormal daily profits or losses given tions to adequately control trading risks. the size of their positions. Options limits should include limits which The following is a summary of limits fre- address exposures to small changes in the quently used by financial institutions: price of the underlying instrument (delta), rate of change in the price of the underlying • Limits on net and gross positions. Limits may instrument (gamma), changes in the volatility be placed on gross positions, net positions, or of the price of the underlying instrument both. Limits on gross positions restrict the size (vega), changes in the option’s time to expi- of a long or short position in a given instru- ration (theta), and changes in interest rates ment. Limits on net positions, on the other (rho). hand, attempt to recognize the natural offset of • Limits for volatile or illiquid markets. Man- long and short positions. Institutions generally agement may choose to limit trading in espe- should employ both types of limits in their cially volatile markets, in which losses could risk management. accumulate quickly, or in illiquid markets, in • Maximum allowable loss (‘‘stop-loss’’). Lim- which management may be forced to take a its may be established to avoid the accumula- loss to close a position it cannot offset.

Trading and Capital-Markets Activities Manual February 1998 Page 7 Market Risk Examination Objectives Section 2010.2

1. To evaluate the organizational structure of understand the potential market exposures the market-risk-management function. of the capital-markets and trading activities 2. To evaluate the adequacy of internal market- of the institution. risk-management policies and procedures 7. To ensure that business-level management for capital-markets and trading activities has formulated contingency plans for and to determine that actual operating prac- illiquid market conditions. tices reflect such policies. 8. To review management information sys- 3. To identify the market risks of the insti- tems for comprehensive coverage of market tution. risks. 4. To determine if the institution’s market-risk- 9. To assess the effectiveness of the global measurement system has been correctly risk-management system and determine if it implemented and adequately measures the can evaluate market, liquidity, credit, opera- institution’s market risks. tional, and legal risks and that management 5. To determine how the institution measures at the highest level is aware of the institu- nonstandard products such as exotic options, tion’s global exposure. structured financings, and certain mortgage- 10. To recommend corrective action when poli- backed securities. cies, procedures, practices, internal con- 6. To determine if senior management and the trols, or management information systems board of directors of the financial institution are found to be deficient.

Trading and Capital-Markets Activities Manual February 1998 Page 1 Market Risk Examination Procedures Section 2010.3

These procedures list processes and activities and limits. Determine whether the risk- that may be reviewed during a full-scope exami- measurement model and methodology nation. The examiner-in-charge will establish adequately address all identified market the general scope of examination and work with risks and are appropriate for the institu- the examination staff to tailor specific areas for tion’s activities. review as circumstances warrant. As part of this b. Review contingency market-risk plans process, the examiner reviewing a function or for adequacy. product will analyze and evaluate internal audit c. Check that limits are in place for market comments and previous examination work- exposures before transacting a deal. If papers to assist in designing the scope of exami- the financial institution relies on one-off nation. In addition, after a general review of a approvals, check that the approval pro- particular area to be examined, the examiner cess is well documented. should use these procedures, to the extent they d. Review accounting and revaluation poli- are applicable, for further guidance. Ultimately, cies and procedures. Determine that it is the seasoned judgment of the examiner and revaluation procedures are appropriate. the examiner-in-charge that determines which 4. Determine the credit rating and market procedures are warranted in examining any acceptance of the financial institution as a particular activity. counterparty in the markets. 5. Obtain all management information analyz- 1. Review the market-risk-management ing market risk. organization. a. Determine the comprehensiveness, accu- a. Check that the institution has a market- racy, and integrity of analysis. risk-management function with sepa- b. Review valuation and simulation meth- rate reporting lines from traders and ods in place. marketers. c. Review stress tests, analyzing changes in b. Determine if market-risk-control person- market conditions. nel have sufficient credibility in the finan- d. Determine whether the management cial institution to question traders’ and information reports accurately reflect marketers’ decisions. risks and that reports are provided to the c. Determine if market-risk management is appropriate level of management. involved in new-product discussions. 6. Determine if any recent market disruptions 2. Identify the institution’s capital-markets and have affected the institution’s trading activi- trading activities and the related balance- ties. If so, determine the institution’s market sheet and off-balance-sheet instruments. response. Obtain copies of all risk-management 7. Establish that the financial institution is reports prepared by the institution. following its internal policies and proce- a Define the use and purpose of the insti- dures. Determine whether the established tution’s capital-markets products. limits adequately control the range of mar- b. Define the institution’s range, scope, and ket risks. Determine whether management size of risk exposures. Determine the is aware of limit excesses and takes appro- products in which the institution makes priate action when necessary. markets. Determine the hedging instru- 8. Determine whether the institution has estab- ments used to hedge these products. lished an effective audit trail that summa- c. Evaluate market-risk-control personnel’s rizes exposures and management approvals demonstrated knowledge of the products with the appropriate frequency. traded by the financial institution and 9. Determine whether management considered their understanding of current and poten- the full range of exposures when establish- tial exposures. ing capital-at-risk exposures. 3. Obtain and evaluate the adequacy of risk- a. Determine if the financial institution management policies and procedures for established capital-at-risk limits which capital-markets and trading activities. address both normal and distressed mar- a. Review market-risk policies, procedures, ket conditions.

Trading and Capital-Markets Activities Manual February 1998 Page 1 2010.3 Market Risk: Examination Procedures

b. Determine if senior management and the 11. Based on information provided, determine board of directors are advised of market- the institution’s exposure from dynamic risk exposures in times of market dis- hedging strategies during times of market ruption and under normal market disruption. conditions. 12. Recommend corrective action when poli- 10. Determine that business managers have cies, procedures, practices, internal con- developed contingency plans which outline trols, and management information systems actions to be taken in times of market are found to be deficient. disruption to minimize losses as well as the potential damage to the institution’s market- making reputation.

February 1998 Trading and Capital-Markets Activities Manual Page 2 Market Risk Internal Control Questionnaire Section 2010.4

1. Review the market-risk-management h. Do the policies authorize the use of organization. appropriate hedging instruments? a. Does the institution have a market-risk- i. Do the policies address the use of management function with separate dynamic hedging strategies? reporting lines from traders and j. Do the policies establish market-risk lim- marketers? its which consider bid/ask spreads for the b. Do market-risk-control personnel have full range of products in normal mar- sufficient credibility in the financial kets? institution to question traders’ and mar- k. Do the policies provide an explanation of keters’ decisions? the board of directors’ and senior man- c. Is market-risk management involved in agement’s philosophy regarding illiquid new-product discussions in the financial markets? institution? l. Do the policies establish market-risk lim- 2. Identify the institution’s capital-markets and its which consider bid/ask spreads in trading activities and the related balance- distressed markets? How do the policies sheet and off-balance-sheet instruments reflect liquidity concerns? and obtain copies of all risk-management m. Are limits in place for market exposures reports prepared. before transacting a deal? If the financial a. Do summaries identify all the institu- institution relies on one-off approvals, is tion’s capital-markets products? the approval process well documented? b. Define the role that the institution takes 4. If the financial institution has recently for the range of capital-markets prod- experienced a ratings downgrade, ascertain ucts. Determine the hedging instruments the impact of the credit-rating downgrade. used to hedge these products. Is the What has been the market response to the institution an end-user, dealer, market financial institution as a counterparty in the maker? In what products? markets? Have instances in which the insti- c. Do market-risk-control personnel dem- tution provides collateral to its counterpar- onstrate knowledge of the products traded ties significantly increased? by the financial institution? Do they 5. Obtain all management information analyz- understand the current and potential ing market risk. exposures to the institution? a. Is management information comprehen- 3. Does the institution have comprehensive, sive and accurate, and is the analysis written risk-management policies and pro- sound? cedures for capital-markets and trading b. Are the simulation assumptions for a activities? normal market scenario reasonable? a. Have limits been approved by the board c. Are stress tests analyzing changes in of directors? market condition appropriate? Are the b. Have policies, procedures, and limits market assumptions reasonable? been reviewed and reapproved within the d. Do management information reports last year? accurately reflect risks? Are reports c. Are market-risk policies, procedures, and provided to the appropriate level of limits clearly defined? management? d. Are the limits appropriate for the insti- 6. If there have been any recent market dis- tution and the level of capital-markets ruptions affecting the institution’s trading and trading activity? activities, what has been the institution’s e. Do the limits adequately distinguish market response? between trades used to manage the insti- 7. Is the financial institution following its tution’s asset-liability mismatch position internal policies and procedures? Do the and discretionary trading activity? established limits adequately control the f. Are there contingency market-risk plans? range of market risks? Are the limits appro- g. Are there appropriate accounting and priate for the institution’s level of activity? revaluation policies and procedures? Is management aware of limit excesses?

Trading and Capital-Markets Activities Manual February 1998 Page 1 2010.4 Market Risk: Internal Control Questionnaire

Does management take appropriate action market disruptions occur? Are manage- when necessary? ment’s activities in times of market disrup- 8. Has the institution established an effective tions prudent? audit trail that summarizes exposures and a. Do opportunities for liquidation or management approvals with the appropriate unwinding of transactions exist? frequency? Are risk-management, revalua- b. Is the depth (volume, size, number of tions, and close-out valuation reserves sub- market makers) of the market such that ject to audit? undue risk is not being taken? 9. Has management considered possible mar- c. If executed on an exchange, is the open ket disruptions when establishing capital-at- interest in the contract sufficient to risk exposures? ensure that management would be a. Has the financial institution established capable of hedging or closing out capital-at-risk limits which address both open positions in one-way directional normal and distressed market condi- markets? tions? Are these limits aggregated on a d. Can management execute transactions in global basis? large enough size to hedge and/or close b. Are senior management and the board of out market-risk exposures without result- directors advised of market-risk expo- ing in significant price adjustments? sures in illiquid markets? 11. Has management determined the institu- 10. Have business managers developed contin- tion’s exposure to dynamic hedging strate- gency plans which outline actions to be gies during times of market disruption? taken to minimize losses as well as to 12. Does the institution have a methodology for minimize the potential damage to the insti- addressing difficult-to-value products or tution’s market-making reputation when positions?

February 1998 Trading and Capital-Markets Activities Manual Page 2 Counterparty Credit Risk and Presettlement Risk Section 2020.1

Broadly defined, credit risk is the risk of eco- ciated with some derivative instruments, banks nomic loss from the failure of an obligor to should ensure that they fully assess the presettle- perform according to the terms and conditions ment credit risks involved with such instru- of a contract or agreement. Credit risk exists in ments. This section discusses the nature of the all activities that depend on the performance of credit risks involved in trading activities and issuers, borrowers, or counterparties, and virtu- reviews basic credit-risk-management issues. ally all capital-markets and trading transactions Settlement risk is the risk of loss when an involve credit exposure. Over-the-counter (OTC) institution meets its obligation under a contract derivative transactions such as foreign exchange, (through either an advance of funds or securi- swaps, and options can involve particularly ties) before the counterparty meets its obliga- large and dynamic credit exposures. Accord- tion. Failures to perform at settlement can arise ingly, institutions should ensure that they iden- from counterparty default, operational prob- tify, measure, monitor, and control all of the lems, market liquidity constraints, and other various types of credit risks encountered in their factors. Settlement risk exists from the time an trading of both derivative and nonderivative outgoing payment instruction cannot be recalled products. until the incoming payment is received with Credit risk should be managed through a finality. This risk exists with any traded product formal and independent process guided by and is greatest when delivery is made in differ- appropriate policies and procedures. Measure- ent time zones. Issues and examination proce- ment systems should provide appropriate and dures regarding settlement risk are discussed at realistic estimates of the credit-risk exposure length in section 2021.1. and should use generally accepted measurement methodologies and techniques. The develop- ment of customer credit limits and the monitor- CREDIT-RISK-MANAGEMENT ing of exposures against those limits is a critical ORGANIZATION control function and should form the backbone of an institution’s credit-risk-management pro- An institution’s process and program for man- cess. The most common forms of credit risks aging credit risks should be commensurate with encountered in trading activities are issuer credit the range and scope of its activities. Institutions risk and counterparty credit risk. Issuer risk is with relatively small trading operations in non- the risk of default or credit deterioration of an complex instruments may not need the same issuer of instruments that are held as long level of automated systems and policies, or the positions in trading portfolios. While the short same level of highly skilled staff, as firms that time horizon of trading activities limits much of make markets in a variety of cash and derivative the issuer credit risk for relatively high-quality products. and liquid instruments, other less-liquid instru- Credit-risk management should begin at the ments such as loans, emerging-market debt, and highest levels of the organization, with credit- below-investment-quality debt instruments, may risk policies approved by the board of directors, be the source of significant issuer credit risk. the formation of a credit-risk policy committee Counterparty risks, the most significant credit of senior management, a credit-approval pro- risks faced in trading operations, consist of both cess, and credit-risk management staff who ‘‘presettlement’’ risk and ‘‘settlement’’ risk. Pre- measure and monitor credit exposures through- settlement risk is the risk of loss due to a out the organization. Although the organiza- counterparty’s failure to perform on a contract tional approaches used to manage credit risk or agreement during the life of a transaction. For may vary, the credit-risk management of trading most cash instruments, the duration of this risk activities should be integrated into the overall exposure is limited to the hours or days from the credit-risk management of the institution to the time a transaction is agreed upon until settle- fullest extent practicable. With regard to poli- ment. However, in the case of many derivative cies, most complex banking organizations appear products, this exposure can often exist for a to have extensive written policies covering their period of several years. Given this potentially assessment of counterparty creditworthiness for longer-term exposure and the complexity asso- both the initial due-diligence process (that is,

Trading and Capital-Markets Activities Manual September 1999 Page 1 2020.1 Counterparty Credit Risk and Presettlement Risk before conducting business with a customer) surement and evaluation of both on- and and ongoing monitoring. However, examiners off-balance-sheet exposures, including poten- should focus particular attention on how such tial future exposure; adequate stress testing; policies are structured and implemented. reliance on collateral and other credit enhance- Typically, credit-risk management in trading ments; and the monitoring of exposures against operations consists of (1) developing and meaningful limits; approving credit-exposure measurement stan- • employ policies that are sufficiently calibrated dards, (2) setting counterparty credit limits, to the risk profiles of particular types of (3) monitoring credit-limit usage and reviewing counterparties and instruments to ensure ade- credits and concentrations of credit risk, and quate credit-risk assessment, exposure mea- (4) implementing minimum documentation stan- surement, limit setting, and use of credit dards. In general, staff responsible for approving enhancements; exposures should be segregated from those • ensure that actual business practices conform responsible for monitoring risk limits and mea- with stated policies and their intent; and suring exposures. Traders and marketers should • are moving in a timely fashion to enhance not be permitted to assume risks without ade- their measurement of counterparty-credit-risk quate institutional credit-risk controls. exposures, including refining potential future Institutions with very large trading operations exposure measures and establishing stress- often have a credit function in the trading area; testing methodologies that better incorporate staff in this area develop a high level of exper- the interaction of market and credit risks. tise in trading-product credit analysis and meet the demand for rapid credit approval in a trading To adequately evaluate these conditions, exam- environment. To carry out these responsibilities iners should conduct sufficient and targeted without compromising internal controls, the transaction testing. See SR-99-3 (February 1, credit-risk-management function must be inde- 1999). pendent of these marketing and trading person- nel who are directly involved in the execution of the transactions. While the credit staff in the trading area may possess great expertise in trading-product credit analysis, the persons CREDIT-RISK MEASUREMENT responsible for the institution’s global credit function should have a solid understanding of Appropriate measurement of exposures is essen- the measurement of credit-risk exposures in tial for effective credit-risk management in trad- trading products and the techniques available to ing operations. For most cash instruments, pre- manage those exposures. The examiner’s review settlement credit exposure is measured as current of credit-risk management in trading activities carrying value. However, in the case of many should evaluate the quality and timeliness of derivative contracts, especially those traded in information going to the global credit function OTC markets, presettlement exposure is mea- and the way that information is integrated into sured as the current value or replacement cost of global exposure reports. the position, plus an estimate of the institution’s Examiners should evaluate whether banking potential future exposure to changes in the institutions— replacement value of that position over the term of the contract. The methods used to measure • devote sufficient resources and adequate atten- counterparty credit risk should be commensu- tion to the management of the risks involved rate with the volume and level of complexity of in growing, highly profitable, or potentially the instruments involved. Importantly, measure- high-risk activities and product lines; ment systems should use techniques that present • have internal audit and independent risk- a relevant picture of the true nature of the credit management functions that adequately focus exposures involved. Some techniques used to on growth, profitability, and risk criteria in measure presettlement risk can generate very targeting their reviews; large exposure estimates that, by definition, are • achieve an appropriate balance among all unlikely to materialize. Unrealistic measures of elements of credit-risk management, includ- credit exposure suggest important flaws in the ing both qualitative and quantitative assess- institution’s risk-management process and should ments of counterparty creditworthiness; mea- receive special examiner attention.

September 1999 Trading and Capital-Markets Activities Manual Page 2 Counterparty Credit Risk and Presettlement Risk 2020.1

Presettlement Risk by the purchaser to the writer of the option. The value of the purchased option may be reduced as Presettlement credit exposure for cash instru- a result of market movements, but cannot become ments is measured as the current carrying value, negative. The seller or writer of an option which for trading operations is the market value receives a premium, usually at inception, and or fair value of the instrument. Market values must deliver the underlying at exercise. There- can be obtained from direct market quotations fore, the party that buys the option contract will and pricing services or, in the case of more always have credit exposure when the option is complex instruments, may be estimated using in the money, and the party selling the option generally accepted valuation techniques. For contract will have none, except for settlement derivative contracts, credit exposure is mea- risk while awaiting payment of the premium. sured as the current value or replacement cost of the position, plus an estimate of the institution’s potential future exposure to changes in that Potential Future Exposure replacement value in response to market price changes. Together, replacement cost and esti- Potential future exposure is an estimate of the mated potential future exposure make up the risk that subsequent changes in market prices loan-equivalent value of a derivative contract. could increase credit exposure. In measuring potential exposure, institutions attempt to deter- For derivative contracts, presettlement expo- mine how much a contract can move into the sure to a counterparty exists whenever a con- money for the institution and out of the money tract’s replacement cost has positive value to the for the counterparty over time. Given the impor- institution (‘‘in the money’’) and negative value tant interrelationships between the market-risk to the counterparty (‘‘out of the money’’). The and credit-risk exposures involved in banks’ current replacement cost of the contract is its derivative activities that have been emphasized mark-to-market value. If a counterparty defaults over the past two years of financial-market on a transaction before settlement or expiration turbulence, examiners should be alert to situa- of the deal, the other counterparty has an imme- tions in which banks may need to enhance their diate exposure which must be filled. If the current computations of potential future expo- contract is in the money for the nondefaulting sures and loan equivalents used to measure and party, then the nondefaulting counterparty has monitor their derivative counterparty credit suffered a credit loss. Thus, all deals with a exposure. positive mark-to-market value represent actual Estimating potential exposure can be subjec- credit exposure. The replacement cost of deriva- tive, and firms approach its measurement in tive contracts is usually much smaller than the several different ways. One technique is to use face or notional value of derivative transactions. ‘‘rules of thumb’’ or factors, such as percentages Some derivatives involving firm commit- of the notional value of the contract, similar to ments, such as swaps, initially have a zero net the ‘‘add-on’’ factors used in bank risk-based present value and, therefore, no replacement capital. Institutions using such an approach cost at inception. At inception, the only potential should be able to demonstrate that the rules of for credit exposure these contracts have is what thumb or factors provide adequate estimates of can arise from subsequent changes in the market potential exposure. For example, differences in price of the instrument, index, or interest rate the add-ons used for different instruments should underlying them. Once market prices move to reflect differences in the volatility of the under- create a positive contract value, the contract has lying instruments and in the tenor (or maturity) the current credit-risk exposure of its replace- across instruments, and should be adjusted peri- ment cost as well as the potential credit expo- odically to reflect changes in market conditions sure that can arise from subsequent changes in and the passage of time. market prices. A more sophisticated and complex practice of Options and derivative contracts which con- measuring the potential exposure of derivatives tain options (for example, swaptions and rate- is to statistically estimate the maximum prob- protection agreements) face both current and able value that the derivative contract might potential credit exposure. However, a difference reach over a specified time horizon, which with option contracts is that they have a positive sometimes may be the life of the contract. This value at inception reflected by the premium paid is often done by estimating the highest value the

Trading and Capital-Markets Activities Manual September 1999 Page 3 2020.1 Counterparty Credit Risk and Presettlement Risk contract will achieve within some confidence the underlying instrument or risk factor. Some interval (for example, 95, 97.5, or 99 percent institutions measure the ‘‘expected’’ exposure of confidence) based on the estimated distribution a contract in addition to its maximum probable of the contract’s possible values at each point in exposure. The expected exposure is the mean of time over the time horizon, given historical all possible probability-weighted replacement changes in underlying risk factors. The specified costs estimated over the specified time horizon. percentile or confidence level of the distribution This calculation may reflect a good estimate of represents the maximum expected value of the present value of the positive exposure that is the contract at each point over the time horizon. likely to materialize. As such, expected expo- The time horizon used to calculate potential sure can be an important measure for use in an future exposure can vary depending on the institution’s internal pricing, limit-setting, and bank’s risk tolerance, collateral protection, and credit-reserving decisions. However, expected ability to terminate its credit exposure. Some exposure is by definition lower than maximum institutions may use a time horizon equal to the probable exposure and may underestimate life of the respective instrument. While such a potential credit exposure. For this reason, time horizon may be appropriate for unsecured expected exposure estimates are not frequently positions, for collateralized exposures, the use used as loan-equivalent amounts in assessing of lifetime, worst-case estimates of potential capital adequacy from either an internal or future exposure may be ineffective in measuring regulatory basis. the true nature of counterparty risk exposure— Statistically generated measures of future especially given the increasing volatility and exposure use sophisticated risk-measurement complexity of financial markets and derivatives models that, in turn, involve the use of important instruments. While life-of-contract potential assumptions, parameters, and algorithms. Insti- future exposure measures provide an objective tutions using such techniques should ensure that and conservative long-term exposure estimate, appropriate controls are in place regarding the they bear little relationship to the actual credit development, use, and periodic review of the exposures banks typically incur in the case of models and their associated assumptions and collateralized relationships. In such cases, a parameters. The variables and models used for bank’s actual credit exposure is the potential both replacement cost and potential exposure future exposure from the time a counterparty should be approved and tested by the credit-risk- fails to meet a collateral call until the time the management function and should be subject to bank liquidates its collateral—a period which is audit by independent third parties with adequate typically much shorter than the contract’s life. technical qualifications. The data-flow process For some institutions, more realistic measures of should also be subject to audit to ensure data collateralized exposures in times of market stress integrity. Equally important are the approval and are needed. These measures should take into testing of information systems that report posi- account the shorter time horizons over which tions. The functions responsible for managing action can be taken to mitigate losses. They credit risk should validate any modifications to should also incorporate estimates of collateral- models made to accommodate new products or recovery rates given the impact of potential variations on existing products. market events on the liquidity of collateral values. Institutions with vigorous monitoring systems Aggregate Exposures can employ additional credit-risk-measurement methodologies that will tend to generate more In measuring aggregate presettlement credit-risk precise and often smaller reported exposure exposures to a single counterparty, institutions levels. Some institutions already calculate such may use either a transactions approach or a port- measures by assessing the worst-case value of folio approach. Under a transactions approach, positions over a time horizon of one or two the loan-equivalent amounts for each derivative weeks—their estimate of a reasonable liquida- contract with a counterparty are added together. tion period in times of stress. Other institutions Some institutions may take a purely transac- are moving to build the capability of estimating tional approach to aggregation and do not incor- portfolio-based potential future exposures by porate the netting of long and short derivatives any one of several different time horizons or contracts, even when legally enforceable bilat- buckets, owing to the liquidity and breadth of eral netting agreements are available. In such

September 1999 Trading and Capital-Markets Activities Manual Page 4 Counterparty Credit Risk and Presettlement Risk 2020.1 cases, simple sum estimates of positive expo- model-review processes and data integrity sures may seriously overestimate true credit checks. Examiners should be aware that some exposure, and examiners should monitor and banks may need to develop more meaningful encourage an institution’s movement toward measures of credit-risk exposures under volatile more realistic measures of counterparty expo- market conditions by developing and implement- sure. When they exist, legally enforceable close- ing timely and plausible stress tests of counter- out netting agreements should be factored into party credit exposures. Stress testing should these measurements, whatever approach is used evaluate the impact of large market moves on to obtain them. Master close-out netting agree- the credit exposure to individual counterparties ments are bilateral contracts intended to reduce and on the inherent liquidation effects. Stress presettlement credit risk in the event that a testing also should consider liquidity impacts on counterparty becomes insolvent before settle- underlying markets and positions, and their ment. Upon default, the nondefaulting party nets effect on the value of any collateral received. gains and losses with the defaulting counter- Moreover, stress-testing results should be incor- party to a single payment for all covered trans- porated in senior management reports and pro- actions. All credit-risk-exposure measures should vide sufficient information to trigger risk- fully reflect the existence of such legally binding reducing actions when necessary. Simply netting agreements as well as any other credit applying higher confidence intervals or longer enhancements. time horizons to potential future exposure mea- Some financial institutions measure potential sures may not capture the market and exposure credit-risk exposures on a portfolio basis, where dynamics under turbulent market conditions, information systems allow and incorporate net- particularly as they relate to the interaction ting (both within and across products, business between market, credit, and liquidity risk. lines, or risk factors) and portfolio correlation Examiners should determine whether stress test- effects to construct a more comprehensive coun- ing has led to risk-reducing actions or a redefi- terparty exposures measure. The portfolio nition of the institution’s risk appetite under approach recognizes the improbability that all appropriate circumstances. transactions with a given counterparty will reach their maximum potential exposure at the same time as is implicitly assumed under the transac- Global Exposures tions approach. The portfolio approach uses simulation modeling to calculate aggregate While an institution may use various methods to exposures through time for each counterparty. measure the credit exposure of specific types of As discussed in section 2070.1, ‘‘Legal Risk,’’ instruments, credit exposures for both loans and gains and losses may be offset in measuring capital-markets products should be consolidated potential credit-risk exposure with the portfolio by counterparty to enable senior management to approach. If legally enforceable netting is not in evaluate the overall counterparty credit risk. To place, then the sum of contracts with positive obtain an aggregate, institution-wide credit value under the simulation should be used as a exposure for a customer in the global credit-risk- measure of potential exposure. Contracts with management system, many institutions use the negative value should only be considered as an risk in commercial loans as a base and convert offset for gains when netting is deemed to be credit-risk exposures in capital-markets instru- legally enforceable. If executed correctly, the ments, both on- and off-balance-sheet, to the portfolio approach may provide a more realistic same base using loan-equivalent amounts. measurement of potential credit exposure for the Together these two measures can be added to portfolio than simply summing the potential any other credit exposures to get the total credit worst-case exposures for each instrument in the exposure to a given counterparty. portfolio. Whatever approach is used, the credit- risk-management function should clearly define the measurement aggregation methodology and apply it consistently across all instruments and CREDIT ENHANCEMENTS types of capital-markets exposures. In addition, examiners should ensure that an As the derivatives market has expanded so has institution has adequate internal controls gov- the number of market participants with lower erning exposure estimation, including robust credit ratings. Accordingly, institutions have

Trading and Capital-Markets Activities Manual September 1999 Page 5 2020.1 Counterparty Credit Risk and Presettlement Risk increased the use of credit enhancements in the liquid assets (initial margin) and often involves derivatives marketplace. Some of the more com- calls for additional collateral based on a periodic mon credit enhancements include the following: marking to market of the position. This type of arrangement is intended to reduce the frequency • Collateral arrangements in which one or both of collateral movements and protect the institu- counterparties agree to pledge collateral, usu- tion against unanticipated swings in credit ally consisting of cash or liquid securities, to exposure. Collateral agreements can require secure credit exposures arising from deriva- either one or both counterparties to pledge tive transactions. collateral. Increasingly, collateral arrangements • Special-purpose vehicles (SPVs) that can be are being formed bilaterally, where either coun- separately capitalized subsidiaries or specially terparty may be asked to post collateral, depend- designed collateral programs organized to ing on whose position is out of the money. obtain a triple A counterparty credit rating. The use of collateral raises several important • Mark-to-market cash settlement in which coun- considerations. Similar to other credit enhance- terparties periodically mark transactions to ments, collateralization mitigates but does not market and make cash payments equal to their eliminate credit risk. To the extent that collateral net present value, thus reducing any exposure is sufficient, credit risk is transferred from the to a preset threshold. counterparty to the obligor of the collateral • Option-to-terminate or ‘‘close out’’ contracts instrument. However, institutions should ensure which give either counterparty, after an agreed- that overreliance on collateralization does not upon interval, the option to instruct the other compromise other elements of sound counter- party to cash settle and terminate a transaction party credit risk management, such as the due- based on the transaction’s net present value as diligence process. In addition, collateralization quoted by agreed-upon reference dealers. The may reduce credit risk at the expense of increas- existence of the option allows both parties to ing other risks, such as legal, operational, and view the transaction as having a maturity liquidity risk. For instance, heavy reliance on which is effectively reduced to the term of the collateral-management systems poses increased option. operational risk. Collateral agreements must be • Material-change triggers that convey the right monitored, the collateral posted must be tracked to change the terms of or terminate a contract and marked to market, and the physical safe- if a prespecified credit event occurs such as a keeping of the collateral must be ensured. Finally, rating downgrade, failure to pay or deliver, an the use of collateral is potentially more costly adverse change in the counterparty’s financial than other forms of credit enhancements, in part standing, or a merger event. Credit events may because it requires a substantial investment in trigger the termination of a contract, the systems and back-office support. imposition of a collateral requirement, or The fundamental aspects of a collateral rela- stricter collateral terms. tionship are usually specified in a security agree- ment or in the credit annex of a master netting Credit enhancements and other nonprice terms agreement. The calculation of required collat- should be tailored to the counterparty and closely eral is usually based on the net market value of linked to assessments of counterparty credit the portfolio. The amount of required collateral quality. and appropriate margin levels are largely deter- mined by the volatility of the underlying port- folio, the frequency of collateral calls, and the type of counterparty. In general, the higher the Collateral Arrangements volatility of an underlying portfolio, the greater the amount of collateral and margin required. Collateral arrangements are becoming an increas- Frequent collateral calls will result in smaller ingly common form of credit enhancement in amounts of margin and collateral posted. Insti- the derivatives market. There are generally two tutions should be aware that if volatility increases types of collateral arrangements. In the first beyond what is covered in the predetermined type, the counterparty does not post collateral margin level, credit exposure to a counterparty until exposure has exceeded a prespecified may be greater than originally anticipated. For amount (threshold). The second type of collat- this reason, institutions generally revalue both eral arrangement requires an initial pledge of the portfolio and the collateral regularly.

September 1999 Trading and Capital-Markets Activities Manual Page 6 Counterparty Credit Risk and Presettlement Risk 2020.1

The amount of collateral and margining levels valuation disputes, the party holding the collat- also should be based on the type of counterparty eral, the window of time allowed for moving involved. Policies should not be overly broad so collateral, trigger thresholds, closeout rights, as to compromise the risk-reducing nature of and rehypothecation. In addition, these policies collateral agreements with certain types of coun- and procedures should address the process of terparties. Indeed, policies governing collateral overriding credit limits, making margin calls, arrangements should specifically define those and waiving margin requirements. cases in which initial and variation margin is In September 1998, the Committee of Pay- required, and should explicitly identify situa- ment and Settlement Systems and the Euro- tions in which lack of transparency, business- currency Standing Committee (now the Com- line risk profiles, and other counterparty charac- mittee on the Global Financial System) of the teristics merit special treatment. When central banks of the Group of Ten countries appropriate to the risk profile of the counter- published a report entitled ‘‘OTC Derivatives party, policies should specify when margining Settlement Procedures and Counterparty Risk requirements based on estimates of potential Management’’ that recommended that deriva- future exposures might be warranted. tives counterparties carefully assess the liquid- Securities that are posted as collateral are ity, legal, custody, and operational risks of using generally subject to haircuts, with the most collateral. The report made the following spe- liquid and least volatile carrying the smallest cific recommendations to counterparties: haircuts. Acceptable forms of collateral tradi- tionally include cash and U.S. Treasury and • Counterparties should review the backlogs of agency securities. However, letters of credit, unsigned master agreements and outstanding Eurobonds, mortgage-backed securities, equi- confirmations and take appropriate steps to ties, and corporate bonds are increasingly being manage the risks effectively. considered acceptable collateral by some market • Counterparties should assess the potential for participants. Institutions that actively accept col- reducing backlogs and associated risks through lateral should ensure that haircuts for instru- use of existing or new systems for the elec- ments accepted as collateral are reviewed at tronic exchange or matching of confirmations. least annually to reflect their volatility and liquidity. • Counterparties should assess the potential for Collateral arrangements sometimes include clearinghouses for OTC derivatives to reduce rehypothecation rights, in which a counterparty credit risks and other counterparty risks, tak- repledges collateral to a third party. Institutions ing into account the effectiveness of the clear- with rehypothecation rights may be exposed to inghouse’s risk-management procedures and the risk that the third party holding the rehypoth- the effects on contracts that are not cleared. ecated collateral may fail to return the collateral or may return a different type of collateral. In March 1999, the International Swaps and Institutions should ensure that they review the Derivatives Association (ISDA) published its legal issues arising from collateral arrangements 1999 collateral review. The ISDA collateral carefully, especially when rehypothecation rights review was an assessment of the effectiveness of are involved and when different locales can existing collateral-management practices and rec- claim jurisdiction over determining the effective- ommendations for improvements in those prac- ness of security interests. Rehypothecation of tices. Among the market-practice recommenda- collateral may have an impact on a counterpar- tions for counterparties arising from the ISDA ty’s right to set off the value of the collateral collateral review were the following: against amounts owed by a defaulting counter- party. In addition, institutions should review the • Counterparties should understand the role of laws of jurisdictions to which they are poten- collateral as a complement to, not a replace- tially subject to determine the potential effects ment for, credit analysis tailored to the risk of stays and the competing claims of other profile presented by the counterparty, type of creditors on the enforcement of security interests. transaction, size of potential future exposure, Institutions with collateralization programs term of risk, and other relevant factors. should establish policies and procedures that • Counterparties should assess the secondary address position and collateral revaluations, the risks of collateralization, for example: frequency of margin calls, the resolution of — Legal risk. The risk that close-out netting

Trading and Capital-Markets Activities Manual September 1999 Page 7 2020.1 Counterparty Credit Risk and Presettlement Risk

provisions under a master agreement are counterparty-specific situations and risk pro- not enforceable upon the counterparty’s files. For example, close-out provisions based insolvency, thus allowing the bankruptcy on annual events or material-change triggers representative to ‘‘cherry pick’’ and repu- based on long-term performance may prove diate contracts. ineffective for counterparties whose risk profiles — Operational risk. The risk that deficiencies can change rapidly. in information systems or internal controls In evaluating an institution’s management of could result in losses. its collateral arrangements and other credit en- — Credit risk. Replacement-cost risk when a hancements, examiners should assess not only counterparty defaults prior to settlement, the adequacy of policies but should determine and settlement risk whether internal controls are sufficient to ensure — Correlation risk. Default may be highly that practices comply with these policies. correlated with the market value of the Accordingly, in reviewing targeted areas dealing contract, as was the case with dollar- with counterparty credit risk management, denominated instruments held by counter- examiners should identify the types of credit parties in emerging-market countries. enhancements and contractual covenants used — Liquidity risk. Close-out provisions trig- by an institution and determine whether the gered by a ratings downgrade may create institution has sufficiently assessed their substantial liquidity demands at a time adequacy relative to the risk profile of the when meeting those demands is particu- counterparty. Finally, examiners should be alert larly costly. to situations in which collateralized exposures • Counterparties should centralize and automate may be mis-estimated, and they should encour- the collateral function and reconciliation pro- age management at these institutions to enhance cedures and impose a rigorous control envi- their exposure-measurement systems and ronment. collateral-protection programs accordingly. • Counterparties should coordinate the collat- eral, payments, and settlement functions in order to maximize information flows regard- ing counterparties and markets in stress situ- ations. COUNTERPARTY ASSESSMENT • Counterparties should consider the use of a As with traditional banking transactions, an wider range of assets as collateral and accept independent credit function should conduct an cash when a collateral-delivery failure occurs. internal credit review before engaging in trans- (Counterparties often do not wish to accept actions with a prospective counterparty. Credit cash because of the costs of reinvestment.) guidelines should be employed to ensure that • Counterparties should establish clear internal limits are approved for only those counterparties policies and methodologies for setting initial that meet the appropriate credit criteria, incor- margins based on the volatility of the value of porating any relevant credit support. The credit- the derivative position. risk-management function should verify that • When setting haircut levels, counterparties limits are approved by credit specialists with should ensure that appropriate asset price sufficient signing authority. volatility measures are considered over the The quick credit-approval process often appropriate timeframe. required in trading operations may lead financial • Counterparties should ensure that collateral institutions to conduct only summary financial agreements address the potential for changes analysis. Institutions should ensure that the level in credit quality over the course of the trans- of financial analysis is adequate and that all action. transactions have formal credit approval. If the credit officers prefer not to establish a formal line for a new relationship, a transaction-specific Other Credit Enhancements written approval should be given based on the potential exposure from the transaction. In mak- Adequate polices should also govern the use of ing such one-off approvals, credit officers and material-change triggers and close-out provi- credit-risk management should keep settlement sions, which should take into account risks in mind.

September 1999 Trading and Capital-Markets Activities Manual Page 8 Counterparty Credit Risk and Presettlement Risk 2020.1

Broad policies that were structured in the ency may hinder market discipline on the risk- interests of flexibility to apply to all types of taking activities of counterparties—which may counterparties may prove inadequate for direct- have been the case with hedge funds. Banking ing bank staff in the proper review of the risks organizations should also understand their conter- posed by specific types of counterparties. The parties’ business purpose for entering into assessment of counterparties based on simple derivatives transactions with the institution. balance-sheet measures and traditional assess- Understanding the underlying business rationale ments of financial condition may be adequate for the transaction allows the institution to for many types of counterparties. However, evaluate the credit, legal, and reputational risks these assessments may be entirely insufficient that may arise if the counterparty has entered for those counterparties whose off-balance-sheet into the transaction to evade taxes, hide losses, positions are a source of significant leverage and or circumvent legal or regulatory restrictions. whose risk profiles are narrowly based on con- Even when credit-risk assessment policies centrated business lines, such as with hedge appear to be sufficiently defined, examiners funds and other institutional investors. should place increasing emphasis on ensuring General policies calling for annual counter- that existing practice conforms with both the party credit reviews are another example of stated objectives and intent of the organization’s broad policies that may compromise the integ- established policies. Quite often, in highly com- rity of the assessment of individual counterpar- petitive and fast-moving transaction environ- ties or types of counterparties—especially in ments, examiners found that the analyses speci- cases when a counterparty’s risk profile can fied in policies, such as the review of a change significantly over much shorter time counterparty’s ability to manage the risks of its horizons. Moreover, credit-risk assessment poli- business, were not done or were executed in a cies should properly define the types of analysis perfunctory manner. to be conducted for particular types of counter- Necessary internal controls for ensuring that parties, based on the nature of their risk profile. practices conform with stated policies include In addition to customizing fundamental analyses actively enforced documentation standards and based on the industry and business-line charac- periodic independent reviews by internal audi- teristics of a counterparty, stress testing may be tors or other risk-control units. Examiners should needed when a counterparty’s creditworthiness evaluate an institution’s documentation stan- may be adversely affected by short-term fluctua- dards and determine if internal reviews are tions in financial markets—especially when adequately conducted for business lines, prod- potential credit exposure to a counterparty ucts, exposures to particular groups of counter- increases when credit quality deteriorates. parties, and individual customers that exhibit A key responsibility of examiners has always significant growth or above-normal profitability. been to identify areas where bank practices may As always, examiners should evaluate the integ- not conform to stated policies. These efforts are rity of these internal controls through their own made especially difficult when bank policies transaction testing of such situations, using tar- lack sufficient granularity, or specificity, to prop- geted examinations and reviews. Testing should erly focus bank-counterparty risk assessments. include robust sampling of transactions with an Accordingly, examiners should ensure that a institution’s major counterparties in the targeted bank’s counterparty credit-risk assessment poli- area, as well as sufficient stratification to ensure cies are sufficiently defined to adequately address that practices involving smaller relationships the risk profiles of specific types of counterpar- also adhere to stated policies. ties and instruments. Policies should specify In stratifying samples and selecting counter- (1) the types of counterparties that may require parties and transactions on which to base tar- special consideration; (2) the types and fre- geted testing of practices and internal controls, quency of information to be obtained from such examiners should incorporate measures of counterparties; (3) the types and frequency of potential future exposure, regardless of whether analyses to be conducted, including the need for such exposures are collateralized. As evidenced and type of any stress-testing analysis; and by banks’ experience with hedge-fund relation- (4) how such information and analyses appro- ships in 1998, meaningful counterparty credit priately address the risk profile of the particular risks during periods of stress can go undetected type of counterparty. This definition in policy is if only unsecured exposures are used in transac- particularly important when limited transpar- tion testing.

Trading and Capital-Markets Activities Manual September 2002 Page 8.1 2020.1 Counterparty Credit Risk and Presettlement Risk

OTC and Exchange-Traded Instruments

Assessing the financial health of counterparties is a critical element in effectively identifying and managing credit-risk exposures. Before con- ducting transactions, institutions should conduct due-diligence assessments of their potential credit-risk exposure to all of the parties that might be involved in the transaction. For OTC transactions, this generally involves a single counterparty. For exchange-traded instruments, involved parties may include brokers, clearing firms, and the exchange’s clearinghouse. In exchange-traded transactions, the clearinghouse guarantees settlement of all transactions. An institution’s policies should clearly iden- tify criteria for evaluating and approving both OTC counterparties and, for exchange-traded instruments, all entities related to a transaction. For counterparties, brokers, and dealers, the approval process should include a review of their financial statements and an evaluation of the counterparty’s ability to honor its commit- ments. An inquiry into the general reputation of the counterparty, dealer, or broker is also appro- priate. At a minimum, institutions should con- sider the following in establishing relationships with counterparties and the dealers and brokers used to conduct exchange-traded transactions:

¥ the ability of the counterparty; broker; and clearinghouse and its subsidiaries, affiliates, or members to fulfill commitments as evidenced by capital strength, liquidity, and operating results ¥ the entity’s general reputation for financial stability and fair and honest dealings with customers ¥ a counterparty’s ability to understand and manage the risks inherent in the product or transaction ¥ information available from state or federal regulators, industry self-regulatory organiza- tions, and exchanges concerning any formal

September 2002 Trading and Capital-Markets Activities Manual Page 8.2 Counterparty Credit Risk and Presettlement Risk 2020.1

enforcement actions against the counterparty, COUNTERPARTY CREDIT RISK dealer, broker, its affiliates, or associated LIMITS personnel

With regard to exchange-traded transactions, Exposure-monitoring and limit systems are criti- institutions should assure themselves that suffi- cal to the effective management of counterparty cient safeguards and risk-management practices credit risk. Examiners should focus special are in place at the involved entities to limit attention on the policies, practices, and internal potential presettlement and settlement risk controls of banking institutions. An effective exposure. Exchange clearinghouses generally exposure-monitoring system consists of estab- use a variety of safeguards to limit the like- lishing meaningful limits on the risk exposures lihood of defaults by clearing members and an institution is willing to take, independent ensure that there are adequate resources to meet ongoing monitoring of exposures against such any losses should a default occur. These safe- limits, and adequate controls to ensure that guards can include (1) financial and operating reporting and meaningful risk-reducing action requirements for clearinghouse membership, takes place when limits are exceeded. Since an (2) margin requirements that collateralize cur- effective exposure-monitoring and limit process rent or potential future exposures and periodic depends on meaningful exposure-measurement settlements of gains and losses that are struc- methodologies, examiners should closely evalu- tured to limit the buildup of these exposures, ate the integrity of these systems at institutions (3) procedures that authorize resolution of a that may have inadequate exposure-measurement clearing member’s default through close-out of systems—especially regarding the estimation of its proprietary positions and transfer or close-out potential future exposures. Overly conservative of its client’s positions, and (4) the maintenance measures or other types of less-than-meaningful of supplemental clearinghouse resources (for exposure measurements can easily compromise example, capital, asset pools, credit lines, guar- well-structured policies and procedures. Such antees, or the authority to make assessments on situations can lead to limits being driven prima- nondefaulting members) to cover losses that rily by customer demand and used only to define may exceed the value of a defaulting member’s and monitor customer facilities, instead of using margin collateral and to provide liquidity during limits as strict levels, defined by credit manage- the time it takes to realize the value of that ment, for initiating exposure-reducing actions. margin collateral. Institutions should assure Limits should be set on the amounts and types themselves of the adequacy of these safeguards of transactions authorized for each entity before before conducting transactions on exchanges. execution of any trade. Distinct limits for pre- Due diligence is especially important when settlement and settlement risk should be estab- dealing with foreign exchanges; institutions lished and periodically reviewed and recon- should be cognizant of differences in the regu- firmed. Both overall limits and product sublimits latory and legal regimes in these markets. Sub- may be established. For example, a customer stantial differences exist across countries, may be assigned a foreign-exchange trading exchanges, and clearinghouses in fundamental line, while interest-rate or cross-currency swaps areas such as mutualization of risk, legal rela- are approved against the general line on a tionships between the clearinghouse and its transaction-by-transaction basis. In some cases, members, legal relationships between the clear- the approach to assigning sublimits reflects the inghouse and customers, procedures in the event pace of transactions in the marketplace as well of default, and segregation of customer funds. as the amount of credit risk (largely a reflection These considerations are particularly important of tenor). The sum of product-specific sublimits for institutions such as futures commission mer- may well exceed the aggregate limit, reflecting chants (FCMs) that conduct trades for customers.1 management’s experience that all sublimits are not used simultaneously. In such cases, how- ever, the organization should have sufficient monitoring of global credit exposures to detect a breach of the global limit. The frequency with which credit exposures 1. See section 3030.1, ‘‘Futures Brokerage Activities and Futures Commission Merchants,’’ as well as the Federal are monitored depends on the size of the trading Reserve’s Bank Holding Company Supervision Manual. and derivatives portfolios and on the nature of

Trading and Capital-Markets Activities Manual March 1999 Page 9 2020.1 Counterparty Credit Risk and Presettlement Risk the trading activities. Active dealers should have risk-management systems and capabilities and counterparty credit exposure monitored daily. its internal control environment to make effec- Irrespective of how credit exposure is moni- tive decisions regarding the level of risk they are tored, the replacement cost should be calculated willing to assume. Institutions should be cau- daily and compared to the approved potential tioned to obtain supporting documentation for exposure figure for validity. the claims of fund managers. Unusual market movements may lead to rapid Counterparty credit risk management should accumulation of credit exposure. The creditwor- emphasize comprehensive stress testing across a thiness of counterparties can also change. variety of scenarios, with particular focus on Between its regular reviews of credit exposures, possible asset or position concentrations. Insti- the institution should have a mechanism that tutions should also determine the investor’s or guarantees timely recognition of either unusual fund’s ability to stress test its portfolio. In credit-exposure buildups or credit deterioration limiting counterparty credit risks through the in a counterparty. For institutions that are deal- use of collateral and other credit enhancements, ers in these markets, the monitoring should be it should be recognized that standard arrange- very frequent, and regular reviews should be ments that may be suitable for most counterpar- conducted with the same frequency as for other ties may not be suitable for counterparties that significant credit customers. have the potential to quickly change their port- Management should have procedures for con- folios, such as hedge funds. For example, 12- trolling credit-risk exposures when they become month rolling average close-out provisions may large, a counterparty’s credit standing weakens, be inappropriate for counterparties engaged in or the market comes under stress. Management active trading, where a prior month’s gains can should show clear ability to reduce large posi- mask serious losses in the current month. Insti- tions. Common ways of reducing exposure tutions that deal with institutional investors and include halting any new business with a coun- hedge funds should have the policies, proce- terparty and allowing current deals to expire, dures, and internal controls in place to ensure assigning transactions to another counterparty, that these exposures are measured, monitored, and restructuring the transaction to limit poten- and controlled by management on an on-going tial exposure or make it less sensitive to market basis. volatility. Institutions can also use many of the The Basle Committee on Banking Supervi- credit enhancement tools mentioned earlier to sion released a report that analyzed the risks manage exposures that have become uncomfort- posed by hedge funds to creditors and published ably large. sound practices standards for interactions with hedge funds. The sound practices standards identified areas in which bank practices could be enhanced, including— INSTITUTIONAL INVESTORS AND HEDGE FUNDS • establishing clear policies and procedures that define the bank’s risk appetite and drive the Examiners should pay increasing attention to the process for setting credit standards; appropriateness, specificity, and rigor of the • obtaining adequate information on which to policies, procedures, and internal controls that base sound judgments of counterparty credit institutions use in assessing, measuring, and quality; limiting the counterparty credit risks arising • performing adequate due diligence, including from their trading and derivative activities with setting standards for risk management by institutional investors in general, and particu- counterparties that are commensurate with the larly with hedge funds. In the area of counter- level of sophistication and complexity of their party assessment, institutions doing business activities; with institutional investors and hedge funds • developing meaningful limits for derivatives should have sufficient information on which to counterparties and more accurate measures of assess the counterparty and its inherent risks, potential future exposure; including information on total leverage, both • adequately assessing and measuring unse- on- and off-balance-sheet, and firm strategies. cured exposures under collateralized deriva- Banks should conduct in-depth due-diligence tives transactions, and setting meaningful reviews of the effectiveness of a counterparty’s credit limits based on such assessments;

March 1999 Trading and Capital-Markets Activities Manual Page 10 Counterparty Credit Risk and Presettlement Risk 2020.1

• adequately stress-testing counterparty credit processing an agent’s trades for an unnamed risk under a variety of scenarios that take into counterparty. An effective and efficient back- account liquidity effects, and incorporating office process helps to ensure that the institution results into management decisions about risk is aware of the size of such exposures on a taking and limit setting; timely basis. • closely linking nonprice terms, including col- Similarly, institutions often manage the settle- lateral arrangements and termination provi- ment process with unnamed counterparties more sions, to assessments of counterparty credit closely than they do with traditional trading quality; and counterparties. Institutions often set settlement • timely monitoring counterparty transactions limits with unnamed counterparties so that large and credit exposures, including frequently sums are not settled on a single day. Institu- reassessing banks’ large exposures, counter- tions sometimes develop procedures that ensure party leverage, and concentration of counter- management is made immediately aware of party activities and strategies. settlement failures by unnamed counterparties.

OFF-MARKET OR PREFUNDED UNNAMED COUNTERPARTIES DERIVATIVES TRANSACTIONS Institutions that deal in products such as foreign Banking organizations may enter into off- exchange, securities, and derivatives sometimes market or prefunded derivatives contracts that face situations in which they are unaware of a are the functional equivalent of extensions of counterparty’s identity. Investment advisers or credit to trading counterparties. However, the agents typically conduct trades on behalf of their business or legal structure of some of these investment-management clients and do not pro- transactions may not readily convey their eco- vide the names of the ultimate counterparty on nomic function. Institutions should ensure that the grounds of confidentiality. In this situation, off-market or prefunded transactions are recog- the dealing institution will most likely never nized appropriately as credit extensions and know the identity of its counterparties. represented accurately and adequately in the Because institutions may not be able to assess institution’s internal risk-management processes, the creditworthiness of unnamed counterparties regulatory reports, and published financial state- in advance, institutions should develop policies ments. Moreover, since off-market or prefunded and procedures that define the conditions under transactions may have the potential to obscure which such transactions can be conducted. the true nature of a counterparty’s assets, liabili- Exposures arising from these transactions should ties, income, or expenses, these transactions be closely monitored and controlled. Given the may expose the originating banking organiza- potential reputational risks involved, trans- tion to increased reputational, legal, or credit actions with unnamed counterparties should be risk. Accordingly, banking organizations should restricted to reputable agents and firms. Institu- have formal policies, procedures, and internal tions that have significant relationships with controls for assessing the business purpose and investment advisers who trade on behalf of appropriateness of off-market or prefunded trans- undisclosed counterparties may wish to estab- actions with customers.2 lish agency agreements with those advisers. These agreements can provide for a series of representations and warranties from the invest- ment adviser on a variety of issues, including Typical Off-Market or Prefunded compliance with local and national laws and Derivatives Transactions regulations, particularly money-laundering regulations. Off-market or prefunded derivatives transac- Techniques used to reduce credit exposure to tions involve an up-front extension of credit to undisclosed counterparties include setting limits the counterparty, either in the form of new on the aggregate amount of business or on the types of instruments or transactions conducted 2. See the committee letter ‘‘Historical-Rate Rollovers: A Dangerous Practice’’ (December 26, 1991), Foreign Exchange with unnamed counterparties. In addition, insti- Committee, Federal Reserve Bank of New York tutions often pay particular attention when (www.newyorkfed.org/fxc/fx26.html).

Trading and Capital-Markets Activities Manual April 2003 Page 11 2020.1 Counterparty Credit Risk and Presettlement Risk money or as a rollover of existing debt. Examples side of the swap are paid on a traditional swap of some off-market or prefunded derivatives schedule. This is the functional equivalent of a transactions are described below. variable-rate loan.

Historical-Rate Rollovers Deep-in-the-Money Options

Often, historical-rate rollovers involve a deal- Sales of deep-in-the-money options can gener- er’s extension of a forward foreign-exchange ate large up-front premiums for the option seller. contract, on behalf of the customer, at off- Deep-in-the-money options are functionally market rates. In a typical rollover, the customer equivalent to loans to the seller because the will ask the dealer to apply the historical rate of option is almost certain to be exercised by the a maturing contract to the spot end of a new pair buyer. of contracts, which in effect extends the matur- ing contract and defers any gains or losses on it. Zero-Coupon Swaps Historical-rate rollovers virtually always involve the extension of credit from one party to the A zero-coupon swap (zero) is an interest-rate other. If the customer has a loss on the maturing swap agreement with the fixed-rate side based contract, the rollover would in effect represent a on a zero-coupon bond. With the agreement of loan by the dealer to the customer. If the the counterparty, the swap agreement may call customer has a profit, the dealer would in effect for a single fixed payment at maturity by the be borrowing from the customer. The resulting holder of the zero. The payments on the other loan or borrowing amount and associated side may follow typical swap interim-payment interest-rate charges are typically built into the schedules. Because of the payment mismatch, a forward points the dealer quotes to the customer. zero-coupon swap exposes one counterparty to significant credit risk and is the functional equivalent of a loan to the holder of the zero. Off-Market Swap Transactions

In off-market swap transactions, the contractual Reverse Zero-Coupon Swaps market rates (for example, the interest rate or currency-exchange rate) used in the swap trans- In a reverse zero-coupon swap, one counterparty action are varied from current market levels. makes a zero-coupon payment up front, and the This necessitates payment at the commencement other counterparty pays interest and principal of the transaction, by one counterparty to the payments over time. Like a zero-coupon swap, a other, to compensate for the off-market coupon. reverse zero-coupon swap is the functional equivalent of a term loan from the counterparty making the up-front payment. Prepaid Swaps A prepaid swap is generally a physical- Specific Risks of Off-Market or commodity forward contract featuring an up-front Prefunded Derivatives Transactions buyer payment that is equal to the present value of future commodity deliveries. The commodity Credit Risk deliveries may be priced at the spot prices in effect on each delivery date, making the trans- Off-market and prefunded derivative transac- action a loan secured by an obligation to deliver tions may expose a banking organization to the commodity at future market prices. Alterna- significant credit risk. Therefore, institutions tively, the contract may call for delivery of should adopt written credit policies and proce- specific quantities of the commodity on each dures guiding the use of these transactions. delivery date, in effect fixing future delivery Off-market and prefunded transactions should prices. A prepaid swap can also be an annuity- be treated as credit extensions for purposes of like transaction in which the present value of the lending institution’s credit-approval, risk- future payments on one side of a swap is paid up measurement, monitoring, and control systems. front, while (variable) payments on the other Failure to recognize the transaction as a credit

April 2003 Trading and Capital-Markets Activities Manual Page 12 Counterparty Credit Risk and Presettlement Risk 2020.1 extension could threaten centralized control over the books and records of both counterparties. the management of credit risk. Lending institu- These policies and procedures may include— tions should also consider establishing transac- tion sizes, maturity limits, and collateral guide- • written documentation from senior manage- lines for these types of nontraditional transactions. ment of the counterparty that is requesting the Procedures for obtaining appropriate sign-off off-market or prefunded transaction that from the finance function to ensure proper explains the reason for the request and con- accounting for the transaction should also be in firms that the request is a request for an place. extension of credit that is consistent with the firm’s internal policies; • written documentation from senior manage- Reputational Risk ment in the appropriate credit, finance, and accounting functions of the banking organiza- Banking organizations should establish written tion that explains the reason for the transac- policies and procedures for assessing the appro- tion and the accounting that will be followed priateness of and for approving off-market or to reflect the transaction on the institution’s prefunded derivatives transactions with a cus- books; and tomer. These policies should consider the • written confirmation to senior management of sophistication of the customer, the reason for the the counterparty that confirms the particulars transaction, whether the customer understands of the transaction and explicitly states the the risks in the transaction, whether the transac- implied loan amount and pricing terms. tion is consistent with the customer’s internal policies, and whether it has been approved at appropriate levels in the customer’s organiza- BLOCK TRADES WITH tion. Transactions generating significant profits INVESTMENT ADVISERS or losses, nontraditional transactions, and trans- actions or patterns of activity that may not be Frequently, investment advisers or agents will compatible with a customer’s business lines or bundle together trades for several clients, par- risk profile should be referred to senior manage- ticularly in the case of mutual funds and hedge ment of both the banking organization and the funds.3 Most of these trades are accompanied counterparty. Importantly, in marketing off- by information about how the trade should be market or prefunded transactions, institutions allocated among the funds for which it was should ensure that the transactions are presented executed, or they are subject to standing alloca- and described in a manner consistent with their tion information. Occasionally, investment true economic substance. advisers may fail to give institutions timely allocation information. Institutions should be concerned that such delays do not become Legal Risk habitual. When significant investment-adviser relationships exist, institutions should adopt poli- Even if a banking organization properly markets cies requiring that all transactions be allocated an off-market or prefunded derivatives transac- within some minimum period (for example, by tion, the organization may be faced with repu- the end of the business day). The credit depart- tational and legal risk exposure if its counter- ment should be promptly notified of any excep- party mischaracterizes the transaction in tions to such policies. regulatory or public reports. Failure to ensure Many institutions track the allocation arrange- that the management of both counterparties ments made by investment advisers. While late understands and signs off on a transaction allocations or frequent changes to allocation increases the risk that the transaction may be mischaracterized. To manage this risk, banking 3. The Securities and Exchange Commission, in a number organizations should adopt specific written poli- of no-action letters, has permitted this practice as long as the cies and procedures to ensure that senior man- adviser does not favor any one client over another, has a agement of the banking organization and the written allocation statement before the bundled order was counterparty fully understand and approve of placed, and receives the client’s written approval. See the following SEC letters: SMC Capital, Inc. (September 5, the transaction, including the appropriate repre- 1995), and Western Capital Management, Inc. (August 11, sentation and accounting of the transaction on 1977).

Trading and Capital-Markets Activities Manual April 2003 Page 13 2020.1 Counterparty Credit Risk and Presettlement Risk arrangements are often symptomatic of back- management system should reflect the size of office problems at the investment adviser, they the collateral program, frequency of collateral could also indicate that the investment adviser is revaluations and associated credit-exposure cal- engaging in unfair allocation. culations, nature of collateral-posting events, Sometimes the allocations provided by invest- and location of the collateral. The most effective ment advisers include counterparties that may collateral-management systems are global and not have established credit lines with the insti- have the ability to identify, post, value, stress- tution. Institutions should try to minimize such test, and monitor collateral. When collateral- situations and may wish to limit the percentage management systems are able to feed data into of any trade that can be allocated to counterpar- the front-office’s credit-line-availability system, ties that do not have an existing credit line with an institution can factor collateral into credit- the institution. approval decisions and, consequently, have a more accurate picture of unsecured credit risk. Institutions often maintain databases that detail the extent to which netting is applicable for a MANAGEMENT INFORMATION given counterparty. Depending on whether net- SYSTEMS ting is applicable, obligations are presented on a net or gross basis in credit-monitoring reports. Management information systems (MIS) used to Credit MIS should furnish adequate reports to control counterparty credit risk include systems credit personnel and business-line management. to monitor exposure levels; track customer lim- Daily reports should address significant counter- its and limit excesses; and, when used, value and party line usage and exceptions to limits. Less track collateral. Important inputs to these sys- frequent reports on the maturity or tenor of tems include transaction data, current market credit exposures, sector and industry concentra- values, and estimated potential credit exposures. tions, trends in counterparty exposures, trends in The primary purpose of these systems is to limit excesses, ‘‘watch lists,’’ and other pertinent provide comprehensive, accurate, and timely reports are also appropriate. Periodic summary credit information to credit-risk management reports on credit exposures should also be pre- personnel; front-office personnel; business-line sented to senior management and the board. and other senior management; and, ultimately, the board of directors. Institutions should ensure that their credit MIS are adequate for the range and scope of their trading and derivative activi- ties and that there are appropriate controls in DOCUMENTATION OF POLICIES place to ensure the integrity of these systems. As AND PROCEDURES part of the normal audit program, internal audit should review credit MIS to ensure their Current and sufficient documentation is critical integrity. to the effective operation of a credit-risk A critical element of MIS is their timeliness management program and is necessary to ensure in reflecting credit exposures. For derivative that the program is consistent with the stated contracts, institutions should be able to update intentions of senior management and the board. the current market values and potential credit The institution’s credit-policy manual is an exposures of their holdings throughout the life important tool for both auditors and examiners, of a contract. The frequency of updates for as well as an important resource for resolving credit-risk management purposes often depends any disputes between credit-risk management on the complexity of the product and the volume and traders or marketers. of trading activity. More sophisticated systems All policies and procedures specific to credit- provide intraday exposure numbers that enable risk management for trading should be added to the front office to determine, without any addi- the financial institution’s overall credit-policy tional calculations, whether a proposed deal will manual. Procedures should include limit- cause a credit excess. approval procedures, limit-excess and one-off Institutions that use collateral to manage credit approval procedures, exposure-measurement risk usually maintain collateral-management sys- methodologies, and procedures for accommodat- tems for valuation and monitoring purposes. ing new products and variations on existing The sophistication of an institution’s collateral- products. Policies should also address the meth-

April 2003 Trading and Capital-Markets Activities Manual Page 14 Counterparty Credit Risk and Presettlement Risk 2020.1 odologies for assessing credit-loss reserves for the available limit to a counterparty before trading operations. When established, such entering into a deal. Signed over-limit or one- reserves should take into account both current off approvals should also be tracked down and and potential future exposure. Credit-approval kept in a file for historical records. A log should documentation should also be closely tracked by be maintained for all missing signed approvals, the credit-risk-management function. All limit and approvals for new products should be approvals should be filed by counterparty and maintained. made available to traders so that they know

Trading and Capital-Markets Activities Manual September 2002 Page 15 Counterparty Credit Risk and Presettlement Risk Examination Objectives Section 2020.2

1. To evaluate the organizational structure of procedures, and legal and operational sup- the credit-risk-management function. port relating to the institution’s use of credit 2. To evaluate the adequacy of internal credit- enhancements. risk-management policies and procedures 11. To determine if the institution has imple- relating to the institution’s capital-markets mented adequate policies and procedures and trading activities and to determine that that are sufficiently calibrated to the risk sufficient resources and adequate attention profiles of particular types of counterparties are devoted to the management of the risks and instruments to ensure adequate credit- involved in growing, highly profitable, or risk assessment, exposure measurement, potentially high-risk activitivies and prod- limit setting, and use of credit enhancements. uct lines. 12. To ensure the comprehensiveness, accuracy, 3. To ensure that actual operating practices and integrity of management information reflect such policies. systems that analyze credit exposures and 4. To identify the credit risks of the institution. to ensure that the methodology and auto- 5. To determine if the institution’s credit-risk- mated processing can accommodate net- measurement system has been correctly ting and other legal offset agreements, if implemented and adequately measures the applicable. institution’s credit risks. 13. To determine if the institution’s credit-risk- 6. To determine if the institution’s credit-risk- management system has been correctly management processes achieve an appropri- implemented and adequately measures the ate balance among all elements of credit- institution’s exposures. risk management, including both qualitative and quantitative assessments of counter- 14. To determine if the institution has an effec- party creditworthiness; measurement and tive global risk-management system that evaluation of both on- and off-balance-sheet can aggregate and evaluate market, liquid- exposures, including potential future expo- ity, credit, settlement, operational, and legal sure; adequate stress testing; reliance on risks, and that management at the highest collateral and other credit enhancements; level is aware of the institution’s global and the monitoring of exposures against exposure. meaningful limits. 15. To determine if the institution is moving in 7. To determine how the institution measures a timely fashion to enhance its measure- difficult-to-value exposures. ment of counterparty-credit-risk exposures, 8. To determine if senior management and the including the refinement of potential future board of directors of the institution under- exposure measures and the establishment of stand the potential credit exposures of the stress-testing methodologies that better in- capital-markets and trading activities of the corporate the interaction of market and institution. credit risks. 9. To ensure that business-level management 16. To recommend corrective action when poli- has formulated contingency plans in the cies, procedures, practices, internal con- event of credit deterioration and associated trols, or management information systems market disruptions. are found to be deficient. 10. To evaluate the adequacy of the policies,

Trading and Capital-Markets Activities Manual September 1999 Page 1 Counterparty Credit Risk and Presettlement Risk Examination Procedures Section 2020.3

These procedures are processes and activities gies used to measure current exposure that may be considered in reviewing the credit- and potential exposure. risk-management of trading and derivative b. Review credit-administration procedures. operations. The examiner-in-charge will estab- • Determine how frequently counter- lish the general scope of examination and work party credit conditions are analyzed with the examination staff to tailor specific areas and lines reviewed. This should be for review as circumstances warrant. As part of done no less frequently than annually. this process, the examiner reviewing a function • Assess whether management has dem- or product will analyze and evaluate internal onstrated an ability to identify down- audit comments and previous examination work- grades in creditworthiness between papers to assist in designing the scope of the reviews. examination. In addition, after a general review • Determine if credit-risk-management of a particular area to be examined, the examiner staff demonstrate an ability to work should use these procedures, to the extent they out of positions with counterparties are applicable, for further guidance. Ultimately, whose credit quality has deteriorated. it is the seasoned judgment of the examiner and • Check that limits are in place for the examiner-in-charge as to which procedures counterparties before transacting a deal. are warranted in examining any particular If the institution relies on one-off activity. approvals, check that the approval pro- cess is as formal as that for counter- 1. Review the credit-risk-management party limits. organization. c. Review contingency credit-risk plans for a. Check that the institution has a credit- adequacy. risk-management function with a sepa- d. Review accounting and revaluation rate reporting line from traders and policies and procedures. Determine that marketers. revaluation procedures are appropriately b. Determine if credit-risk-control person- controlled. nel have sufficient authority in the insti- e. Determine the extent to which manage- tution to question traders’ and marketers’ ment relies on netting agreements. Deter- decisions. mine if aggregation of exposure assumes c. Determine if credit-risk management is netting, and check that netting agree- involved in new-product discussions in ments are in place and that legal research the institution. is performed to justify management’s 2. Identify the institution’s capital-markets and confidence in the enforceability of the trading activities and the related balance- netting agreements. sheet and off-balance-sheet instruments. 4. Determine the credit rating and market Obtain copies of all risk-management reports acceptance of the institution as a counter- prepared by the institution. Using this party in the markets. information, evaluate credit-risk-control per- 5. Obtain all management information analyz- sonnel’s demonstrated knowledge of the ing credit risk. products traded by the institution and their a. Determine the comprehensiveness, accu- understanding of current and potential racy, and integrity of analysis. exposures. b. Review valuation and simulation meth- 3. Obtain and evaluate the adequacy of risk- ods in place. management policies and procedures for c. Review stress tests analyzing changes in capital-markets and trading activities. credit quality, including deterioration of a. Review credit-risk policies, procedures, credit due to changing macroeconomic and limits. Determine whether the risk- conditions. Review stress-testing meth- measurement model and methodology odologies to determine the extent to adequately address all identified credit which they incorporate both credit and risks and are appropriate for the institu- market risk. tion’s activities. Review the methodolo- d. Review potential future exposure calcu-

Trading and Capital-Markets Activities Manual September 1999 Page 1 2020.3 Counterparty Credit Risk and Presettlement Risk: Examination Procedures

lations to determine whether they reflect tion’s use of credit enhancements. realistic measures of exposure in both a. Review collateralization policies and normal and stressed markets. procedures. e. Determine whether the management • Determine the frequency of margin information reports accurately reflect calls and portfolio and collateral risks and whether reports are provided to revaluations. the appropriate levels of management. • Ensure that legal agreements are in 6. Determine if any of the institution’s coun- place and that the fundamental aspects terparties have recently experienced credit of collateral relationships are specified downgrades or deteriorations and whether in the agreements. the institution’s trading activities have been • Review the policies for determining affected. If so, determine the institution’s the types of acceptable collateral, hair- response. cuts on the collateral, and margin 7. Review documentation that evidences credit- requirements. risk management’s adherence to its program. b. Determine whether the institution has a. Obtain copies of written approvals for rehypothecation rights. Determine limit excesses or one-off approvals. whether appropriate policies and pro- Determine the timeliness of these cedures are in place to manage the approvals. risks associated with collateral b. Select a sample of master agreements rehypothecation. to ensure that each counterparty with c. Ensure that collateral-management sys- whom management nets exposure for tems and operational internal controls risk-management purposes has signed a are fully documented and able to support master agreement. Review the master the institution’s credit enhancement agreement aging report of unsigned activity. master agreements to ensure adequate 13. Determine whether policies and procedures chasing procedures are in place. reflect the risk profiles of particular coun- 8. Establish that the institution is following its terparties and instruments. If the institution internal policies and procedures. Determine trades with institutional investors, hedge whether the established limits adequately funds, or unnamed counterparties, deter- control the range of credit risks. Determine mine if the institution has an overall limit on that the limits are appropriate for the insti- trading with these types of counterparties. tution’s level of activity. Determine whether 14. Determine whether appropriate policies and management is aware of limit excesses and procedures are in place if the institution takes appropriate action when necessary. engages in block trades with investment 9. Determine whether the internal-audit and advisors. independent risk-management functions a. Determine if the institution has a policy adequately focus on growth, profitability, that all trades not allocated at the time of and risk criteria in targeting their reviews. the trade must be allocated by the end of 10. Determine whether the institution has the trading day. Determine whether established an effective audit trail that exceptions to such a policy are moni- summarizes exposures and management tored by the credit area. approvals with the appropriate frequency. b. Determine how the institution deals with 11. Determine that business managers have investment advisors who are habitually developed contingency plans which reflect late with allocation information. actions to be taken in times of market c. Determine whether the institution limits disruption (and major credit deteriorations) the percentage of a block trade that can to minimize losses as well as the potential be allocated to counterparties without damage to the institution’s market-making credit lines. reputation. These should include controls 15. Recommend corrective action when poli- over the settlement process. cies, procedures, practices, internal con- 12. Obtain and evaluate the adequacy of poli- trols, or management information systems cies and procedures relating to the institu- are found to be deficient.

September 1999 Trading and Capital-Markets Activities Manual Page 2 Counterparty Credit Risk and Presettlement Risk Internal Control Questionnaire Section 2020.4

1. Review the credit-risk-management • Can management identify downgrades organization. in creditworthiness between reviews? a. Does the institution have a credit-risk- • Has credit-risk-management staff management function with a separate demonstrated an ability to work out of reporting line from traders and marketers? positions with counterparties whose b. Do credit-risk-control personnel have credit quality has deteriorated? sufficient credibility in the institution to • Are limits in place for counterparties question traders’ and marketers’ before transacting a deal? If the insti- decisions? tution relies on one-off approvals, is c. Is credit-risk management involved in the approval process as formal as that new-product discussions in the for counterparty limits? institution? c. Have limits been approved by the board 2. Identify the institution’s capital-markets and of directors? trading activities and the related balance- d. Have policies, procedures, and limits sheet and off-balance-sheet instruments and been reviewed and reapproved within the obtain copies of all risk-management reports last year? prepared. e. Are credit-risk policies, procedures, and a. Do summaries identify all the institu- limits clearly defined? tion’s capital-markets products? f. Are the credit limits appropriate for the b. Define the role that the institution takes institution and its level of capital? for the range of capital-markets prod- g. Are there contingency credit-risk plans? ucts. Determine the instruments used to h. Are there appropriate accounting and hedge these products. Is the institution revaluation policies and procedures? an end-user, dealer, or market maker? If i. Does management rely on netting so, in what products? agreements? c. Do credit-risk-control personnel demon- • Does aggregation of exposure assume strate knowledge of the products traded netting? by the institution? Do they understand • Are netting agreements in place and the current and potential exposures to the has legal research been performed institution? to justify management’s confidence 3. Does the institution have comprehensive, in the enforceability of the netting written risk-management policies and pro- agreements? cedures for capital-markets and trading 4. Has there been a credit-rating downgrade activities? for the examined institution? What has been a. Review credit-risk policies and the market response to the financial institu- procedures. tion as a counterparty in the markets? • Do the risk-measurement model and 5. Obtain all management information analyz- methodology adequately address all ing credit risk. identified credit risks? Are the risk- a. Is management information comprehen- measurement model and methodology sive and accurate and is the analysis appropriate for the institution’s sound? activities? b. Are the simulation assumptions for a • Do the policies explain the board of normal market scenario reasonable? directors’ and senior management’s c. Are stress tests analyzing changes in philosophy regarding illiquid markets credit quality appropriate? Are the mar- and credit events (downgrades/ ket assumptions reasonable given credit deteriorations)? deterioration of concentrations? Do stress- b. Review credit-administration procedures. testing methodologies incorporate both • Are counterparty credit conditions credit and market risk? analyzed and lines reviewed with d. Are calculations of potential future adequate frequency? (This should be exposure realistic in both normal and done no less frequently than annually.) stressed markets?

Trading and Capital-Markets Activities Manual September 1999 Page 1 2020.4 Counterparty Credit Risk and Presettlement Risk: Internal Control Questionnaire

e. Do management information reports c. Does the institution have policies speci- accurately reflect risks? Are reports fying the types of acceptable collateral, provided to the appropriate levels of haircuts on the collateral, and margin management? requirements? How often are these poli- 6. Have any of the institution’s counterparties cies reviewed by management? recently experienced credit downgrades or d. Does the institution have rehypotheca- deteriorations? If so, how have the institu- tion rights? tion’s trading activities been affected and • Does the institution have policies and what was the institution’s response? procedures in place to manage the risk 7. Review documentation that evidences credit that a third party holding rehypoth- management’s adherence to its program. ecated collateral may fail to return the a. Does the institution maintain copies of collateral or may return a different written approvals for limit excesses or type of collateral? one-off approvals? Are these prepared in • Does the institution have measures in a timely manner? place to protect its security interest in b. Obtain a sample of master agreements. the rehypothecated collateral? Are they appropriately signed? Are they e. Do material-change triggers and close- signed in a timely manner? Does the out provisions take into account institution have an appropriate chasing counterparty-specific situations and risk process to follow up on unsigned master profiles? agreements? f. Are the collateral-management system 8. Is the institution following its internal poli- and operational environment able to cies and procedures? Do the established support the institution’s collateral limits adequately control the range of credit activity? risks? Are the limits appropriate for the 13. Does the institution trade with institu- institution’s level of activity? Is manage- tional investors, hedge funds, or unnamed ment aware of limit excesses? Does man- counterparties? agement take appropriate action when a. Does the institution place an overall limit necessary? on trading with these types of 9. Do the internal audit and independent risk- counterparties? management functions adequately focus on growth, profitability, and risk criteria in b. Are credit officers aware of all cases targeting their reviews? in which a counterparty’s identity is 10. Has the institution established an effective unknown? audit trail that summarizes exposures and 14. Does the institution engage in block trades management approvals with the appropriate with investment advisors? frequency? Are risk-management, revalua- a. Does the institution have a policy that all tions, and closeout valuation reserves sub- trades not allocated at the time of the ject to audit? trade must be allocated by the end of the 11. If any recent market disruptions affected the trading day? Are exceptions to the policy institution’s trading activities, what has been monitored closely by the credit area? the institution’s market response? b. How does the institution deal with invest- 12. Does the institution have comprehensive ment advisors who are habitually late written policies and procedures relating to with allocation information? its use of credit enhancements? c. Does the institution limit the percentage a. Does the institution revalue collateral of a block trade that can be allocated to and positions with adequate frequency? counterparties without credit lines? b. Are the fundamental aspects of collateral 15. Do policies and procedures generally reflect relationships reflected in legal the risk profiles of particular counter- agreements? parties and instruments?

September 1999 Trading and Capital-Markets Activities Manual Page 2 Counterparty Credit Risk and Settlement Risk Section 2021.1

Settlement risk is the risk of loss when an banks of the Group of Ten Countries, ‘‘Settle- institution meets its payment obligation under a ment in Foreign Exchange Transactions,’’ which contract (through either an advance of funds or was prepared under the auspices of the Bank for securities) before its counterparty meets a coun- International Settlements. In addition, the Board terpayment or delivery obligation. Failures to issued a policy statement, effective January 4, perform at settlement can arise from counter- 1999, that addresses risks relating to private party default, operational problems, market multilateral settlement systems (63 FR 34888, liquidity constraints, and other factors. Settle- June 26, 1998). ment risk exists for any traded product and is greatest when delivery is made in different time zones. For banking institutions, foreign-exchange SETTLEMENT-RISK- (FX) transactions are, perhaps, the greatest MANAGEMENT ORGANIZATION source of settlement-risk exposure. For large, money-center institutions, FX transactions can An institution’s process and program for man- involve sizable credit exposures amounting to aging its settlement risks should be commensu- tens of billions of dollars each day. Accordingly, rate with the range and scope of its activities. although the following general guidance can be Institutions with relatively small trading opera- applied to the settlement of all types of traded tions in noncomplex instruments may not need instruments, it focuses primarily on the settle- the same level of automated systems, policies, ment risks involved in FX transactions. and staff skills as do firms that are heavily Settlement risk has a number of dimensions engaged in FX transactions and other trading that extend beyond counterparty credit risk to activities. include liquidity, legal, operational, and system- The management of settlement risk should atic risks. Even temporary delays in settlement begin at the highest levels of the organization, can expose a receiving institution to liquidity with senior management exercising appropriate pressures if unsettled funds are needed to meet oversight of settlement exposures. Although the obligations to other parties. Such liquidity specific organizational approaches may vary exposure can be severe if the unsettled amounts across institutions, managing settlement risk for are large and alternative sources of funds must FX and other trading activities should be inte- be raised at short notice in turbulent or unrecep- grated into the overall risk management of the tive markets. In an extreme example, the finan- institution to the fullest extent practicable. Set- cial failure of a counterparty can result in the tling transactions can involve many different loss of the entire amount of funds. functional areas of an institution, including trad- ing, credit, operations, legal, risk assessment, As with other forms of credit risk, settlement branch management, and correspondent rela- risk should be managed through a formal and tions. Only senior management can effect the independent process with adequate senior man- coordination necessary to define, measure, man- agement oversight and should be guided by age, and limit settlement risks across such varied appropriate polices, procedures, and exposure functions. Accordingly, senior management limits. Measurement systems should provide should ensure that they fully understand the appropriate and realistic estimates of the settle- settlement risks incurred by the institution and ment exposures and should use generally accepted should clearly define lines of authority and measurement methodologies and techniques. The responsibility for managing these risks so that development of customer credit limits and the priorities, incentives, resources, and procedures monitoring of exposures against those limits is a across different areas can be structured to reduce critical control function and should form the exposures and mitigate risks. Staff responsible backbone of an institution’s settlement-risk- for all aspects of settlement-risk management management process. should be adequately trained. This section discusses settlement risks involved in trading activities, especially as they apply to FX transactions. A primary reference for this Measuring FX Settlement Exposures material is the 1996 report of the Committee on Payment and Settlement Systems of the central Settlements generally involve two primary

Trading and Capital-Markets Activities Manual March 1999 Page 1 2021.1 Counterparty Credit Risk and Settlement Risk events: the transmission of payment orders and The effect of an institution’s internal process- the actual advance or receipt of funds. In FX ing patterns on its settlement risk should also be transactions, it is important to distinguish a considered. The interval from the unilateral payment order, which is an instruction to make cancellation deadline for sold currency until a payment, from the payment, which involves an final receipt of bought currency is generally exchange of credits and debits on the accounts referred to as the period of irrevocability. The of a correspondent bank or the accounts of a full face value of the trade is at risk and the central bank when an interbank transfer takes exposure on this amount can last overnight and place. To avoid paying late delivery fees, banks up to one or two full days. If weekends and try to send their orders to their back office, holidays are included, the exposure can exist for branch, or correspondent bank on the day of several days. The total exposures outstanding trade or the next day. Since spot FX transactions during this interval constitutes an institution’s generally call for settlement on the second day minimum FX settlement exposure. after the trade, orders are transmitted one or two The process of reconciling payments received days before settlement. On settlement day, pay- with expected payments can also be a significant ment orders are routed to the receiving institu- source of settlement-risk exposure. Many insti- tion through its correspondent or through the tutions may not perform this exercise until the domestic payment system for actual final pay- day after settlement. During this interval, there ment. Final payment may also be made through is uncertainty as to whether the institution has book-entry transfer if the two trading banks use received payments from particular counter- a common correspondent. parties. This period of uncertainty can create A bank’s settlement exposure runs from the increased exposure, if it extends past the unilat- time that its payment order for the currency sold eral cancellation deadline for payments on the can no longer be recalled or canceled with following day. For example, if an institution is certainty and lasts until the time that the cur- subject to a unilateral cancellation deadline of rency purchased is received with finality. In 3:00 a.m. on settlement day and payments from general, book-entry payments provide some- the prior day’s settlements are not reconciled what greater flexibility in terms of the ability to until mid-morning on the day following settle- cancel a transfer because their processing does ment, it may be too late to manage its payments not rely on domestic payment systems. How- exposure for that following day. In this case, the ever, even the cancellation of book-entry trans- maximum exposure from the evening of settle- fers is still subject to restrictions presented by an ment day to morning on the following day can institution’s internal processing cycles and com- amount to both the receipts expected on settle- munication networks as well as time zone dif- ment day (since their receipt has not been ferences between branch locations. In theory, reconciled) and the entire amount of the follow- institutions may retrieve and cancel payment ing day’s settlements (since they cannot be orders up until the moment before the funds are recalled.) In effect, an estimation of worst-case finally paid to a counterparty. However, many or maximum settlement exposures involves add- institutions have found that operational, eco- ing the exposures outstanding during the period nomic, and even legal realities may result in of irrevocability to the exposures outstanding payment orders becoming effectively irrevo- during the period of uncertainty. In a worst-case cable one or two business days before settlement situation, a bank might find itself in the position day. of having sent out payments to a counterparty on Institutions should specifically identify the one day when it had not been paid on the actual time past which they can no longer stop a previous day. payment without the permission of a third party. Many institutions commonly define and mea- This time is termed the unilateral cancellation sure their daily settlement exposures as the total deadline and should be used as a key parameter receipts coming due that day. In some cases, this in assessing settlement-risk exposure. The doc- technique may either understate or overstate umentation covering a correspondent’s ser- exposures. Simple measures using multiples of vice agreement generally identifies these cutoff daily receipts can also incorrectly estimate risk. times. In the event of a dispute, a correspondent For example, using simple ‘‘rules of thumb’’ of is likely to use the contractually agreed-upon two or three days of receipts may not sufficiently unilateral cancellation deadline as a binding account for the appropriate timing of the settle- constraint. ment processing across different currencies.

March 1999 Trading and Capital-Markets Activities Manual Page 2 Counterparty Credit Risk and Settlement Risk 2021.1

Appropriately measuring FX settlement expo- also be broken down into sublimits by product. sures requires an institution to explicitly identify Sublimits may also be specified by date since both the unilateral cancellation deadlines and settlement risk tends to be highest on the date of the reconciliation process times involved in each settlement. type of currency transaction. Accordingly, any Effective monitoring of exposures is crucial simple rules used to measure settlement expo- to the management of settlement risk, and insti- sures should be devised in such a way as to tutions with large settlement exposures should consider both the unilateral cancellation dead- strive to monitor payment flows on a real-time lines and the reconciliation process involved in basis. Institutions should look to reduce settle- settlement. Identifying the duration of the settle- ment risk by arranging with their correspondents ment process and the related exposures does and counterparties to minimize, as much as not require real-time tracking of all payments practicable, the timing of an exchange of pay- and can be accomplished through estimations ments. Collateral arrangements and net settle- based on standard settlement instructions and an ment agreements are also important settlement- understanding of the key milestones in the risk-management tools. settlement process. Institutions should have a The timely reconciliation of nostro accounts clear means of reflecting this risk in their expo- also helps to mitigate settlement risk. Institu- sure measurements. tions often assume they have settlement expo- Explicit consideration of unilateral cancella- sure until they can confirm final receipt of funds tion deadlines and the reconciliation process can or securities. Timely reconciliation enables an help an institution identify areas for improve- institution to determine its settlement exposure ment. If the time from its unilateral cancellation accurately and make informed judgments about deadline to reconciliation can be reduced to its ability to assume additional settlement risk. under 24 hours, then an exposure measure of one day’s receivables may provide a reasonable approximation of the duration and size of the Procedures settlement exposure to a counterparty. However, even then it must be recognized that overnight From time to time, institutions may misdirect and weekend exposure may remain and that their payments, and funds may fail to arrive in different currency pairs may require different promptly. While such mistakes may be inadvert- intervals, which might overlap. ent and corrected within a reasonable time, institutions should have procedures for quickly identifying fails, obtaining the funds due, and Limits taking steps to avoid recurrences. Some institu- tions deduct fails from counterparty limits and Institutions should ensure that settlement expo- review a series of fails to determine whether sures to counterparties are properly limited. FX their pattern suggests that the problem is not settlement exposures should be subject to an procedural. adequate credit-control process, including credit evaluation and review and determination of the maximum exposure the institution is willing to Netting take with a particular counterparty bank. The process is most effective when the counterpar- Banks can reduce the size of their counterparty ty’s FX settlement exposure limit is subject to exposures by entering into legally binding agree- the same procedures used to devise limits on ments for the netting of settlement payments. exposures of similar duration and size to the (Netting of payment obligations should not be same counterparty. For example, in cases where confused with the more common netting of the FX settlement exposure to a counterparty mark-to-market credit exposures of outstanding lasts overnight, the limit might be assessed in contracts such as swaps and forward FX.) Com- relation to the trading bank’s willingness to lend mon arrangements involving bilateral netting of fed funds on an overnight basis. settlement flows, including FXNet, ValueNet, Examiners should verify that the firm has set and Swift Accord, and bilateral agreements up separate presettlement and settlement lines following IFEMA or other contracts. Legally for counterparties. Settlement exposures may binding netting arrangements permit banks to

Trading and Capital-Markets Activities Manual March 1999 Page 3 2021.1 Counterparty Credit Risk and Settlement Risk offset trades against each other so that only the Risk-management measures to mitigate credit net amount in each currency must be paid or risk include monitoring participants’ financial received by each bank to its netting counter- condition; setting caps or limits on some or all parts. Depending on trading patterns, netting can participants’ positions in the system; and requir- significantly reduce the value of currencies ing collateral, margin, or other security. To settled. Netting also reduces the number of mitigate liquidity risk, institutions operating mul- payments to one per currency either to or from tilateral settlement systems may also consider the counterparty. external liquidity resources and contingency Netting is most valuable when counterparties arrangements. Liquidity risk also is mitigated by have a considerable two-way flow of business. timely notification of settlement failures to enable As a consequence, netting may only be attrac- participants to borrow funds to cover shortfalls. tive to the most active institutions. To take Operational risks are mitigated by contingency advantage of risk-reducing opportunities, insti- plans, redundant systems, and backup facilities. tutions should have a process for identifying Legal risks are mitigated by operating rules and attractive netting situations that would provide participant agreements, especially when transac- netting benefits that outweigh the costs involved. tions are not covered by an established body of Some banks use the procedure of informal law. payment netting. Based on trading patterns, Large multilateral settlement systems also back offices of each counterparty will confer by must meet the more comprehensive require- telephone on the day before settlement and ments of the Lamfalussy Minimum Standards agree to settle only the net amount of the trades established by the central banks of the Group of falling due. Since there may not be a legal Ten countries. Under the policy statement, in opinion underpinning such procedures, institu- determining whether a system must meet the tions should ensure that they develop a good Lamfalussy Minimum Standards, the Board will understanding of their ability to manage the consider whether the system settles a high pro- legal, credit, and liquidity risks of this practice. portion of large-value interbank or other finan- cial market transactions, has very large liquidity exposures that have potentially systemic conse- quences, or has systemic credit exposures rela- Multilateral Settlement Systems tive to the participants’ financial capacity.

The use of multilateral settlement systems by institutions raises additional settlement risks Contingency Planning insofar as the failure of one system participant to settle its obligations when due can have credit or Contingency planning and stress testing should liquidity effects on participants that have not be an integral part of the settlement-risk- dealt with the defaulting participant. The Board’s management process. Contingencies should be recent Policy Statement on Privately Operated established to span a broad spectrum of stress Multilateral Settlement Systems provides guid- events, ranging from internal operational diffi- ance on the risks of these systems. The policy culties to individual counterparty defaults to statement applies to systems with three or more broad market-related events. Adequate contin- participants that settle U.S. dollar payments with gency planning in the FX settlement-risk area an aggregate gross value of more than $5 billion includes ensuring timely access to key infor- on any one day. However, the principles set mation such as payments made, received, or in forth in the policy statement can be used to process; developing procedures for obtaining evaluate risks in smaller systems. information and support from correspondent The policy statement addresses the credit, institutions; and well-defined procedures for liquidity, operational, and legal risks of multi- informing senior management about impending lateral settlement systems and provides risk- problems. management measures for consideration. The policy statement is intended to provide a flex- ible, risk-based approach to multilateral Internal Audit settlement system risk management and should not be interpreted as mandating uniform, rigid Institutions should have in place adequate inter- requirements for all systems under its purview. nal audit coverage of the settlement areas to

March 1999 Trading and Capital-Markets Activities Manual Page 4 Counterparty Credit Risk and Settlement Risk 2021.1 ensure that operating procedures are adequate to accounting, systems development, and manage- minimize exposure to settlement risk. The scope ment information systems. In automated FX of the FX settlement internal audit program settlement processing, the internal audit depart- should be appropriate to the risks associated ment should have some level of specialization in with the market environment in which the insti- information technology auditing, especially if tution operates. The audit frequency should be the institution maintains its own computer adequate for the relevant risk associated with the facility. FX settlement area. Most institutions base audit frequency on a risk-assessment basis, and examiners should consult with the internal audit examiner to determine the adequacy of the Management Information Systems risk-assessment methodology used by the institution. In larger, more complex institutions, counter- Audit reports should be distributed to appro- party exposures and positions can run across priate levels of management, who should take departments, legal entities, and product lines. appropriate corrective action to address findings Institutions should have clearly defined methods pointed out by the internal audit department. and techniques for aggregating exposures across Audit reports should make recommendations for multiple systems. In general, automated aggre- minimizing settlement risk in cases where weak- gation produces fewer errors and a higher level nesses are cited. Management should provide of accuracy in a more timely manner than written responses to internal audit reports, indi- manual methods. cating its intended action to correct deficiencies The institution should have a contingency where noted. plan in place to ensure continuity of its FX When audit findings identify areas for settlement operations if its main production site improvement in the FX settlement area, other becomes unusable. This plan should be docu- areas of the institution on which this may mented and supported by contracts with outside have an impact should be notified. This could vendors, where appropriate. The plan should be include credit-risk management, reconciliations/ tested periodically.

Trading and Capital-Markets Activities Manual March 1999 Page 5 Market Liquidity Risk of Trading Activities Section 2030.1

Market liquidity risk refers to the risk of being tant impact on the liquidity of the market. unable to close out open positions quickly Market liquidity for an instrument may erode if, enough and in sufficient quantities at a reason- for example, a decline in the credit quality of able price. In dealer markets, the size of the certain market makers eliminates them as bid-asked spread of a particular instrument pro- acceptable counterparties. The impact on market vides a general indication as to the depth of the liquidity could be severe in those OTC markets market under normal circumstances. However, in which a particularly high proportion of activ- disruptions in the marketplace, contraction in ity is concentrated with a few market makers. In the number of market makers, and the execution addition, if market makers have increased con- of large block transactions are some factors that cerns about the credit risk of some of their may result in the widening of bid-asked spreads. counterparties, they may reduce their activities Disruptions in various financial markets may by reducing credit limits, shortening maturities, have serious consequences for a financial or seeking collateral for security—thus dimin- institution that makes markets in particular ishing market liquidity. instruments. These disruptions may be specific In the case of OTC off-balance-sheet instru- to a particular instrument, such as those cre- ments, liquid secondary markets often do not ated by a sudden and extreme imbalance in the exist. While cash instruments can be liquidated supply and demand for a particular product. and exchange-traded instruments can be closed Alternatively, a market disruption may be all- out, the ability to effectively unwind OTC encompassing, such as the stock market crash of derivative contracts is limited. Many of these October 1987 and the associated liquidity crisis. contracts tend to be illiquid, since they can The decision of major market makers to enter generally only be canceled by an agreement or exit specific markets may also significantly with the counterparty. Should the counterparty affect market liquidity, resulting in the widening refuse to cancel the open contract, the financial of bid-asked spreads. The liquidity of certain institution could also try to arrange an assign- markets may depend significantly on the active ment whereby another party is ‘‘assigned’’ the presence of large institutional investors; if these contract. Contract assignments, however, can be investors pull out of the market or cease to trade difficult and cumbersome to arrange. A financial actively, liquidity for other market participants institution’s ability to cancel these financial can decline substantially. contracts is a critical determinant of the degree Market liquidity risk is also associated with of liquidity associated with the instruments. the probability that large transactions in particu- Financial institutions that are market makers, lar instruments, by nature, may have a signifi- therefore, typically attempt to mitigate or elimi- cant effect on the transaction price. Large trans- nate market-risk exposures by arranging OTC actions can strain liquidity in markets that are contracts with other counterparties executing not deep. Also relevant is the risk of an unex- hedge transactions on the appropriate exchanges, pected and sudden erosion of liquidity, possibly or, most typically, a combination of the two. as a result of a sharp price movement or jump in In using these alternative routes, the financial volatility. This could lead to illiquid markets, in institution must deal with two or more times the which bid-asked spreads are likely to widen, number of contracts to cancel its risk exposures. reflecting declining liquidity and further increas- While market-risk exposures can be mitigated or ing transaction costs. completely canceled in this manner, the finan- cial institution’s credit-risk exposure increases in the process. OVER-THE-COUNTER INSTRUMENTS EXCHANGE-TRADED Market liquidity in over-the-counter (OTC) INSTRUMENTS dealer markets depends on the willingness of market participants to accept the credit risk of For exchange-traded instruments, counterparty major market makers. Changes in the credit risk credit exposures are assumed by the clearing- of major market participants can have an impor- house and managed through netting and margin

Trading and Capital-Markets Activities Manual September 2006 Page 1 2030.1 Market Liquidity Risk of Trading Activities arrangements. The combination of margin rate risk of a U.S. dollar interest-rate swap can requirements and netting arrangements of clear- be hedged with other swaps, forward rate agree- inghouses is designed to limit the spread of ments (FRAs), Eurodollar futures contracts, credit and liquidity problems if individual firms Treasury notes, or even bank loans and deposits. or customers have difficulty meeting their obli- The customized swap may appear to be illiquid gations. However, if there are sharp price changes but, if its component risks are not, then other in the market, the margin payments that clear- market makers would, under normal market inghouses require to mitigate credit risk can conditions, be willing and able to provide the have adverse effects on liquidity, especially in a necessary liquidity. Positions, however, can falling market. In this instance, market partici- become illiquid, particularly in a crisis. pants may sell assets to meet margin calls, further exacerbating liquidity problems in the marketplace. Many exchange-traded instruments are liquid DYNAMIC HEDGING RISKS only for small lots, and attempts to execute a large block can cause a significant price change. Certain unbundled market-risk exposures may Additionally, not all financial contracts listed on tend to be managed as individual transactions, the exchanges are heavily traded. While some while other risks may be managed on a portfolio contracts have greater trading volume than the basis. The more ‘‘perfectly hedged’’ the trans- underlying cash markets, others trade infre- actions in the portfolio are, the less the need to quently. Even with actively traded futures or actively manage residual risk exposures. Con- options contracts, the bulk of trading generally versely, the use of dynamic hedging strategies to occurs in short-dated contracts. Open interest, or cover open price-risk exposures exposes the the total transaction volume, in an exchange- financial institution to increased risk when traded contract, however, provides an indication hedges cannot be easily adjusted. (Dynamic of the liquidity of the contract in normal market hedging is not applied to an entire portfolio but conditions. only to the uncovered risk.) The use of dynamic hedging strategies and technical trading by a sufficient number of market participants can introduce feedback mechanisms that cause price ‘‘UNBUNDLING’’ OF PRODUCT movements to be amplified and lead to one-way RISK markets. Some managers may estimate exposure on the basis of the assumption that dynamic Both on- and off-balance-sheet products typi- hedging or other rapid portfolio adjustments will cally contain more than one element of market- keep risk within a given range even in the face risk exposure; therefore, various hedging instru- of large changes in market prices. However, ments may need to be used to hedge the inherent such portfolio adjustments depend on the exist- risk in one product. For example, a fixed coupon ence of sufficient market liquidity to execute the foreign currencyÐdenominated security has desired transactions, at reasonable costs, as interest-rate and foreign-exchange risks which underlying prices change. If a liquidity disrup- the financial institution may choose to hedge. tion were to occur, difficulty in executing the The hedging of the risks of this security would transactions needed to change the portfolio’s likely result in the use of both foreign-exchange exposure will cause the actual risk to be higher and interest-rate contracts. Likewise, the hedg- than anticipated. Those institutions who have ing of a currency interest-rate swap, for exam- open positions in written options and, thus, are ple, would require the same. short volatility and gamma will be the most By breaking the market risk of a particular exposed. product down into its fundamental elements, or The complexity of the derivatives strategies ‘‘unbundling’’ the risks, market makers are able of many market-making institutions can further to move beyond product liquidity to risk liquid- exacerbate the problems of managing rapidly ity. Unbundling not only eases the control of changing positions. Some financial institutions risk, it facilitates the assumption of more risk construct complex arbitrage positions, than was previously possible without causing sometimes spanning several foreign markets immediate market concern or building up unac- and involving legs in markets of very different ceptable levels of risk. For example, the interest- liquidity properties. For example, a dollar-

September 2006 Trading and Capital-Markets Activities Manual Page 2 Market Liquidity Risk of Trading Activities 2030.1 based institution might hedge a deutschemark have difficulty unwinding their positions with- convertible bond for both equities and foreign- out substantial losses. exchange risk and finance the bond with a dollar-deutschemark bond swap. Such a transac- tion may lock in many basis points in profit for MARKET LIQUIDITY RISK the institution but exposes it to considerable liquidity risk, especially if the arbitrage transac- LIMITS tion involves a combination of long-term and short-term instruments (for example, if the Risk measures under stress scenarios should be foreign-exchange hedging was done through estimated over a number of different time hori- three-month forwards, and the bond had a zons. While the use of a short time horizon, such maturity over one year). If key elements of the as a day, may be useful for day-to-day risk arbitrage transaction fall away, it may be management, prudent managers will also esti- extremely difficult for the institution to find suit- mate risk over longer horizons because the use able instruments to close the gap without of such a short horizon assumes that market sustaining a loss. liquidity will always be sufficient to allow posi- tions to be closed out at minimal losses. How- Multifaceted transactions can also be particu- ever, in a crisis, market liquidity, or the institu- larly difficult to unwind. The difficulty of tion’s access to markets, may be so impaired unwinding all legs of the transaction simulta- that closing out or hedging positions may be neously can temporarily create large, unhedged impossible, except at extremely unfavorable exposures for the financial institution. The abil- prices, in which case positions may be held for ity to control the risk profile of many of these longer than envisioned. This unforeseen length- transactions lies in the ability to execute trades ening of the holding period will cause a portfo- more or less simultaneously and continuously in lio’s risk profile to be much greater than envi- multiple markets, some of which may be subject sioned in the original risk measure, as the to significant liquidity risks. Thus, the examiner likelihood of a large price change (volatility) should determine whether senior management is increases with the horizon length. Additionally, aware of multifaceted transactions and can moni- the risk profiles of some instruments, such as tor exposures to such linked activity, and whether options, change radically as their remaining adequate approaches exist to control the associ- time to maturity decreases. Market makers ated risks in a dynamic environment. should consider the bid-asked spreads in normal markets and potential bid-asked spreads in dis- tressed markets and establish risk limits that consider the potential illiquidity of the instru- CONCENTRATED POSITIONS ments and products. Stress tests evidencing the ‘‘capital-at-risk’’ exposures under both sce- If positions, either long or short, are sizable narios should be available for examiner review. relative to the traded volume in a market, the Market makers should consider placing limits liquidation of those positions may disrupt the on the size of concentrated positions relative to market and cause a market participant to suffer the market volume. greater-than-expected losses when exiting the positions. Market makers should monitor the extent to which the positions they take constitute a large portion of open interest, volume, or some REVALUATION ISSUES other indicator of market size. Contracts that have different maturities or expirations, that are Market makers may establish closeout valuation traded on different exchanges, or that represent reserves covering open positions to take into even slightly different underlying products may consideration a potential lack of liquidity in the have different market liquidity characteristics marketplace upon liquidation, or closing out, of and should be monitored separately. Market market-risk exposures. These ‘‘holdback’’ makers should also (1) monitor the concentra- reserves are typically booked as a contra account tion of positions of counterparties relative to the for the unrealized gain account. Since transac- market and (2) recognize that counterparties that tions are marked to market, holdback reserves take on large positions relative to the market establish some comfort that profits taken into volume are taking on greater price risk and may current earnings will not dissipate over time as a

Trading and Capital-Markets Activities Manual September 2006 Page 3 2030.1 Market Liquidity Risk of Trading Activities result of ongoing hedging costs. Holdback ing. The examiner should ensure, however, that reserves may represent a significant portion of the analysis provided can demonstrate a quanti- the current mark-to-market exposure of a trans- tative methodology for the establishment of action or portfolio, especially for those transac- these reserves and that these reserves, if neces- tions involving a large degree of dynamic hedg- sary, are adequate.

September 2006 Trading and Capital-Markets Activities Manual Page 4 Market Liquidity Risk of Trading Activities Examination Objectives Section 2030.2

For examination objectives on funding liquidity 6. To ensure that business-level management risk, see section 3005.2. The following exami- has formulated contingency plans in the nation objectives relate to the examination of event of sudden illiquid markets. market liquidity risk. 7. To ensure the comprehensiveness, accuracy, and integrity of the management informa- 1. To evaluate the organizational structure of tion systems that analyze market liquidity the risk-management function. risk exposures. 2. To evaluate the adequacy of internal poli- 8. To determine if the institution’s liquidity- cies and procedures relating to the institu- risk management system has been correctly tion’s capital-markets and trading activities implemented and adequately measures the in illiquid markets and to determine that institution’s exposures. actual operating practices reflect such policies. 9. To determine if the open interest in exchange- 3. To identify the institution’s exposure and traded contracts is sufficient to ensure that potential exposure resulting from trading in management would be capable of hedging illiquid markets. or closing out open positions in one-way 4. To determine the institution’s potential directional markets. exposure if liquid markets suddenly become 10. To determine if management is aware of illiquid. limit excesses and takes appropriate action 5. To determine if senior management and the when necessary. board of directors of the financial institution 11. To recommend corrective action when poli- understand the potential market liquidity cies, procedures, practices, or internal con- risk exposures of the institution’s trading trols are found to be deficient. activities.

Trading and Capital-Markets Activities Manual April 2007 Page 1 Market Liquidity Risk of Trading Activities Examination Procedures Section 2030.3

These procedures list processes and activities holding company and subsidiary bank that can be reviewed during a full-scope exami- levels. Determine if contingency plans nation. The examiner-in-charge will establish are appropriate in light of (1) anticipated the general scope of examination and work with sources and uses of funds and (2) the the examination staff to tailor specific areas for timing of those sources and uses. Deter- review as circumstances warrant. As part of this mine if the plans identify stable, flexible, process, the examiner reviewing a function or and diverse sources of liquidity under product will analyze and evaluate internal audit both business-as-usual and stress comments and previous examination workpa- scenarios. pers to assist in designing the scope of exami- c. Review accounting and revaluation poli- nation. In addition, after a general review of a cies and procedures. Determine if revalu- particular area to be examined, the examiner ation procedures are appropriate. should use these procedures, to the extent they 4. Determine the credit rating and market are applicable, for further guidance. Ultimately, acceptance of the financial institution as a the seasoned judgment of the examiner and the counterparty in the markets. examiner-in-charge will determine which proce- 5. Obtain all management information analyz- dures are warranted in examining any particular ing market liquidity risk. activity. a. Determine the comprehensiveness, accu- For examination procedures on funding liquid- racy, and integrity of analysis. ity risk, see section 3005.3. The following b. Review bid-asked assumptions in a nor- examination procedures relate to the examina- mal market scenario. tion of market liquidity risk. c. Review stress tests that analyze the wid- ening of bid-asked spreads and deter- 1. Review the organization of liquidity-risk mine the reasonableness of assumptions. management. d. Determine whether management infor- a. Check that the institution has a liquidity- mation reports accurately reflect risks risk management function that has a and whether reports are provided to the separate reporting line from that of trad- appropriate level of management. ers and marketers. 6. Determine if any recent market disruptions b. Determine if liquidity-risk control per- have affected the institution’s trading activi- sonnel have sufficient credibility in the ties. If so, determine the institution’s market financial institution to question traders’ response. and marketers’ decisions. 7. Establish that the financial institution is c. Determine if liquidity-risk management following its internal policies and proce- is involved in new-product discussions dures. Determine whether the established in the financial institution. limits adequately control the range of liquid- 2. Identify the institution’s capital-markets and ity risks, the limits are appropriate for the trading activities and the related balance- institution’s level of activity, and manage- sheet and off-balance-sheet instruments. ment is aware of limit excesses and takes Obtain copies of all risk-management reports appropriate action when necessary. prepared by the institution in order to evalu- 8. Determine whether the institution has estab- ate liquidity-risk control personnel’s dem- lished an effective audit trail that summa- onstrated knowledge of the products traded rizes, with the appropriate frequency, expo- by the financial institution and their under- sures and management approvals. standing of current and potential exposures. 9. Determine whether management considered 3. Obtain and evaluate the adequacy of risk- the potential illiquidity of the markets when management policies and procedures for establishing the institution’s capital-at-risk capital-markets and trading activities. exposures. a. Review market-risk policies, procedures, a. Determine if the financial institution and limits. established capital-at-risk limits to address b. Review contingency plans for market both normal and distressed market liquidity risk both at the parent bank conditions.

Trading and Capital-Markets Activities Manual April 2007 Page 1 2030.3 Market Liquidity Risk of Trading Activities: Examination Procedures

b. Determine if senior management and the market-making reputation. board of directors are advised of market 11. On the basis of the information provided, liquidity risk exposures in illiquid mar- determine the institution’s exposure to sud- kets and of potential risk arising as a denly illiquid markets as a result of its result of distressed market conditions. dynamic hedging strategies. 10. Determine whether business managers have 12. Recommend corrective action when poli- developed contingency plans that specify cies, procedures, practices, internal con- actions to be taken in suddenly illiquid trols, or management information systems markets in order to minimize losses as well are found to be deficient. as potential damage to the institution’s

April 2007 Trading and Capital-Markets Activities Manual Page 2 Market Liquidity Risk of Trading Activities Internal Control Questionnaire Section 2030.4

For the internal control questionnaire on funding f. Are there contingency plans for market liquidity risk, see section 3005.4. The following liquidity risk? internal control questions relate to the examina- g. Do the policies address the use of tion of market liquidity risk. dynamic hedging strategies? 4. Has there been a credit-rating downgrade? 1. Review the liquidity-risk management What has been the market response to the organization. financial institution as a counterparty in the a. Does the institution have a liquidity-risk markets? Are instances in which the insti- management function that has a separate tution provides collateral to its counterpar- reporting line from that of traders and ties minimal? marketers? 5. Obtain all management information analyz- b. Do liquidity-risk control personnel have ing market liquidity risk. sufficient credibility in the financial a. Is management information comprehen- institution to question traders’ and mar- sive and accurate, and is the analysis keters’ decisions? sound? c. Is liquidity-risk management involved in b. Are the bid-asked assumptions in a nor- new-product discussions in the financial mal market scenario reasonable? institution? c. Do management information reports 2. Identify the institution’s capital-markets and accurately reflect risks? Are reports pro- trading activities and the related balance- vided to the appropriate level of sheet and off-balance-sheet instruments; management? obtain copies of all risk-management reports 6. If any recent market disruptions affected the prepared. institution’s trading activities, what has been a. Do summaries identify all the institu- the institution’s market response? tion’s capital-markets products? b. Define the role that the institution takes 7. Is the financial institution following its for the range of capital-markets prod- internal policies and procedures? Do the ucts. Is the institution an end-user, dealer, established limits adequately control the or market maker? If so, in what prod- range of liquidity risks? Are the limits ucts? Determine the hedging instruments appropriate for the institution’s level of used to hedge these products. activity? c. Do liquidity-risk control personnel dem- 8. Has the institution established an effective onstrate knowledge of the products traded audit trail that summarizes exposures and by the financial institution? Do they management approvals? Are these sum- understand the current and potential mary reports presented and reviewed with exposures to the institution? the appropriate frequency? 3. Does the institution have comprehensive, 9. Has management considered potential illi- written risk-management policies and pro- quidity of the markets when establishing cedures for capital-markets and trading capital-at-risk exposures? activities? a. Has the financial institution established a. Do the policies explain the board of capital-at-risk limits that address both directors’ and senior management’s phi- normal and distressed market condi- losophy regarding illiquid markets? tions? Are these limits aggregated on a b. Have limits been approved by the board global basis? of directors? b. Are senior management and the board of c. Have policies, procedures, and limits directors advised of market liquidity risk been reviewed and reapproved within the exposures in illiquid markets, as well as last year? of potential risk arising as a result of d. Are policies, procedures, and limits for distressed market conditions? market liquidity risk clearly defined? 10. Has management determined the institu- e. Are the limits appropriate for the insti- tion’s exposure to suddenly illiquid markets tution and its level of capital? resulting from dynamic hedging strategies?

Trading and Capital-Markets Activities Manual April 2007 Page 1 Operations and Systems Risk (Management Information Systems) Section 2040.1

Management information systems (MIS) should understood by senior managers and directors, accumulate, interpret, and communicate infor- who may not have specialized and technical mation regarding the institution’s positions, prof- knowledge of trading activities and derivative its, business activities, and inherent risks. The products. Risk exposures arising from various form and content of management information products within the trading function should be for trading activities will be a function of the reported to senior managers and directors using size and complexity of the trading operation and a common conceptual framework for measuring organization, policies and procedures, and man- and limiting risks. agement reporting lines. MIS generally take two forms: computing systems with business appli- cations and management reporting. For institu- PROFESSIONAL EXPERTISE tions with trading operations, a computerized system should be in place. For a small number The trading institution should have personnel of institutions with limited trading activity, an with sufficient expertise to understand the finan- elaborate computerized system may not be cost cial instruments and maintain the management effective. Not all management information sys- information system. Reports should be updated tems are fully integrated. Examiners should to reflect the changes in the business environ- expect to see varying degrees of manual inter- ment. Institutions that develop their own appli- vention and should determine whether the integ- cations should have adequate staff to alter and rity of the data is preserved through proper test current software. Also, the implementation controls. The examiner should review and eval- of automated reporting systems is not a substi- uate the sophistication and capability of the tute for an adequate reconcilement procedure financial institution’s computer systems and soft- that would ensure the integrity of data inputs. ware, which should be capable of supporting, The system must be independently audited by processing, and monitoring the capital-markets personnel with sufficient expertise to perform a and trading activities of the financial institution. comprehensive review of management report- An accurate, informative, and timely manage- ing, financial applications, and systems capacity. ment information system is essential to the prudent operation of a trading or derivative activity. Accordingly, the examiner’s assess- COMPUTING SYSTEMS ment of the quality of the management informa- tion system is an important factor in the overall Worldwide deregulation of financial markets evaluation of the risk-management process. combined with the latest tools in information Examiners should determine the extent to which technologies have brought capital markets the risk-management function monitors and together so that geographic financial centers are reports its measure of trading risks to appropri- no longer as important. Access to markets on ate levels of senior management and the board competitive terms from any location is made of directors. Exposures and profit-and-loss state- possible by instantaneous worldwide transmis- ments should be reported at least daily to man- sion of news and market information. To man- agers who supervise but do not conduct trading age their risk-management process in the current activities. More frequent reports should be made financial and technological environment, finan- as market conditions dictate. Reports to other cial institutions are more readily prepared to levels of senior management and the board may incorporate the latest communications systems occur less frequently, but examiners should and database management techniques. In addi- determine whether the frequency of reporting tion, new financial concepts are rapidly becom- provides these individuals with adequate infor- ing standard practice in the industry, made mation to judge the changing nature of the possible by powerful computing tools and com- institution’s risk profile. munications systems. Examiners should ensure that the manage- Some capital-markets instruments require ment information systems translate the mea- information technologies that are more complex sured risk from a technical and quantitative than those used for more traditional banking format to one that can be easily read and products, such as loans, deposits, and standard

Trading and Capital-Markets Activities Manual February 1998 Page 1 2040.1 Operations and Systems Risk (Management Information Systems) foreign-exchange transactions. Indeed, a depart- traded instruments used by an institution. The ment developing specialized trading products group of systems used may be a combination of and their supporting systems is often viewed by systems purchased from vendors and applica- senior management as the laboratory for the tions developed in-house by the firm’s software financial institution. For financial institutions programmers. Standard instructions should be active in capital markets, conducting business in set within the automated systems. The organi- a safe and sound manner depends on the suc- zation should identify which instructions may be cessful integration of management information overridden and under what circumstances. systems into the daily processes of market- and The organization should give planned credit-risk management; transaction processing; enhancement or development projects appropri- settlement; accounting; and financial, regula- ate priority, given management’s stated goals tory, and management reporting. and capital-markets activity. Third-party ven- Examiners should evaluate the processes of dors should be provided with adequate lead time software development, technical specifications, to make changes to existing programs. Sufficient database management, local area networks, and testing should be performed before system communication systems. Access to the auto- upgrades are implemented. mated systems should be adequately protected. When consolidating data derived from mul- If the organization uses PCs, a written policy to tiple sources, the institution should perform address access, development, maintenance, and controls and reconciliations that minimize the other relevant issues should exist. Given the potential for corrupting consolidated data. If specialized management skills and heightened independent databases are used to support sophistication in information technologies found subsidiary systems, then reconciliation controls in many trading rooms, an evaluation of systems should be evident at each point that multiple management should be incorporated into the data files are brought together. Regardless of the overall assessment of management and internal combination of automated systems and manual controls. A full-scope examination of these processes, examiners should ensure that appro- areas is best performed by specialized electronic priate validation processes are effected to ensure data processing examiners. However, a general data integrity. review of these processes must also be incorpo- Not all financial institutions have the same rated in the financial examination. automation requirements. For institutions with For examination purposes, the scope of the limited transaction volume, it is not cost effec- review should be tailored to the functionality of tive to perform risk-management reporting in an the management information system as opposed automated environment, and most analysis can to its technical specifications. Functionality refers be handled manually. When volumes increase to how well the system serves the needs of users such that timely risk monitoring can no longer in all areas of the institution, including senior be handled manually, then automated applica- management, risk management, front office, back tions may be appropriate. office, financial reporting, and internal audit. The organization should have flow charts or narratives that indicate the data flow from input through reporting. The comprehensiveness of MODEL RISK this information, however, will depend on the level of reporting necessary for the institution. A key element of the management information An important aspect of evaluating informa- system of trading operations is models and tion technology is the degree to which various algorithms used to measure and manage risk. systems interface. For purposes of this discus- The frequency and extent to which financial sion, automated systems refers to the collection institutions should reevaluate their models and of various front-office and control systems. assumptions depend, in part, on the specific risk Financial institutions relying on a single data- exposures created by their trading activities, the base of client and transaction files may have pace and nature of market changes, and the pace stronger controls on data integrity than those of innovation with respect to measuring and with multiple sources of data. However, rarely managing risks. At a minimum, financial does a single automated system handle data institutions with significant capital-markets and entry and all processing and control functions trading activities should review the underlying relevant to all over-the-counter and exchange- methodologies and assumptions of their models

February 1998 Trading and Capital-Markets Activities Manual Page 2 Operations and Systems Risk (Management Information Systems) 2040.1 at least annually, and more often as market tions have a process whereby parameters used in conditions dictate, to ensure that they are appro- valuation models depend on rigorous statistical priate and consistent for all products. Such methods and are updated to reflect changing internal evaluations may, in many cases, be market conditions. To the extent possible, the supplemented with reviews by external auditors results derived from statistical methods should or other qualified outside parties, such as con- be validated against available market information. sultants who have expertise with highly techni- Models that incorporate assumptions about cal models and risk-management techniques. underlying market conditions or price relation- When a pricing model is introduced, systems ships require ongoing monitoring. Input param- personnel should ensure that testing of the eters such as volatility, correlations between algorithm is adequate. The users of the model market prices, interest rates and currencies, and (traders, controllers, and auditors) should also prepayment speeds of underlying mortgage pools sign off on it. In practice, pricing models for the require frequent review. For example, volatility most heavily traded financial instruments are quotes may be compared with those in available well tested. Financial algorithms for complex, published sources, or they may be implied exotic products should be well documented as volatilities derived from a pricing model using part of the policies and procedures manual and current market prices of actively traded exchange- the functional specifications. Hazards are more listed options. Mortgage securities prepayment likely to arise for instruments that have non- assumptions can be compared with vectors pro- standard or option-like features. The use of vided by the dealer community to automated proprietary models that employ unconventional services or with factors provided by third-party techniques that are not widely agreed upon by vendors. market participants should lead to further ques- Examiners should evaluate the ability of an tioning by examiners. Even the use of standard institution’s model to accommodate changes in models may lead to errors if the financial tools assumptions and parameters. Institutions should are not appropriate for a given instrument. conduct ‘‘what-if’’ analyses and tests of the sensitivity of specific portfolios or their aggre- gate risk position. Examiners should expect the NEW PRODUCTS risk-management and measurement system to be sufficiently flexible to stress-test the range of The development of new products is a key portfolios managed by the institution. Any feature of capital-markets and trading opera- parameter variations used for stress tests or tions. The general risks associated with new what-if analyses should be clearly identified. products should be addressed through the new- These simulations usually summarize the profit product approval process. When reviewing finan- or loss given a change in interest rates, foreign- cial applications, examiners should evaluate exchange rates, equity or commodity prices, whether the current tools quantify and monitor volatility, or time to maturity or expiry. the range of relevant exposures. New applica- tions require special review and additional mea- sures of control. In the absence of a model that provides a reasonable simulation of market price, MANAGEMENT INFORMATION the risk-management, control, and audit areas REPORTING should be responsible for developing an appro- priate valuation methodology. All software appli- Management reporting summarizes day-to-day cations should proceed through the institution’s operations, including risk exposure. The finan- software development process for testing before cial institution’s goal and market profile will be implementation. They should not be released reflected in the reporting format and process at for actual business use until validation and the operational level. These reporting formats sign-off is obtained from appropriate functional should be evaluated for data integrity and clar- departments. ity. Examiners should determine if reporting is sufficiently comprehensive for sound decision making. Parameter Selection and Review In addition, reports are used to provide man- agement with an overall view of business activ- Examiners should ensure that financial institu- ity for strategic planning. Overall management

Trading and Capital-Markets Activities Manual April 2003 Page 3 2040.1 Operations and Systems Risk (Management Information Systems) reporting should reflect the organizational struc- aware of potential weaknesses in the data pro- ture of the institution and the risk tolerance of vided. Risk reporting should be assessed and senior management. Examiners should expect performed independently of the front office to reports to aggregate data across geographic ensure objectivity and accuracy and to prevent locations when appropriate and to segregate manipulation or fraud. However, if the back positions by legal entity when appropriate. office uses databases and software programs that Examiners may find that periodic reporting is are independent from those used in the front provided to management on market-limit and office, it needs to perform a periodic reconcili- credit-line utilization. Management uses these ation of differences. For financial institutions reports to reevaluate the limit structure, relate operating in a less automated environment, report risks to profitability over a discrete period, preparation should be evaluated in terms of evaluate growing businesses, and identify areas timeliness and data accuracy. Cross-checking of potential profit. Management reporting also and sign-off by the report preparer and a reviewer should relate risks undertaken to return on with appropriate authority should be evident. capital. In fact, management information sys- Each financial institution will define the tems should allow management to identify and acceptable tradeoff between model accuracy and address market, credit, and liquidity risks. (See information timeliness. As part of their appraisal sections 2010.1, 2020.1, and 2030.1.) of risk management, examiners should review Management reports will usually be gener- the frequency and accuracy of reporting against ated by control departments within the institu- the institution’s posture in the marketplace, tion, independent from front-office influence. volume of activity, aggregate range of expo- When front-office managers have input on sures, and capacity to absorb losses. reports, the senior managers should be well

April 2003 Trading and Capital-Markets Activities Manual Page 4 Operations and Systems Risk (Management Information Systems) Examination Objectives Section 2040.2

1. To determine the scope and adequacy of the and manual processes are designed with audit function for management information sufficient audit trails to evaluate and ensure systems and management reporting. data integrity. 2. To determine if the policies, practices, pro- 8. To ensure that reports are fully described cedures, and internal controls regarding in functional specifications and are also management information systems and man- included in the policies and procedures of agement reporting are adequate. the respective user departments. 3. To ensure that only authorized users are 9. To determine whether management report- able to gain access to automated systems. ing provides adequate information for stra- 4. To evaluate computer systems, communica- tegic planning. tions networks, and software applications in 10. To determine that risk-management report- terms of their ability to support and control ing summarizes the quantifiable and non- the capital-markets and trading activities. quantifiable risks facing the institution. 5. To determine that the functions of auto- mated systems and reporting processes 11. To determine whether financial perfor- are well understood by staff and are fully mance reports are accurate and sufficiently documented. detailed to relate profits to risks assumed. 6. To determine that software applications per- 12. To evaluate summary reports on operations taining to risk reporting, pricing, and other for adequacy. applications that depend on modeling are 13. To recommend corrective action when poli- fully documented and subject to indepen- cies, practices, procedures, internal con- dent review. trols, or management information systems 7. To determine that the automated systems are deficient.

Trading and Capital-Markets Activities Manual February 1998 Page 1 Operations and Systems Risk (Management Information Systems) Examination Procedures Section 2040.3

These procedures represent a list of processes istration. Determine the types of reconcili- and activities that may be reviewed during a ations performed, frequency of database full-scope examination. The examiner-in-charge reconciliation, and tolerance for variance. will establish the general scope of examination The more independent databases are, the and work with the examination staff to tailor more the potential for data error exists. specific areas for review as circumstances 7. Determine the extent of data-parameter warrant. As part of this process, the examiner defaults, for example, standard settlement reviewing a function or product will analyze and instructions to alleviate manual interven- evaluate internal-audit comments and previous tion. Determine the extent of manual inter- examination workpapers to assist in designing vention for transaction processing, financial the scope of examination. In addition, after a analysis, and management reporting. general review of a particular area to be exam- 8. Review the policies and procedures manual ined, the examiner should use these procedures, for reporting requirements for management. to the extent they are applicable, for further 9. Determine whether the automated and guidance. Ultimately, it is the seasoned judg- manual process have sufficient audit trails ment of the examiner and the examiner-in- to evaluate and ensure data integrity for the charge as to which procedures are warranted in range of functional applications. Determine examining any particular activity. how control staff validates report content and whether the report content is well 1. Obtain copies of internal and external audit understood by the preparer. reports for MIS and management reporting. 10. Determine whether the processing and pro- Review findings and management’s duction of reports is segregated from front- responses to them and determine whether office staff. When the front office has influ- appropriate corrective action was taken. ence, how does management validate 2. Obtain a flow chart of reporting and sys- summary data and findings? tems flows and review information to iden- tify important risk points. Review policies 11. Review the functional applications such as and procedures for MIS. Review the per- credit administration, trade settlement, sonal computer policy for the institution, if accounting, revaluation, and risk monitor- available. ing to determine the combination of auto- 3. Determine the usage of financial applica- mation and manual intervention for man- tions on terminals that are not part of the agement reporting. Compare findings with mainframe, minicomputer, or local area net- examiners reviewing specific products or work. For instance, traders may use their business lines. own written spreadsheet to monitor risk 12. Determine whether the documentation sup- exposure or for reconciliation. porting pricing models is adequate. Deter- 4. Obtain an overview of the system’s func- mine whether ‘‘user instructions’’ provide tional features. Browse the system with the sufficient guidance in model use. institution’s systems administrator. Deter- 13. Determine whether the range of risk- mine whether passwords are used and management reports is adequately docu- access to the automated system is restricted mented in terms of inputs (databases, data- to approved users. feeds external to the organization, economic 5. Review a list of ongoing or planned man- and market assumptions), computational fea- agement information systems projects. Deter- tures, and outputs (report formats, defini- mine whether the priority of projects is tions). Evaluate the documentation for thor- justified given management’s strategic goals oughness and comprehensiveness. and recent mix of business activity. 14. Determine whether the range of reports 6. From the systems overview, ascertain the (risk management, financial performance range of databases in use. Some system and operational controls) provides valid architecture may use independent databases results to evaluate business activity and for for front office, back office, or credit admin- strategic planning.

Trading and Capital-Markets Activities Manual February 1998 Page 1 2040.3 Operations and Systems Risk (Management Information Systems): Examination Procedures

15. Recommend corrective action when poli- cies, practices, procedures, internal con- trols, or management information systems are deficient.

February 1998 Trading and Capital-Markets Activities Manual Page 2 Operations and Systems Risk (Management Information Systems) Internal Control Questionnaire Section 2040.4

1. Is the scope of the audit coverage compre- before system upgrades are implemented? hensive? Are audits for management infor- 9. Do planned enhancement or development mation systems and reporting available? projects have appropriate priority, given Are findings discussed with management? management’s stated goals and capital- Has management implemented timely cor- markets activity? rective actions for deficiencies? 10. Identify the key databases used for the 2. Do policies and procedures address the range of management reports. range of system development and technical a. Are direct electronic feeds from external maintenance at the institution, including the services such as Reuters, Telerate, and use of outside vendors and consultants? Bloomberg employed? How are incom- Does the institution have a comprehensive plete datafeeds identified? Can market personal computer policy? If the organiza- data be overridden by users? How does tion uses PCs, is there a written policy to the institution ensure the data integrity of address access, development, maintenance, datafeeds or manually input rates, yields, and other relevant issues? or prices from market sources? 3. Do the new product policies and procedures b. Are standard instructions set within the require notification and sign-off by key automated systems? Can these be over- systems development and management ridden? Under what circumstances? reporting staff? 4. Are there functional specifications for the c. For merging and combining databases, systems? Are they adequate for the current how does the institution ensure accurate range of automated systems at the institu- output? tion? Do they address both automated and d. What periodic reconciliations are per- manual input and intervention? formed to ensure data integrity? Is the 5. Does the organization have flow charts or reconciliation clerk sufficiently familiar narratives that indicate the data flow from with the information to identify ‘‘con- input through reporting? Is this information taminated’’ data? comprehensive for the level of reporting 11. Does the institution have a model-validation necessary for the financial institution? process? Does the organization use consult- 6. Is access to the automated systems ade- ants for model development and validation? quately protected? Are these consultants used effectively? Are a. Do access rights, passwords, and logon the yield curve calculations, interpolation ID’s protect key databases from methods, discount factors, and other param- corruption? eters used clearly documented and appro- b. Are ‘‘write or edit’’ commands restricted priate to the instruments utilized? Regard- to a limited set of individuals? less of the source of the model, how does c. Are specific functions assigned to a lim- management ensure accurate and consistent ited set of individuals? Are access rights results? reviewed periodically? 12. Does the system design account for the d. Does the system have an audit report for different pricing conventions and accrual monitoring user access? methods across the range of products in use e. Is access logon information stored in at the financial institution? Evaluate the records for audit trail support? range of system limitations for processing 7. Is management information provided from and valuation across the range of products mainframe, minicomputers, local area net- used by the institution. Assess the pos- works (multiuser personal computer net- sible impact on accuracy of management works), or single-user personal computers reporting. or a combination of the above? 13. Is management reporting prepared on a 8. Are third-party vendors provided with ade- sufficiently independent basis from line man- quate lead time to make changes to existing agement? Is management reporting ade- programs? Is sufficient testing performed quate for the volume and complexity of

Trading and Capital-Markets Activities Manual February 1998 Page 1 2040.4 Operations and Systems Risk (Management Information Systems): Internal Control Questionnaire

capital-markets and trading activities for the 15. Do reports segregate positions by legal types of reports listed below? Are reports entity when appropriate? complete? Do they have clear formats? 16. Determine whether the system for measur- Are the data accurate? Are exceptions high- ing and managing risk is sufficiently flex- lighted? Is appropriate segregation of duties ible to stress test the range of portfolios in place for report preparation? Are there managed by the institution. Does the system reports for the following: provide usable and accurate output? If the a. Market-risk exposure against limits? institution does not perform automated stress b. Credit-risk exposure against limits? testing, what process is used to minimize c. Market-liquidity risk exposure against quantifiable risks in adverse markets? limits? 17. Are parameter variations used for stress d. Funding-liquidity risk exposure against tests or are ‘‘what if’’ analyses clearly market demand? identified? 18. Does management reporting relate risks e. Transaction volumes and business mix? undertaken to return on capital? f. Profit and loss? 19. Do reports provide information on the busi- g. Other risk exposures and management ness units that is adequate for sound strate- information reports? gic planning? Are profitable and unprofit- 14. Do reports reflect aggregation of data across able businesses clearly identified? Does geographic locations when appropriate? management have adequate information?

February 1998 Trading and Capital-Markets Activities Manual Page 2 Operations and Systems Risk (Front-Office Operations) Section 2050.1

The front office is where trading is initiated and bid/ask levels in the marketplace. The difference the actual trading takes place. It consists of between the bid and the ask is called the spread. traders, marketing staff, and sometimes other Dealers are not necessarily obliged to make trading-support staff. Front-office personnel two-way markets. Many market participants are execute customer orders, take positions, and actively involved in facilitating customer trans- manage the institution’s market risks. The front actions even though they are not considered office is usually organizationally and function- market makers. In some cases, these institutions ally separate and distinct from the back-office act similarly to market makers, hedging incre- operation, which is part of the institution’s mental transactions derived from their customer overall operations and control infrastructure. base. In other cases, the institution may mark The back-office function completes the trad- transactions up from the bid/ask levels in the ing transactions executed by the front office. marketplace, enter into a transaction with its (See section 2060, ‘‘Back-Office Operations.’’) customer, and fill the order in the marketplace, It processes contracts, controls various clearing effectively taking a spread on the transaction. accounts, confirms transactions, and is typically While it may appear as if the dealer is acting as responsible for performing trade revaluations. a broker, it should be noted that both the Additionally, back-office personnel investigate transaction with the customer and the transac- operational problems which may arise as a result tion with the marketplace are executed with the of business activities. The back office provides financial institution as principal. logistical support to the trading room and should A proprietary trader takes on risk on the be the area where errors are caught and brought institution’s behalf, based on a view of eco- to the attention of the traders. While the dealing nomic and market perceptions and expectations. room and back office must cooperate closely to This type of trader will take a position in the ensure efficiency and prevent problems, their market to profit from price movements and price duties should be segregated to provide an volatility. Proprietary traders may incur high appropriate level of independence and control. levels of market risk by managing significant While the overall size, structure, and sophis- positions which reflect their view of future tication of an institution’s front office will market conditions. This type of activity requires vary, the general functions and responsibilities the highest level of experience and sophistica- described in this section prevail across the tion of all traders in the institution. majority of financial institutions. The following Intermediaries communicate bid and ask discussion describes a typical front office, but it levels to potential principals and otherwise is important to consider individual instrument arrange transactions. These transactions are profiles and market-specific characteristics in entered into on an ‘‘as agent’’ basis, and do not conjunction with the review of front-office result in the financial institution acting as a activities. principal to either counterparty involved in the transaction. An intermediary typically charges a fee for its service. ROLE AND STRUCTURE End-users are purchasers or sellers of prod- OF THE FRONT OFFICE ucts for investment or hedging purposes. Some- times an end-user will be a short-term trader, but The trading operation of a financial institution its volume will usually be lower than that of a can be categorized by the various roles the front proprietary trader. office performs in the marketplace. The front An institution may not function in all the office’s responsibilities may include any combi- above-mentioned roles. Each type of market nation of the following: market maker (dealer), participant strives to maintain or improve its proprietary trader, intermediary, and end-user. posture in the market based on its own actual or A market maker makes two-way markets. perceived competitive advantages. The institu- When initially contacted, the market maker may tion may also have a sales force or marketing not know whether the counterparty wishes to staff that receives price quotes from the institu- buy or sell a particular product. The market tion’s trading staff and represents market oppor- maker quotes two-way prices, reflective of the tunities to current and potential clients. Usually,

Trading and Capital-Markets Activities Manual February 1998 Page 1 2050.1 Operations and Systems Risk (Front-Office Operations) marketing staff is paid based on volume or on desired positions, and the likely needs of the the profit margin for the business developed. initiating trader. The trader assesses the current Sound business practices dictate that financial status of the market through information institutions take steps to ascertain the character obtained from other financial institutions, bro- and financial sophistication of counterparties. kers, or information services, and uses this These practices include efforts to ensure that the information to anticipate the direction of the counterparties understand the nature of the trans- market. Upon determining the most favorable actions into which they are entering. When the rate, the initiating trader closes the transaction counterparties are unsophisticated, either gen- by signifying a purchase or sale on the quoting erally or with respect to a particular type of trader’s terms. transaction, financial institutions should take Before closing the transaction, the traders additional steps to ensure that they adequately must also ensure that it falls within the institu- disclose the risks associated with the specific tion’s counterparty credit lines and authorized type of transaction. Ultimately, counterparties trading limits. A trade is usually completed in a are responsible for the transactions into which matter of seconds and the commitments entered they choose to enter. However, when an insti- into are considered firm contracts. tution recommends specific transactions to an Traders at competing institutions may arrange unsophisticated counterparty, the institution profit-sharing arrangements or provide other should ensure that it has adequate information forms of kickbacks without attracting the notice on which to base its recommendation. of control staff or trading management. To protect against this occurrence, a daily blotter (price/rate sheet) or comparable record or data- Organizational Structure base should be maintained. The blotter or data- base should be validated against the daily trading range within a narrow tolerance level. The organizational structure of the front office Off-market rates should be recorded in a is usually a function of the particular roles it log with appropriate control justification and performs. In general, the broader the scope of a sign-off. financial institution’s trading activities, the more Time-stamping of trade tickets by the trader structured the front-office organization. A mar- or computer system permits comparison between ket maker of various products can be expected the market rates recorded on the rate sheet and to have numerous trading and sales desks, with the rates at which trades are transacted. This each business activity managed independently system not only protects against deliberate trans- and overseen by the trading manager. Corre- actions at off-market rates, but it is also useful in spondingly, traders acting exclusively in a pro- resolving rate discrepancies in transactions with prietary capacity may act relatively indepen- other financial institutions and customers. dently, reporting only to the trading manager.

Transaction Flow TRADE CONSUMMATION Upon execution of the transaction, vital trade Trading is transacted through a network of information is captured. The form in which communications links among financial institu- details of trade transactions are captured is tions and brokers, including telephone lines, contingent on the trading systems of the finan- telexes, facsimile machines, and other electronic cial institution. When distinct front- and back- means. The party initiating the transaction con- office transaction systems are used, trade tickets tacts one or more dealers, typically over taped or initial input forms typically provide the input telephone lines, to request a ‘‘market,’’ that is, a detail for the back office. These trade tickets are two-sided quote. More than one institution may usually handwritten by the trader and hand- be contacted to obtain the most favorable rate or delivered to the back office. When straight- execute several trades quickly. through or automated processing systems are The initiating trader does not normally indi- used, trade input is typically performed by the cate which side of the market he or she is on. In front office. Details are input onto a computer response, the trader receiving the call considers screen and verified by the back office before the current market, the institution’s actual and final acceptance. In either case, trade details

February 1998 Trading and Capital-Markets Activities Manual Page 2 Operations and Systems Risk (Front-Office Operations) 2050.1 should include such basic information as the policies and procedures governing standards for trade date, time of trade, settlement date, coun- dealing with counterparties. An appropriate level terparty, instrument, amount, price or rate, and, of due diligence should be performed on all depending on the instrument, manner and place counterparties with which the institution deals, of settlement. even if the transactions do not expose the The trader’s own principal record is the trad- financial institution to much credit risk (for ing blotter or position book, which is a chrono- example, collateralized transactions). logical record of deals and a running record of Finally, management should ensure that the the trader’s position. The blotter may or may not marketing practices of its salespersons are ethi- be automated, depending on the sophistication cal. Standards addressing the sales of complex of the computer systems at the institution. products should be established to ensure that customers are not entering into transactions about which they have no understanding of the Transaction Reporting potential risks. Management should remain cog- nizant of the risk to the institution’s reputation at Traders track market-risk exposures and profit all times. Once an institution’s reputation is and loss in the ordinary course of business. damaged, it can be very difficult to restore. (See These calculations, however, should not form section 2150, ‘‘Ethics.’’) the basis for official risk or profit-and-loss reporting. Management information distributed to senior management should be prepared and reviewed independent of the trading function. UNACCEPTABLE PRACTICES Certain trading practices are considered unac- ceptable and require close supervision to control TRAINING AND TECHNICAL or prevent. In the foreign-exchange market, in COMPETENCE which prices will probably change before a dispute or counterparty can be settled, the prac- Trading-support functions are technical and tice of brokers’ points has evolved. The use of require levels of skills and training commensu- brokers’ points involves one side agreeing to the rate with the type of institution and the type and other’s price in a disputed trade, but with the variety of products handled. Back-office person- caveat that the discrepancy will be made up in nel should demonstrate a level of competence so the future. The parties keep an unofficial list of that they act as a viable check and balance to the owed or lent monies. The party agreeing to the financial institution’s front-office staff. Addition- other’s price can then call in the favor at a later ally, financial institutions must be able to attract date. This practice may be used to hide losses and retain competent personnel, as well as train in a trading portfolio until there are sufficient them effectively. Finally, a sufficient level of profits to offset them. The practice of brokers’ staffing is required to ensure the timely and points is considered an unsafe and unsound accurate processing, reporting, controlling, and banking practice, and a financial institution auditing of trading activities. should have a policy forbidding it. Another unacceptable practice is adjusted- price trading. This practice is used to conceal ETHICS losses in a trading portfolio and involves a collusive agreement with a securities dealer The potential risk of trading transactions to a from which the institution previously purchased financial institution emphasizes the importance a security that has now dropped in value. The of management’s ascertaining the character of security is resold to the dealer at the institution’s its potential traders. While there are no guaran- original purchase price, and the institution pur- tees as to how a particular trader may react to chases other securities from the dealer at an seriously adverse market conditions, proper per- inflated price. This practice could also involve sonnel screening, internal controls, and commu- ‘‘cross parking,’’ whereby the collusive parties nication of corporate policies should reduce the are both attempting to conceal trading losses. possibility of trading improprieties. Adjusted-price trading is further described in the Additionally, management should establish Municipal Securities Activities Exam Manual.

Trading and Capital-Markets Activities Manual February 1998 Page 3 2050.1 Operations and Systems Risk (Front-Office Operations)

Transactions involving off-market rates Evaluating the adequacy of internal controls (including foreign-exchange historical-rate roll- requires sound judgment on the part of the overs) should be permitted only in limited cir- examiner. The following is a list of some of the cumstances with strict management oversight. practices examiners should look for. The use of off-market rates introduces risks above and beyond those normally faced by • Every organization should have comprehen- dealing institutions in day-to-day trading activi- sive policies and procedures in place that ties. Because off-market rates could be used to describe the full range of capital-markets and shift income from one institution to another or trading activities performed. These docu- from one reporting period to another, they can ments, typically organized into manuals, serve illegitimate purposes, such as to conceal should at a minimum include front- and back- losses, evade taxes, or defraud a trading institu- office operations, reconciliation guidelines and tion. All financial institutions should have poli- frequency, revaluation guidelines, accounting cies and procedures for dealing with trades guidelines, descriptions of accounts, broker conducted at off-market rates. policies, a code of ethics, and the risk- Customers may give a financial institution the measurement and management methods, discretionary authority to trade on their behalf. including the limit structure. This authority should be documented in a writ- • For every institution, existing policies and ten agreement between the parties that clearly procedures should ensure the segregation of lists the permissible instruments and financial duties between trading, control, and payment terms, collateral provisions and monitoring, con- functions. firmation of trades, reporting to the client, and • The revaluation of positions may be con- additional rights of both parties. For institutions ducted by traders to monitor positions, by that have discretionary authority, examiners controllers to record periodic profit and loss, should ensure that additional policies and pro- and by risk managers who seek to estimate cedures are in place to prevent excessive trading risk under various market conditions. The in the client’s account (account churning). Close frequency of revaluation should be driven by supervision of sales and marketing staff and the level of an institution’s trading activity. adequate client reporting and notification are Trading operations with high levels of activity extremely important to ensure that the institu- should perform daily revaluation. Every insti- tion adheres to the signed agreement. tution should conduct revaluation for profit From a management standpoint, inappropri- and loss at least monthly; the accounting ate trading and sales practices can be avoided by revaluation should apply rates and prices from establishing proper guidelines and limits, enforc- sources independent of trader input. ing a reporting system that keeps management • Taping of trader and dealer telephone lines informed of all trading activities, and enforcing facilitates the resolution of disputes and can the segregation of responsibilities. Experience be a valuable source of information to audi- has shown that losses can occur when such tors, managers, and examiners. guidelines are not respected. • Trade tickets and blotters (or their electronic equivalents) should be created in a timely and complete manner to allow for easy reconcili- ation and appropriate position-and-exposure SOUND PRACTICES monitoring. The volume and pace of trading may warrant the virtually simultaneous cre- Capital-markets and trading operations vary sig- ation of records in some cases. nificantly among financial institutions, depend- • Computer hardware and software applications ing on the size of the trading operation, trading must accommodate the current and projected and management expertise, the organizational level of trading activity. Appropriate disaster- structure, the sophistication of computer sys- recovery plans should be tested regularly. tems, the institution’s focus and strategy, histori- • Every institution should have a methodology cal and expected income, past problems and to identify and justify any off-market transac- losses, risks, and the types and sophistication of tions. Ideally, off-market transactions would the trading products and activities. As a result, be forbidden. practices, policies, and procedures expected in • A clear institutional policy should exist con- one institution may not be necessary in another. cerning personal trading. If personal trading is

February 1998 Trading and Capital-Markets Activities Manual Page 4 Operations and Systems Risk (Front-Office Operations) 2050.1

permitted at all, procedures should be estab- switches, and relevant credit authorities should lished to avoid even the appearance of con- be involved. flicts of interest. • Every institution that uses brokers for foreign- • Every institution should ensure that manage- exchange transactions should establish a ment of after-hours and off-premises trading, clear statement forbidding lending or borrow- if permitted at all, is well documented so that ing brokers’ points as a method to resolve transactions are not omitted from the auto- discrepancies. mated blotter or the bank’s records. • Every organization should have explicit com- • Every institution should ensure that staff is pensation policies to resolve disputed trades both aware of and complies with internal for all traded products. Under no circum- policies governing the trader-broker stances should soft-dollar or off-the-books relationship. compensation be permitted for dispute • Every institution that uses brokers should resolution. monitor the patterns of broker usage, be alert • Every institution should have ‘‘know-your- to possible undue concentrations of business, customer’’ policies, and they should be under- and review the short list of approved brokers stood and acknowledged by trading and sales at least annually. staff. • Every institution that uses brokers should • The designated compliance officer should per- establish a firm policy to minimize name form a review of trading practices annually. substitutions of brokered transactions. All such In institutions with a high level of activity, transactions should be clearly designated as interim reviews may be warranted.

Trading and Capital-Markets Activities Manual February 1998 Page 5 Operations and Systems Risk (Front-Office Operations) Examination Objectives Section 2050.2

1. To review the organization and range of ing staff is adequate for sound decision activities of the front office. making. 2. To determine whether the policies, proce- 7. To evaluate the adequacy of the supervision dures, and internal systems and controls for of trading and marketing personnel. the front office are adequate and effective 8. To determine that front-office personnel are for the range of capital-markets products technically competent and well trained, and used by the financial institution. that ethical standards are established and 3. To determine whether the financial insti- respected. tution adequately segregates the duties of 9. To ascertain the extent, if any, of unaccept- personnel engaged in the front office from able business practices. those involved in the back-office-control 10. To determine that traders and salespeople function. know their customers and engage in 4. To ascertain that the front office is comply- activities appropriate for the institution’s ing with policies and established market counterparties. and counterparty limits. 11. To recommend corrective action when poli- 5. To determine that trade consummation and cies, procedures, practices, internal con- transaction flow do not expose the financial trols, or management information systems institution to operational risks. are found to be deficient, or when violations 6. To ensure that management’s reporting to of laws, rulings, or regulations have been front-office managers, traders, and market- noted.

Trading and Capital-Markets Activities Manual February 1998 Page 1 Operations and Systems Risk (Front-Office Operations) Examination Procedures Section 2050.3

These procedures represent a list of processes for any counterparties, determine that trans- and activities that may be reviewed during a actions are appropriately reflected. (See sec- full-scope examination. The examiner-in-charge tion 2020, ‘‘Counterparty Credit Risk and will establish the general scope of examination Presettlement Risk.’’) and work with the examination staff to tailor 3. Ensure that comprehensive policies and pro- specific areas for review as circumstances cedures covering the introduction of new warrant. As part of this process, the examiner trading products exist. A full review of the reviewing a function or product will analyze and risks involved should be performed by all evaluate internal audit comments and previous relevant parties: trading, credit- and market- examination workpapers to assist in designing risk management, audit, accounting, legal, the scope of examination. In addition, after a tax, and operations. general review of a particular area to be exam- 4. Determine that policies and procedures ined, the examiner should use these procedures, adequately address the following: to the extent they are applicable, for further guidance. Ultimately, it is the seasoned judg- a. The financial institution complies with ment of the examiner and the examiner-in- regulatory policy regarding brokers’ points. charge as to which procedures are warranted in b. The financial institution has policies examining any particular activity. addressing traders’ self-dealing in com- modities or instruments closely related to those traded within the institution. A writ- ten policy requires senior management to GENERAL PROCEDURES grant explicit permission for traders to trade for their personal account, and pro- 1. Obtain the following: cedures are established that permit man- a. policies and procedures agement to monitor these trading activities. b. organization chart c. The financial institution does not engage c. resumes of key trading personnel in adjusted-price trading. d. systems configuration d. The financial institution has adequate poli- e. management information reports cies regarding off-market-rate transac- 2. Determine the roles of front office in the tions. All requests for the use of off- marketplace. market rates are referred to management 3. Ensure that the terms under which brokerage for policy and credit judgments as well service is to be rendered are clear and that as for guidance on appropriate internal management has the authority to intercede in accounting procedures. Specifically, review any disputes that may arise. Additionally, and assess the financial institution’s poli- ensure that any exclusive broker relation- cies and procedures regarding historical- ships in a single market do not result in an rate rollovers. overdependence or other vulnerability on the part of the financial institution. e. Adequate control procedures are in place for trading that is conducted outside of normal business hours—either at the office or at traders’ homes. Personnel permitted POLICIES AND PROCEDURES to engage in such dealing should be clearly identified along with the types of autho- 1. Check that procedures clearly indicate under rized transactions. Additionally, proce- what conditions, if any, market-risk limits dures ensure that off-premises transac- may be exceeded and what authorizations tions will not exceed risk limits. must be obtained. (See section 2010, ‘‘Mar- f. The financial institution has adequate pro- ket Risk.’’) cedures for handling customer stop-loss 2. Check that procedures clearly indicate under orders. Documentation related to both the what conditions, if any, counterparty risk agreed-on arrangements as well as the limits may be exceeded and what approvals individual transactions is available for must be obtained. If netting agreements exist review.

Trading and Capital-Markets Activities Manual February 1998 Page 1 2050.3 Operations and Systems Risk (Front-Office Operations): Examination Procedures

g. The financial institution requires that the recorded by the trader after the deal has been appropriate level of due diligence be per- completed. formed on all counterparties with which 2. Ensure that the financial institution has the institution enters into transactions, established satisfactory controls over trade even if the transactions do not expose the input. financial institution to credit risk (for 3. Confirm that a separation of duties exists for example, delivery versus payment and the revaluation of the portfolio, reconcilia- collateralized transactions). tion of traders’ positions and profits, and the h. The marketing practices of the institu- confirmation of trades. tion’s salespersons are ethical. Standards address the sales of complex products to ensure that customers are not entering into TRANSACTION-CONSUMMATION transactions about which they have no PROCEDURES understanding of the potential risks. 1. Ensure that traders and marketers check that TRAINING AND TECHNICAL they are within market- and credit-risk limits COMPETENCE PROCEDURES before the execution of the transaction.

1. Evaluate key personnel policies and practices and their effects on the financial institution’s TRANSACTION-FLOW capital-markets and trading activities. PROCEDURES a. Evaluate the experience level of senior personnel. 1. Ensure that trade tickets or input sheets b. Determine the extent of internal and include all trade details needed to validate external training programs. transactions. c. Assess the turnover rate of front-office 2. Ensure that transactions are processed in a personnel. If the rate has been high, deter- timely manner. Check that some type of mine the reasons for the turnover and method exists to reconstruct trading history. evaluate what effect the turnover has 3. Ensure that the transaction-discrepancy pro- had on the financial institution’s trading cedure is adequate and includes independent operations. validation of the back office. d. Review the financial institution’s compen- sation program for trading activities to determine whether remuneration is based TRANSACTION REPORTING on volume and profitability criteria. If so, determine whether controls are in place to 1. Ensure that management information reports prevent personnel from taking excessive prepared for front-office management pro- risks to meet the criteria. vide adequate information for risk moni- e. Determine the reasons for each trader’s toring, including financial performance and termination or resignation. transaction detail, to ensure sound decision 2. Determine whether the financial institution making. has a management succession plan. 3. Evaluate the competence of trading and mar- keting personnel. Determine whether infor- ETHICS PROCEDURES mation on the organization, trading strategy, and goals is well disseminated. 1. Evaluate the level of due diligence per- 4. Determine if management remains informed formed on counterparties. about pertinent laws, regulations, and account- 2. Evaluate the code of ethics and staff adher- ing rules. ence to it. 3. Evaluate ‘‘know-your-customer’’ guidelines SEGREGATION OF DUTIES and staff adherence. PROCEDURES 4. Evaluate the management of trading and marketing staff. Evaluate the seriousness of 1. Ensure that all transactions are promptly any ethical lapses.

February 1998 Trading and Capital-Markets Activities Manual Page 2 Operations and Systems Risk (Front-Office Operations): Examination Procedures 2050.3

CORRECTIVE ACTION management information systems are found to be deficient, or when violations of laws, 1. Recommend corrective action when policies, rulings, or regulations have been noted. procedures, practices, internal controls, or

Trading and Capital-Markets Activities Manual February 1998 Page 3 Operations and Systems Risk (Front-Office Operations) Internal Control Questionnaire Section 2050.4

POLICIES AND PROCEDURES TRANSACTION CONSUMMATION

1. Do policies and procedures establish market- 1. Do traders ensure that transactions are within risk limits, and do the policies and pro- market- and credit-risk limits before the cedures clarify the process for obtaining execution of the transaction? approvals for excessions? 2. Do policies and procedures establish credit- TRANSACTION FLOW risk limits, and do the policies and pro- cedures clarify the process for obtaining 1. Do trade tickets or input sheets include all approvals for excessions? necessary trade details? 3. Do policies address the approval process for 2. Does the institution have procedures to ensure new products? the timely processing of all transactions? 4. Is an appropriate level of approval obtained 3. Does the institution have a method with for off-market transactions and for additional which to resolve trade discrepancies on credit risk incurred on off-market trades? transactions, regardless of communication 5. Does management make sure that senior medium used? management is aware of off-market trades 4. Do traders include an adequate amount of and the special risks involved? trade details on blotters, input sheets, and 6. Does management inquire about a custom- computer screens to enable reconciliation by er’s motivation in requesting an off-market- the front and back office? rate trade to ascertain its commercial 5. Do automated systems for input appear justification? adequate for the volumes and range of prod- 7. Do procedures manuals cover all the securi- ucts transacted by the institution? ties activities that the financial institution conducts, and do they prescribe appropriate internal controls relevant to those functions TRANSACTION REPORTING (such as revaluation procedures, accounting and accrual procedures, settlement proce- 1. Are reports prepared for front-office manage- dures, confirmation procedures, accounting ment to allow the monitoring of market- and and auditing trails, and procedures for estab- credit-risk limits? lishing the sequential order and time of transactions)? TRAINING AND TECHNICAL COMPETENCE

1. Does the financial institution have a manage- ROLE OF THE FRONT OFFICE ment succession plan? 2. Does the financial institution have an 1. Do policies clarify the responsibilities of appropriate program for cross-training of traders as to market making, dealing, pro- personnel? prietary, and intermediary roles? 3. Does the financial institution provide for the 2. Are the financial institution’s dealings with adequate training of front-office personnel? brokers prudent? 4. Are traders technically competent in their 3. Is the financial institution’s customer base existing positions? diverse? Is the customer base of high credit 5. Does management remain informed about and ethical quality? pertinent laws, regulations, and accounting rules?

SEGREGATION OF DUTIES ETHICS

1. Is there adequate segregation of duties 1. Is an appropriate level of due diligence between the front and back office? performed on all counterparties with which

Trading and Capital-Markets Activities Manual February 1998 Page 1 2050.4 Operations and Systems Risk (Front-Office Operations): Internal Control Questionnaire

the front office enters into transactions, 6. Were any unacceptable practices noted by regardless of collateralization? internal or external auditors? Has manage- 2. Is there a code of ethics? Do traders and ment addressed these actions? From exam- marketers appear to be familiar with it? iner observation, are there any ongoing 3. Are there ‘‘know-your-customer’’ guide- unacceptable practices? Is management’s lines? Do traders and marketers appear to be response to deficiencies adequate? familiar with them? 7. Does the financial institution have discretion- 4. Do internal memos detail any ethical lapses? ary authority over client monies? Are poli- If so, how were they resolved? Does senior cies and procedures adequate to control management take its guidance role seriously? excessive trading by sales and marketing 5. Are customer relationships monitored by staff? Is front-office supervision adequate? senior management in the front office? How Does the back office have additional controls are customer complaints resolved? Are the to alert senior control staff and the compli- back office, control staff, and compliance ance department of deficiencies? Is discre- involved in the process? Are overall controls tionary trading activity included in the insti- for customer complaints adequate? tution’s audit program?

February 1998 Trading and Capital-Markets Activities Manual Page 2 Operations and Systems Risk (Back-Office Operations) Section 2060.1

Operational risks managed outside of the deal- tion process that leads to the maintenance of the ing room are potentially more costly than those subsidiary ledgers and the general ledger. managed inside the dealing room. While the Another crucial function of the back office is function of dealers in the front office is primarily accepting or releasing securities, commodities, to transact and manage positions, the processing and payments on trades, as well as identifying of transactions, the recording of contracts in the possible mistakes. Clearly, trading personnel accounting system, and reconciliations and pro- need to be separate from control of receipts, cedures required to avoid errors are functions disbursements, and custody functions to mini- that must take place outside the dealing room. In mize the potential for manipulation. Regulatory conducting these functions, the back office pro- reports and management accounting may also be vides the necessary checks to prevent unautho- the responsibility of the back office. rized trading. Management responsibilities performed by Back office, for the purposes of this manual, the back office vary by institution. The evalua- may be a single department or multiple units tion of transaction exposure against established (such as financial control, risk management, market, liquidity, or credit limits may be per- accounting, or securities custody), depending on formed by back-office staff or by a separate the organizational structure of the financial risk-management function, independent of front- institution. Some institutions have combined office traders and marketers. Risk-management some of the responsibilities usually found in the reporting may also be performed by back-office back office into a middle-office function, which staff. Legal documentation, while initiated by is also independent of dealing activities. internal or external counsel, may be followed up Close cooperation must exist between the (chased) by back-office staff. dealing room and the back office to prevent The links between front- and back-office costly mistakes. An understanding of each role operations may range from totally manual to and function is important. While their priorities fully computerized systems in which the func- are different, both functions work toward the tions are directly linked. The complexity of same goal of proper processing, control, and linking systems should be related to the volume recording of contracts; this goal is essential to the and complexity of capital-markets and trading success of a trading department. activities undertaken. Manual operations are The back office serves several vital functions. subject to error. However, management should It records and confirms trades transacted by the not have a false sense of security with auto- front office and provides the internal-control mated systems. Changes in programming codes mechanism of segregation of duties. The checks installed through the maintenance process, new and balances provided by the back-office func- financial structures, and inadequate testing of tion help management supervise the trading software may lead to computational and process- activities conducted by the front office. A prop- ing errors. Regardless of the operational process erly functioning back office will help ensure the in place, the back-office functions should be integrity of the financial institution and mini- subject to comprehensive audit. mize operations, settlement, and legal risks. Operational risk is the risk that deficiencies in Segregation of front- and back-office duties information systems or internal controls will minimizes legal violations, such as fraud or result in unexpected loss. Although operational embezzlement, or violation of regulations. risk is difficult to quantify, it can be evaluated by Operational integrity is maintained through the examining a series of plausible worst-case or independent processing of trades, trade confir- what-if scenarios, such as a power loss, dou- mations, and settlements. The goal is to avoid bling of transaction volume, or mistake found in potentially costly mistakes such as incorrectly the pricing software. It can also be assessed recorded or unrecorded contracts. The back through periodic reviews of procedures, data office also is responsible for the reconcilement processing systems, contingency plans, and other of positions and broker statements and may operating practices. These reviews may help monitor broker relationships with the financial reduce the likelihood of errors and a breakdown institution. The back-office staff independently in controls, improve the control of risk and the assesses the price quotes used for the revalua- effectiveness of the limit system, and prevent

Trading and Capital-Markets Activities Manual April 2003 Page 1 2060.1 Operations and Systems Risk (Back-Office Operations) unsound marketing practices and premature ¥ a market-risk-management system to monitor adoption of new products or lines of business. the organization’s exposure to market risk, Considering the extent that capital-markets and written procedures for authorizing trades activities rely on computerized systems, finan- and excesses of position limits; cial institutions should have plans that take into ¥ a credit-risk management system to monitor account potential problems with their normal the organization’s exposure to customers and processing procedures. broker-dealers; Financial institutions should also ensure that ¥ separation of duties and supervision to ensure trades that are consummated orally are con- that persons executing transactions are not firmed as soon as possible. Oral transactions involved in approving the accounting method- conducted over the telephone should be recorded ology or entries (Persons executing transac- and subsequently supported by written or printed tions should not have the authority to sign documents. Examiners should ensure that the incoming or outgoing confirmations or con- institution monitors the consistency between the tracts, reconcile records, clear transactions, or terms of transactions as they were orally agreed control the disbursement of margin payments.); on and as they were subsequently confirmed. ¥ a clearly defined flow of order tickets and Examiners should also consider the extent confirmations (The flow of order tickets and to which financial institutions evaluate and con- confirmations should be designed to verify trol operating risks through the use of internal their accuracy and enable reconciliations audits, stress testing, contingency planning, and throughout the system and to enable the rec- other managerial and analytical techniques. oncilement of traders’ position reports to those Financial institutions should have approved poli- positions maintained by an operating unit.); cies that specify documentation requirements ¥ procedures for promptly resolving failures to for capital-markets activities as well as formal receive or deliver securities on the date secu- procedures for saving and safeguarding impor- rities are settled; tant documents. All policies and procedures ¥ procedures for someone other than the person should be consistent with legal requirements and who executed the contract to resolve customer internal policies. complaints; ¥ procedures for verifying brokers’ reports of margin deposits and contract positions and for INTERNAL CONTROLS reconciling such reports to records; and ¥ guidelines for the appropriate behavior of Management is responsible for minimizing the dealing and control staff and for the selection risks inherent in executing financial contracts. and training of competent personnel to follow Policies and procedures should be established to written policies and guidelines. cover organizational structure, segregation of duties, operating and accounting system con- trols, and comprehensive management report- ing. Formal written procedures should be in TICKET FLOW place for purchases and sales, processing, accounting, clearance, and safekeeping activi- Once a transaction has been initiated by the ties relating to financial contracts transactions. front office, the primary responsibility for pro- In general, these procedures should be designed cessing trades rests with various back-office to ensure that all financial contracts are properly personnel. Back-office staff process all pay- recorded and that senior management is aware ments and delivery or receipt of securities, of the exposure and gains or losses resulting commodities, and written contracts. Addition- from these activities. Desirable controls include— ally, the back office is responsible for verifying the amounts and direction of payments, which ¥ written documentation indicating the range of are made under a range of netting agreements. permissible products, trading authorities, and After sending the trade tickets to the back permissible counterparties; office, the traders are removed from the rest of ¥ written position limits for each type of con- the processing, except to check their daily posi- tract or risk type established by the board of tions against the records developed separately directors; by the back office and to verify any periodic

April 2003 Trading and Capital-Markets Activities Manual Page 2 Operations and Systems Risk (Back-Office Operations) 2060.1 reports it prepared. After receipt of the trade Examiners should determine whether systems ticket from the front office, back-office person- and processes enable audit and control staff to nel verify the accuracy of the trade ticket, and adequately monitor dealing activity. Time stamp- any missing information is obtained and recorded. ing transactions at the time of execution will A confirming communication will be sent to the enable an institution to validate intraday dealing counterparty, who, in turn, will respond with an prices and reconstruct trading activity. More- acceptance communication. The acceptance over, time-stamp sequences of the trade tickets comunication will either confirm the trade or should closely, if not exactly, match the serial identify discrepancies for resolution. The trade order for a particular trader or dealer. is then ready to be processed. It is appropriate to evaluate whether an insti- Trade processing involves entering the trade tution’s automated systems provide adequate agreement on the correct form or into an auto- support for its dealing and processing functions. mated system. When the front office has already Systems that have increased dealing volumes performed this function, verification of transac- should be examined for downtime, capacity tion data should be performed. The copy of the constraints, and error rates for transaction trade agreement to be sent to the counterparty is throughput. Further, institutions that deal in once more checked against the original ticket, complex derivative products should have auto- and the trade agreement is transmitted. mated systems commensurate with the analyti- Other copies of the trade agreement will be cal and processing tasks required. used for all bookkeeping entries and settlement during the life of the agreement. For instance, all contingent liability, general ledger, and sub- ledger entries will be supported by copies of the TRADE TRANSACTIONS trade agreement, with the relevant entry high- lighted on the copy. Likewise, at maturity of Confirmations an agreement, payment or receipt orders will be initiated by the relevant trade-agreement Whenever trading transactions are agreed upon, copies. a confirmation is sent to the counterparty to the After the trades are recorded on the institu- agreement. A confirmation is the record of the tion’s books, they will be periodically revalued. terms of a transaction sent out by each party, Over time, trades will mature or be sold, before the actual settlement of the transaction unwound, exercised, or expire as worthless, itself. The confirmation contains the exact details depending on circumstances and instruments. of the transaction and thus serves legal, practi- Subsequently, these transactions will be removed cal, and antifraud purposes. The confirmation from the books of the institution, and related can be generated manually or automatically by deferred accounts will pass through the account- an on-line computer trading system. ing cycle. The back office should initiate, follow up, and Financial institutions active in global markets control counterparty confirmations. Usually, an may permit some traders to transact business incoming confirmation from the counterparty after normal business hours. This activity should can be compared with a copy of the outgoing be well defined in the institution’s policies and confirmation. If an incoming confirmation is not procedures manual, in which trading instru- expected or if the transaction is carried out with ments should be listed and possible counterpar- commercial customers and individuals, it is wise ties defined. Supervisory responsibility of after- to send confirmations in duplicate and request a hours and off-premises trading and the authorities return copy signed or authenticated by the other for traders should be delineated. party. A policy should be in place for off-market When a financial institution deals in faster- transactions, and the organization should review paced markets, such as foreign exchange, or in trading activity to determine if off-market rates instruments which have very short settlement are used. Justification for off-market transac- periods, trade validation may be performed tions should be registered in a log by the back through taped telephone conversations before office. Frequent use of off-market rates may the exchange, with corroboration of a written or reflect the extension of credit to a counterparty electronically dispatched confirmation. The use and should be the subject of further examiner of taped phone conversations can help reduce inquiry. the number and size of discrepancies and is a

Trading and Capital-Markets Activities Manual February 1998 Page 3 2060.1 Operations and Systems Risk (Back-Office Operations) useful complement to (as opposed to a substitute and comprehensive explanation for any forms for) the process of sending out and verifying not used. confirmations. At a minimum, institutions should retain the past 90 days of taped phone conver- sations, but this time frame may need to be expanded depending on the volume and term of Settlement Process instruments traded. It is poor practice to rely solely on telephone verifications because of After an outright or contingent purchase or sale their ineffectiveness in litigation in some juris- has been made, the transaction must be cleared dictions. Additionally, certain jurisdictions only and settled through back-office interaction with recognize physical confirmations. the clearing agent. On the date of settlement (value date), payments or instruments are An institution dealing in global markets should exchanged and general-ledger entries are updated. ensure the adequacy of its confirmations through Depending on the nature of the deal, currency legal study of the regulations specific to the instruments will be received, paid, or both. The foreign locales of its counterparties. In all process of paying and receiving must be handled trading markets, the confirmation should pro- carefully because errors can be extremely costly. vide a final safeguard against dealing errors or When all the proper information is recorded, fraud. contracts are placed in ‘‘dead files.’’ All confirmations should be sent to the atten- Settlement is completed when the buyer (or tion of a department at the counterparty institu- the buyer’s agent) has received the securities or tion which is independent of the trading room. products, and the seller has been paid. Brokers Incoming information should be compared in may assign these tasks to a separate organiza- detail with the outgoing confirmation, and any tion, such as a clearinghouse, but remain respon- discrepancies should be carefully appraised. sible to their customers for ensuring that the If the discrepancy is significant, it should be transactions are handled properly. They are also investigated independently. If the discrepancy is responsible for maintaining accurate accounting small, a copy of the confirmation may be given records. to the trader for clarification with the counter- Examiners should review the various methods party, since the trader will probably have daily of settlement for the range of products covered contact with the other party. Most importantly, and note any exceptions to commonly accepted the department should follow up on all these practices. Unsettled items should be monitored discrepancies and ensure that new confirma- closely by the institution. The handling of prob- tions are obtained for any agreed-on changes in lems is always a delicate matter, especially when terms. the cost is considerable. Anything more than a A strictly controlled confirmation process routine situation should be brought to the atten- helps to prevent fraudulent trades. For example, tion of the chief dealer and a senior officer in the in a fraudulent deal, a trader could enter into a back office. Further action should be handled by contract, mail out the original of a confirmation, management. and then destroy all copies. This technique Losses may be incurred if a counterparty fails would enable a trader to build up positions to make delivery. In some cases, the clearing- without the knowledge of the financial institu- house and broker may be liable for any prob- tion’s management. If the incoming confirma- lems that occur in completing the transaction. tion is directed to the trader, it could be destroyed Settlement risk should be controlled through the as well, and nobody would ever know about the continuous monitoring of movement of the position. The trader, when closing this position, institution’s money and securities and by the would make up a ticket for the originally establishment of counterparty limits by the credit destroyed contract and pass it on together with department. A maximum settlement-risk limit the offsetting contract so that the position is should be established for each counterparty. square again. Receipt and verification of the incoming confirmation by an independent department would immediately uncover this type Foreign Payments of fraudulent activity. An additional protection is the use of serially numbered manifold forms Two control steps are involved when making for confirmations, with an exact accounting of foreign payments. The first step is internal; each

February 1998 Trading and Capital-Markets Activities Manual Page 4 Operations and Systems Risk (Back-Office Operations) 2060.1 payment should be carefully checked with the onciled include trader position sheets to the corresponding contract to ensure the accuracy of general ledger, general ledger to regulatory the amount, date, and delivery instructions. The reports, broker statements to the general ledger, second is checking with the dealer responsible and the income statement. for the currency involved to ensure that cash- flow figures for the delivery date, excluding nostro balances, agree with the net of all con- DISCREPANCIES AND DISPUTED tracts maturing on that day. TRADES If the financial institution uses more than one financial institution abroad for the payment or Any discrepancy in trading transactions must receipt of a currency, the back office must be brought immediately to the attention of the ensure that the flow of funds does not leave one appropriate operations manager. All discrepan- account in overdraft while another account has cies should be entered into a log, which should excessive balances; this check will avoid unnec- be reviewed regularly by a senior operations essary overdraft charges. The final check of officer. The log should contain the key financial flows of foreign funds is made through the terms of the transaction, indicate the disputed reconciliation of the foreign account. This is items, and summarize the resolution. The coun- always a retrospective reconciliation because of terparty should receive notice of the final dispo- the delays in receiving the statement of account. sition of the trade, and an adequate audit trail Some extra actions that can help prevent prob- of that notice should be on file in the back lems abroad or resolve them more quickly are office. The institution should have clear and (1) sending details of expected receipts to the documented policies and procedures regard- counterparty or correspondent with a request to ing the resolution of disputed trades with advise if funds are not received, (2) asking counterparties. the correspondent financial institution to advise immediately if the account is in overdraft or if balances are above a certain level, and (3) establishing a contact person in the corre- Brokers’ Commissions and Fees spondent bank to be notified if problems arise. Brokers charge a commission or fee for each Delivery versus payment. Many foreign secu- transaction they perform. The commission should rities and U.S. Treasury securities are settled on not be included in the price of the transaction, a delivery-versus-payment basis, under which and it should be billed separately by the brokers. counterparties are assured that delivery of a Checking the commissions, initiating the pay- security from the seller to the buyer will be ments, and reviewing brokers’ statements are completed if, and only if, the buyer pays the other functions of the back office. To ensure the seller. integrity of fees and commissions, brokers’ points arrangements and other trader-negotiated solutions to trade disputes should be avoided. Reconciliations REVALUATION The back office should perform timely reconcili- ations in conformity with the policies and pro- Revaluation is the process by which financial cedures of the institution. The minimum appro- institutions update or ‘‘mark to market’’ the priate frequency for reconciliation will be linked value of their trading-product portfolios. Guide- to the volume and complexity of the transactions lines for the formal revaluation should be delin- at the financial institution. The individual eated in written policies and procedures. Weak responsible for performing the reconcilement of policies and procedures increase the potential accounts should be independent of the person for fraud and raise doubt about the integrity of responsible for the input of transaction data. trading profits and a firm’s ability to evaluate Reconciliations should determine positions risk. A common deficiency of revaluation pro- held by the front office, as well as provide an cedures is the improper segregation of duties audit trail detailing reclassified accounts for between traders and control personnel, includ- regulatory reporting. Typical reports to be rec- ing a disproportionate dependence on trader

Trading and Capital-Markets Activities Manual February 1998 Page 5 2060.1 Operations and Systems Risk (Back-Office Operations) input and the lack of independent verification of The mark-to-market methodology for risk pricing parameters. In addition, the use of management may be calculated on the same inconsistent pricing assumptions and methodolo- basis as the controller’s income-recognition gies between the trading desk and back office method. Some financial institutions use equiva- can lead to incorrect financial reporting and lency formulas that convert gross exposures to evaluations of market risk. standard measures based on the price sensitivity The determination of current market value is of benchmark securities. In this regard, the both an intraday activity performed by traders to revaluation process serves as a starting point for monitor their position as well as a daily activity risk assessment of capital-markets products. The performed by control staff to determine the assessment of exposures by risk management, impact on earnings. Discrepancies between trader however, should never be less conservative than input and independent market rates should be assessment by actual market levels. resolved and documented. Procedures should be established for maintaining a discrepancy log containing the reason for the discrepancy and the profit-and-loss impact. Significant dis- ACCOUNTING crepancies should be reported to senior management. The recording of outstanding transactions allows Sufficient information regarding the periodic verification of dealer positions, risk control, and revaluation and resolution of discrepancies recording of profit and loss. Each institution should be documented and maintained. In addi- should follow guidelines established by industry tion, any adjustments to the general ledger due practice or the applicable governing bodies, to changes in revaluation estimates should be including— clearly recorded and reported to management. The revaluation process is transparent for • generally accepted accounting principles securities, futures, and other instruments that are (GAAP) traded on organized exchanges. Published prices • regulatory accepted principles (RAP) from exchanges provide an objective check • Federal Reserve Board policy statements against the price provided by traders, although • Federal Financial Institutions Examination liquidity considerations make evaluating quoted Council statements prices more complex. A secondary comfort level for exchange-traded products is the margin For further discussion, see sections 2120.1, call in which a position is evaluated at the ‘‘Accounting,’’ and 2130.1, ‘‘Regulatory posted end-of-day price. Prices of actively traded Reporting.’’ over-the-counter (OTC) products available from electronic wire services provide a similar check against trader prices for these products. MANAGEMENT INFORMATION However, with less actively traded products, REPORTS especially exotic OTC-traded derivatives and options, the revaluation process is more com- Management information reports are prepared plex. The pricing of illiquid instruments has a by the back office and trader-support areas to greater potential for error or abuse because enable management and trading personnel to valuation is more subjective. For example, assess the trading position, risk positions, profit options that are tailored for customer require- and loss, operational efficiency, settlement costs, ments may have no two-way market, yet still and volume monitoring of the institution. For must be evaluated at current market value. further discussion, see section 2040.1, ‘‘Man- While various pricing models exist, all depend agement Information Systems.’’ on critical assumptions and estimates used to calculate the probable price. Errors can arise from incorrect estimates or manipulation of variables and assumptions. One particular vul- DOCUMENTATION AND nerability concerns the observed volatility of RECORDKEEPING options. See section 2010.1, ‘‘Market Risk,’’ for a discussion of problems that can arise with Accurate recording of transactions by back- measuring volatilities. office personnel is crucial to minimizing the risk

February 1998 Trading and Capital-Markets Activities Manual Page 6 Operations and Systems Risk (Back-Office Operations) 2060.1 of loss from contractual disputes. Poor docu- ing on the size of the trading operation, trading mentation can lead to unenforceable transac- and management expertise, organizational struc- tions. Similarly, poor recordkeeping can render ture, sophistication of computer systems, insti- audit trails ineffective, and can result in a tution’s focus and strategy, historical and qualified or adverse opinion by the public expected income, past problems and losses, accountant, a violation of Federal Reserve Board risks, and types and sophistication of the trading policy, or loss due to fraud. products and activities. As a result, practices, An institution should keep confirmations sum- policies, and procedures expected in one insti- marizing the specific terms of each trade. Addi- tution may not be necessary in another. The tionally, master agreements should be kept on adequacy of internal controls requires sound premises or a copy should be available locally judgment on the part of the examiner. The for examiner reference. For further discussion following is a list of sound back-office opera- on master agreements, see section 2070.1, ‘‘Legal tions to check for. Risk.’’ • Every organization should have comprehen- sive policies and procedures in place that AUDITS describe the full range of capital-markets and trading activities performed. These docu- The scope and frequency of an institution’s ments, typically organized into manuals, audit program should be designed to review its should at a minimum include front- and back- internal control procedures and verify that con- office operations; reconciliation guidelines and trols are, in fact, being followed. Any weak- frequency; revaluation guidelines; accounting nesses in internal control procedures should be guidelines; descriptions of accounts; broker reported to management, along with recommen- policies; a code of ethics; and the risk- dations for corrective action. measurement and risk-management methods, Audits of capital-markets and trading prod- including the limit structure. ucts provide an indication of the internal control • For every institution, existing policies and weaknesses of the financial institution. The procedures should ensure the segregation of audit function should have a risk-assessment duties between trading, control, and payment map of the capital-markets and trading function functions. that identifies important risk points for the • The revaluation of positions may be con- institution. For back-office operations, the risk ducted by traders to monitor positions, by assessment may highlight manual processes, controllers to record periodic profit and loss, complex automated computations, independent and by risk managers who seek to estimate revaluation, key reconciliations, approval pro- risk under various market conditions. The cesses, and required investigations or staff frequency of revaluation should be driven by inquiries. Examiners should review a sample of the level of an institution’s trading activity. internal auditors’ workpapers and findings to Trading operations with high levels of activity determine their adequacy. The institution’s man- should perform daily revaluation. Every insti- agement should review responses to internal tution should conduct revaluation for profit audit findings. Appropriate follow-up by audi- and loss at least monthly; the accounting tors should be in evidence to ensure that defi- revaluation should apply rates and prices from ciencies are, in fact, remedied. Assuming that sources independent of trader input. examiners are comfortable with the quality of an • The organization should have an efficient internal audit, they should use audit findings confirmation-matching process that is fully from internal and external auditors as a starting independent from the dealing function. Docu- point to evaluate the internal controls of the mentation should be completed and exchanged institution. as close to completion of a transaction as possible. • Computer hardware and software applications SOUND PRACTICES FOR must have the capacity to accommodate the BACK-OFFICE OPERATIONS current and projected level of trading activity. Appropriate disaster-recovery plans should be Capital-markets and trading operations vary sig- tested regularly. nificantly among financial institutions, depend- • Auditors should review trade integrity and

Trading and Capital-Markets Activities Manual February 1998 Page 7 2060.1 Operations and Systems Risk (Back-Office Operations)

monitoring on a schedule that conforms with transactions should be clearly designated as the institution’s appropriate operational-risk switches, and relevant credit authorities should designation. be involved. • Every institution should have a method- • Every institution that uses brokers for foreign- ology to identify and justify any off-market exchange transactions should establish a clear transactions. statement forbidding lending or borrowing • A clear institutional policy should exist con- broker’s points as a method to resolve cerning personal trading. If permitted at all, discrepancies. procedures should be established to avoid • Every organization should have explicit com- even the appearance of conflicts of interest. pensation policies to resolve disputed trades • Every institution should ensure that the man- for all traded products. Under no circum- agement of after-hours and off-premises trad- stances should soft-dollar or off-the-books ing, if permitted at all, is well documented so compensation be permitted for dispute resolu- that transactions are not omitted from the tion. automated blotter or the bank’s records. • Every institution should ensure that staff is • Every institution should have ‘‘know-your- both aware of and complies with internal customer’’ policies, which should be under- policies governing the trader-broker stood and acknowledged by trading and sales relationship. staff. • Every institution that uses brokers should • In organizations that have customers who monitor the patterns of broker usage, be alert trade on margin, procedures for collateral to possible undue concentrations of business, valuation and segregated custody accounts and review the short list of approved brokers should be established. at least annually. • The designated compliance officer should • Every institution that uses brokers should perform a review of trading practices annu- establish a firm policy to minimize name ally. In institutions with a high level of activ- substitutions of brokered transactions. All ity, interim reviews may be warranted.

February 1998 Trading and Capital-Markets Activities Manual Page 8 Operations and Systems Risk (Back-Office Operations) Examination Objectives Section 2060.2

1. To determine whether the policies, proce- 10. To evaluate the process for resolving dis- dures, practices, and internal systems and puted trades with customers and brokers. controls for back-office operations are 11. To determine the reasonableness of brokers’ adequate and effective for the range of fees and commissions. capital-markets products used by the finan- 12. To evaluate the effectiveness of and con- cial institution. trols on the revaluation process. 2. To determine whether trade-processing per- 13. To review the accounting treatment, report- sonnel are operating in conformance with ing, and control of deals for adherence to established policies and procedures. generally accepted accounting principles and 3. To determine whether the financial institu- the institution’s internal chart of accounts tion adequately segregates the duties of and procedures. personnel engaged in the front office from 14. To review adherence to regulatory reporting those involved in the back-office control instructions. function (operations, revaluation, account- ing, risk management, and financial 15. To evaluate the adequacy of management reporting). information reporting systems on trading 4. To evaluate the adequacy of supervision of activities. the trade-processing operation. 16. To evaluate the adequacy of documentation 5. To evaluate the sophistication and capabil- and other requirements necessary to accu- ity of computer systems and software for rately record trading activity, such as signed the operation and control function. agreements, dealer tickets, and confirmations. 6. To assess the adequacy of confirmation 17. To evaluate the adequacy of audits of capital- procedures. markets and trading activities. 7. To assess the adequacy of settlement 18. To recommend corrective action when poli- procedures. cies, procedures, practices, internal con- 8. To evaluate the adequacy and timeliness of trols, or management information systems the reconciliation procedures of outstanding are found to be deficient, or when violations trades, positions, and earnings with the of laws, rulings, or regulations have been front office and the general ledger. noted. 9. To evaluate the process for resolving discrepancies.

Trading and Capital-Markets Activities Manual February 1998 Page 1 Operations and Systems Risk (Back-Office Operations) Examination Procedures Section 2060.3

These procedures represent a list of processes j. an approved list of brokers, counterpar- and activities that may be reviewed during a ties, and an explicit dispute-resolution full-scope examination. The examiner-in-charge methodology (that is, brokers’ points will establish the general scope of examination policy) and work with the examination staff to tailor k. the procedure for addressing disputed specific areas for review as circumstances war- trades and discrepancies in financial terms rant. As part of this process, the examiner l. revaluation procedures reviewing a function or product will analyze and m. accounting procedures, including a chart evaluate internal-audit comments and previous of accounts and booking policies for examination workpapers to assist in designing internal transactions and transactions with the scope of examination. In addition, after a affiliates general review of a particular area to be exam- ined, the examiner should use these procedures, n. guidelines for management information to the extent they are applicable, for further reporting guidance. Ultimately, it is the seasoned judg- o. requirements for documentation and ment of the examiner and the examiner-in- recordkeeping charge as to which procedures are warranted in p. guidelines for the quality control and stor- examining any particular activity. age of taped conversations of dealer transactions q. guidelines for brokers’ commissions and GENERAL PROCEDURES fees and their appropriate reconciliations r. a code of ethics for traders and other 1. Obtain copies of all policies and procedures personnel with insider information, and governing back-office operations. Policies ‘‘know-your-customer’’ guidelines and procedures should at a minimum include s. personal-trading guidelines and monitor- the following. ing procedures a. the mission statement t. a list of authorized signatures b. organizational structure and responsibili- u. the policy for off-market rates which ties includes the following: c permissible activities and off-premises dealing rules • A letter from someone in senior cus- d. limits approved by the board of directors tomer management (treasurer or above) for the full range of activities and risks, should be kept on file explaining (1) that including intraday and overnight net open the customer will occasionally request positions, instrument types, contracts, off-market rates, (2) the reasons such individual traders, settlement, price move- requests will be made, and (3) that such ment, market liquidity, counterparty, and requests are consistent with the cus- commodity or product types, if applicable tomer firm’s internal policies. This let- (For more details on limits, see sec- ter should be kept current. tions 2010.1, 2020.1, and 2030.1, ‘‘Mar- • The dealer should solicit an explanation ket Risk,’’ ‘‘Counterparty Credit and Pre- from the customer for each request for settlement Risk,’’ and ‘‘Liquidity Risk,’’ an off-market-rate deal at the time the respectively.) request is made. e. the limit-monitoring process used by back- • Senior management and appropriate office or risk-management staff indepen- credit officers at the dealer institution dent of the front office, and limit-excess- should be informed of and approve each approval procedures transaction and any effective extension f. a detailed description of transaction- of credit. processing procedures and flow • A letter should be sent to senior cus- g. procedures for confirming trades tomer management immediately after h. procedures for settlement of trades each off-market transaction is executed i. required reconciliations explaining the particulars of the trade

Trading and Capital-Markets Activities Manual February 1998 Page 1 2060.3 Operations and Systems Risk (Back-Office Operations): Examination Procedures

and explicitly stating the implied loan or SEGREGATION OF DUTIES borrowing amount. • Normally, existing forward contracts 1. Ensure that the process of executing trades is should not be extended for more than separate from that of confirming, reconciling, three months nor extended more than revaluing, or clearing these transactions or once; however, any extension of a roll- controlling the disbursement of funds, secu- over should itself meet the requirements rities, or other payments, such as margins, above. commissions, and fees. 2. Review the financial institution’s policies to 2. Ensure that individuals initiating transactions determine whether they are adequate and do not confirm trades, revalue positions, effective. Does top management have clear approve or make general-ledger entries, or directives regarding the responsibilities of resolve disputed trades. Additionally, within management personnel in charge of oversee- the back office, segregation must occur ing and controlling risk? See sections 2010.1, between reconciling and confirming posi- 2020.1, 2030.1, and 2070.1, ‘‘Market Risk,’’ tions. Accounting entry and payment receipt ‘‘Counterparty Credit and Presettlement and disbursement must also be performed by Risk,’’ ‘‘Liquidity Risk,’’ and ‘‘Legal Risk,’’ distinct individuals with separate reporting respectively. lines. 3. Determine whether access to trading prod- 3. Conduct interviews with senior and middle ucts, trading records, critical forms, and both management to determine their familiarity the dealing room and processing areas is with policy directives in day-to-day situa- permitted only in accordance with stated tions. Develop conclusions as to the adequacy policies and procedures. of these policies in defining responsibilities 4. Determine whether a unit independent of the at lower levels of management in addressing trading room is responsible for reviewing the nature of the business and the business daily reports to detect excesses of approved risks being undertaken, and in defining spe- trading limits. cific limitations on all types of transactional risks and operational failures intended to 5. Review the job descriptions and reporting protect the organization from unsustainable lines of all trading and supervisory personnel losses. Are these policies reviewed periodi- to ensure that they support the segregation of cally to ensure that all risk-bearing busi- duties outlined in the financial institution’s nesses of the financial institutions come under policies. In addition, during the course of the directives approved by top management and examination, observe the performance of per- in light of the financial institution’s profit sonnel to determine whether certain duties experience? Develop an understanding of the that are supposed to be segregated are truly degree of commitment of middle and lower- segregated. level management to the institution’s policy directives. a. Evaluate whether management is TICKET-FLOW PROCEDURES informed about pertinent laws, regula- tions, and accounting conventions. Evalu- 1. Confirm that the trading tickets or auto- ate whether training of back-office staff is mated transactions used to record pur- adequate for the institution’s volume and chases, sales, and trading contracts are well business mix. controlled. Sequential ticketing may be b. Evaluate the management-succession plan appropriate to permit reconstruction of trad- for back-office and control staff. ing history, if required. 2. Verify that trading tickets are verified and c. Evaluate the impact of staff turnover on time coded by the front-office personnel. back-office operations. 3. If risk management is monitored by the 4. Determine the extent to which the financial back office, determine that traders are institution adheres to its established limits, adhering to stated limits. If limit excesses policies, and procedures. exist, ensure that management approval has 5. Determine the adherence of key personnel to been obtained and documented before the established policies, procedures, and limits. occurrence of the limit violation. Determine

February 1998 Trading and Capital-Markets Activities Manual Page 2 Operations and Systems Risk (Back-Office Operations): Examination Procedures 2060.3

whether the institution maintains adequate ent types of transactions sometimes have records of limit violations. varying legal or regulatory standards for the 4. Review transactions for any unusual pattern medium of communication that can be used or activity, such as an increase in volume, (such as telex). new trading counterparties, or a pattern of 2. Review the confirmation process and top-price or bottom-price trades relative to follow-up procedures. Determine that person- the day’s trading range or with the same nel check all incoming confirmations to counterparties. internal records and immediately record, 5. Determine whether the institution holds col- investigate, and correct any discrepancies. In lateral for margin trading. Determine whether addition, determine whether— adequate procedures are in place to monitor a. outgoing confirmations are sent not later positions against collateral. Ensure that the than one business day after the transaction margin-monitoring process is wholly inde- date; pendent of the front office. Review the b. outgoing confirmations contain all rel- adequacy of procedures for verifying reports evant contract details, and incoming con- of margin deposits and contract-position firmations are delivered directly to the valuations (based on outside pricing sources) back office for review; submitted by brokers and futures commis- c. all discrepancies between an incoming con- sion merchants. Review procedures for rec- firmation and the financial institution’s onciling these reports to the financial insti- own records are recorded in a confirmation- tution’s records. discrepancy register, regardless of disposi- 6. Review the financial institution’s system for tion, and open items are reviewed regu- ensuring that deals are transacted at market larly and resolved in a timely manner; rates. d. discrepancies are directed and reviewed 7. Determine whether the institution can iden- for resolution by an officer independent of tify off-market rates for the range of instru- the trading function; ments transacted. Determine whether appro- e. all discrepancies requiring corrective action priate justification for these transactions is are promptly identified and followed up on file and acknowledged by senior man- on; and agement. f. any unusual concentrations of discrepan- 8. Review the holdover-trade policy and the cies exist for traders or counterparties. holdover register’s record of trades made 3. Review confirmation-aging reports to iden- but not posted to the ledgers at the end of tify trades without confirmations that have the day, the identification of such contracts been outstanding more than 15 days. (Sig- as ‘‘holdover’’ items, and their inclusion in nificantly less than 15 days in some markets trader or trading-office position reports to may be a cause for concern.) management. 4. Determine whether the information on con- 9. Determine whether all holdover trades are firmations received is verified with the trad- properly recorded and monitored. In addi- er’s ticket or the contract. tion, review the financial institution’s hold- 5. Determine whether the institution has over register and evaluate the reasons for an effective confirmation-matching and any unusually high incidence of held-over confirmation-chasing process. deals. 10. Identify transactions undertaken with affili- ated counterparties to determine whether such dealings have been transacted at prices SETTLEMENT PROCEDURES comparable to those employed in deals with nonaffiliated counterparties. 1. In all instances, particularly those in which the settlement of trades occurs outside an established clearing system, review the finan- cial institution’s settlement controls to deter- CONFIRMATION PROCEDURES mine whether they adequately limit settle- ment risk. 1. Determine whether the confirmation process 2. Determine whether the financial institution is controlled by the back-office area. Differ- uses standardized settlement instructions.

Trading and Capital-Markets Activities Manual February 1998 Page 3 2060.3 Operations and Systems Risk (Back-Office Operations): Examination Procedures

(Their use can significantly reduce both the 2. Confirm that customer complaints are resolved incidence and size of differences arising from by someone other than the person who the mistaken settlement of funds.) executed the contract. 3. Review the nostro accounts to determine if 3. Ensure that the institution’s policy prohibits there are old or numerous outstanding items the use of brokers’ points in the foreign- which could indicate settlement errors or exchange market and properly controls any poor procedures. brokers’ switch transactions that are permitted. 4. Determine if the institution prepares adequate 4. Review the trade-investigations log to deter- aging schedules and if they are appropriately mine the size and amount of outstanding monitored. disputes, the number resolved and not paid, 5. Determine whether disbursements and the amount paid out in the most recent receipts have been recalculated to reflect period, and the trend of dispute resolutions the net amounts for legally binding netting (the institution’s fault versus counterparties’ arrangements. fault). 5. Review the volume of confirmation and settle- ment discrepancies noted and the correspond- RECONCILIATION PROCEDURES ing levels of overdraft interest or compen- sation expenses paid to counterparties to 1. Obtain copies of reconciliations (for trade, determine— revaluation confirmation, positions) for a. the adequacy of operations staffing (num- capital-markets products. Verify that bal- ber and skill level), ances reconcile between appropriate subsid- b. the adequacy of current operating policies iary controls and the general ledger. Review and procedures, and the reconciliation process used by the back c. the overall standard of internal controls. office for its adequacy. a. Determine the adequacy of the frequency of the reconciliations in light of the trad- ing operation. BROKERS’ COMMISSIONS AND b. Investigate unusual items and any items FEES PROCEDURES outstanding for an inordinately long period of time. 1. Evaluate the volume of trading deals trans- c. Assess the adequacy of the audit trail to acted through brokers. ensure that balances and accounts have 2. Review brokerage expenses. Determine that been properly reconciled. at least monthly brokerage expenses are— d. Determine that reconciliations are main- a. commensurate with the level of trading tained for an appropriate period of time activity and profits, before their destruction. b. spread over a fair number of brokers with 2. Determine that timely reconciliations are pre- no evidence of favoring particular brokers, pared in conformity with applicable policies c. reconciled by personnel independent of and procedures of the reporting institution traders for accuracy and distribution of and with regulatory accounting principles. expenses. 3. Determine that the reconcilement of front- 3. Scrutinize transactions for which the broker office positions is performed by an individual has not assessed the usual fee. without initial transaction responsibility. 4. Does the financial institution retain informa- Determine that timely reconciliations are per- tion on and authorizations for all overdraft formed given capital-markets and trading charges and brokerage bills within the last 12 activity. months and retain all telex tapes or copies and recorded conversation tapes for at least 90 days? (This retention period may need to PROCEDURES FOR be considerably longer for some markets.) DISCREPANCIES AND DISPUTED 5. Review the retention policy for brokers’ TRADES commission and fee reports. 6. Assess that adequate information is obtained 1. Assess the process and procedures for the to substantiate compensated contracts, liqui- resolution of disputed trades. dation of contracts, and canceled contracts.

February 1998 Trading and Capital-Markets Activities Manual Page 4 Operations and Systems Risk (Back-Office Operations): Examination Procedures 2060.3

7. Review a sample of brokered transactions d. the names of firms or institutions with and their documentation. whom employees are authorized to con- duct business (counterparties) REVALUATION PROCEDURES 2. Determine whether the institution has a for- mal record-retention policy and whether it 1. Determine whether revaluation procedures results in an adequate audit trail for internal address the full range of capital-markets and and external auditors. trading instruments at the institution. 2. Determine the frequency of revaluation by product and application (use). AUDIT PROCEDURES 3. Determine the source of market rates and whether the selection process is subject to 1. Determine whether the audit program includes manipulation or override by traders. Deter- a risk assessment of all front- and back-office mine if trader override is justified and well activities. documented. 2. Determine whether the audits performed are 4. Evaluate the methodology of revaluing illiq- comprehensive and address areas of concern uid or structured products when prices are with appropriate frequency. not readily available. If the institution estab- 3. Determine whether audit findings are lishes reserves for these products, review the complete. adequacy of those reserves. 5. Determine whether investment portfolios are 4. Determine whether audit findings are relayed adequately monitored on a reasonable to the appropriate level of management and frequency. that there is appropriate follow-up and response. 5. Determine whether the audit staff is adequately DOCUMENTATION AND trained to analyze the range of capital- RECORDKEEPING PROCEDURES markets activities at the financial institution. 1. Determine the adequacy of control on docu- mentation. Review written documentation for the following: CORRECTIVE ACTION a. the types of contracts eligible for purchase or sale by the financial institution 1. Recommend corrective action when policies, b. individuals eligible to purchase and sell procedures, practices, internal controls, or contracts management information systems are found c. individuals eligible to sign contracts or to be deficient, or when violations of laws, confirmations rulings, or regulations have been noted.

Trading and Capital-Markets Activities Manual February 1998 Page 5 Operations and Systems Risk (Back-Office Operations) Internal Control Questionnaire Section 2060.4

POLICIES AND PROCEDURES list of all traders authorized to trade off premises? The following questions are appropriate for policies and operating procedures for capital- markets and trading activities. SEGREGATION OF DUTIES

1. Do the policies and procedures have the 1. Does the back office have a current organi- approval of the board of directors? zation chart? If so, obtain a copy. 2. Do they give sufficiently precise guidance 2. Is the organization chart supplemented by to officers and employees? position descriptions and summaries of 3. Do they have clear directives regarding the major functions? If so, obtain copies of responsibilities of management personnel in them. charge of overseeing and controlling risk? 3. Is there a management-succession plan for (See sections 2010.1, 2020.1, 2030.1, and back-office and control staff, and is it ad- 2070.1, ‘‘Market Risk,’’ ‘‘Counterparty equate? Is the experience level of personnel Credit and Presettlement Risk,’’ ‘‘Liquidity commensurate with the institution’s activity? Risk,’’ and ‘‘Legal Risk,’’ respectively. Is the turnover rate high? 4. Do they appear to be appropriate to man- 4. Compare organizational charts between agement’s objectives and the needs of the exams. If the turnover rate has been high, institution’s customers? determine the reasons for the turnover and 5. Do they cover all of the financial institu- evaluate what effect the turnover has had on tion’s back-office operations and adequately the financial institution’s trading operations. describe the objectives of these activities? Determine the reasons for each trader’s 6. Are they updated on a timely basis when termination or resignation. new products are introduced or when exist- 5. Are all employees required to take two ing products are modified? consecutive weeks of vacation annually? Is this policy followed? 7. Do they fully describe all the documenta- 6. Does the institution perform background tion requirements relating to trading checks on employees? products? 7. Review the financial institution’s compen- 8. Do they establish parameters which prevent sation program for these activities to deter- conflicts of interest within the financial mine whether remuneration is based on institution’s overall trading operations (that volume and profitability criteria. If so, deter- is, do safeguards prevent insider abuses)? mine whether controls are in place to pre- 9. Do procedures manuals cover all the secu- vent personnel from taking excessive risks rities activities that the financial institution to meet the criteria. conducts, and do they prescribe appropriate 8. Is there a list of locations where trading internal controls relevant to those functions activities are carried out, supplemented by a (such as revaluation procedures, accounting description of the activities at each location and accrual procedures, settlement proce- and an explanation of each location’s dures, confirmation procedures, accounting/ responsibilities with regard to risk manage- auditing trails, and procedures for establish- ment and control? If so, obtain copies of the ing the sequential order and time of list and arrange for access to the supplemen- transactions)? tal information. 10. Do prodedures include a code of ethics? Is 9. Are dealers and position clerks that report to there a ‘‘know-your-customer’’ guideline at them excluded from the following functions: the institution? How does the institution a. preparing, validating (officially signing), ensure compliance? and mailing trading contracts? 11. Are there written procedures to control b. recording trading transactions, maintain- after-hours trades and trades originating ing position ledgers and maturity files, outside the trading room (for example, at and preparing daily activity and position the trader’s home)? Is there an approved reports (except for memorandum records

Trading and Capital-Markets Activities Manual February 1998 Page 1 2060.4 Operations and Systems Risk (Back-Office Operations): Internal Control Questionnaire

used to inform dealers of position TICKET FLOW information)? c. periodically revaluing positions and 1. Are tickets prenumbered? If not, are trading determining gains or losses for official tickets assigned a computer-generated num- accounting records? ber? Does control over tickets appear rea- d. settling transactions and other paying or sonable and adequate? receiving functions, such as issuing or 2. Do tickets clearly define the type of product receiving, and processing cable or mail (for example, interest-rate swap, OTC bond transactions, drafts, or bills of exchange? option, or gold bullion)? 3. Do tickets contain all other pertinent infor- e. receiving counterparty confirmations and mation to prepare the related contract with- reconciling them to contracts or broker out recourse to the dealing room? statements, following up on outstanding 4. Are trading tickets time and date stamped in confirmations, and correcting related the front office? Are dual signatures on the errors and similar processing functions? tickets for the trader and back-office f. operating and reconciling nostro and personnel? other due-to or due-from accounts related 5. Are there any unusual patterns of activity to trading activities? (for example, an increase in volume, new g. preparing, approving, and posting any trading counterparties, a pattern of top-price other accounting entries? or bottom-price trades relative to the 10. Is management informed about pertinent day’s trading range or with the same laws, regulations, and accounting conven- counterparties)? tions? Is training of back-office staff adequate 6. Are reviews of outstanding contracts per- for the institution’s volume and business formed on a frequency commensurate with mix? trading activity? 11. Does management have a strategy for the 7. Are trader positions reviewed and approved back office that parallels that for the by management on a timely basis? organization? 8. Can the institution identify off-market 12. Is the process of executing trades separate transactions? from that of confirming, reconciling, revalu- 9. Does the institution ensure that senior cus- ing, or clearing these transactions or from tomer management is aware of off-market controlling the disbursement of funds, secu- transactions and the special risks involved? rities, or other payments, such as margins, Is appropriate justification for these trans- commissions, or fees? actions on file and acknowledged by senior management? 13. Are front-office functions segregated from 10. Are holdover trades adequately controlled? those individuals who confirm trades, revalue 11. Are all holdover trades properly recorded positions, approve or make general-ledger and monitored? Can the institution justify entries, or resolve disputed trades? Addi- the reasons for any unusually high incidence tionally, within the back office, are recon- of held-over deals? ciling and confirming positions segregated? Is accounting entry and payment receipt or 12. Does the institution transact trades with disbursement performed by distinct indi- affiliated counterparties? Are such dealings viduals with separate reporting lines? transacted at prices comparable to those employed in deals with nonaffiliated 14. Is access to trading products, trading records, counterparties? critical forms, and both the dealing room 13. Does the financial institution have specific and processing areas permitted only in policies for margin lending, and are cus- accordance with stated policies and tomer requests adequately reviewed and procedures? authorized? Does it enforce all margin 15. Is a unit independent of the trading room requirements and sell securities if custom- responsible for reviewing daily reports to ers do not meet margin calls? detect excesses of approved trading limits? 14. Does the back office monitor collateral 16. From observation, are back-office tasks truly against open positions for margin custom- segregated from front-office tasks? ers? Is the supervision adequate?

February 1998 Trading and Capital-Markets Activities Manual Page 2 Operations and Systems Risk (Back-Office Operations): Internal Control Questionnaire 2060.4

15. Are margin requirements on all outstanding communication that can be used (for exam- contracts for a customer monitored daily? ple, telex)? In the case of actively trading customers, 10. Does the institution have an effective are margin requirements checked after cash confirmation-matching and confirmation- trades? chasing process? 11. Are there procedures to uncover unusually heavy trading by a single counterparty? CONFIRMATIONS SETTLEMENT PROCESS Review the confirmation process and follow-up procedures. 1. Do the financial institution’s controls adequately limit settlement risk? 1. Are all data on incoming and outgoing 2. Are nostro accounts reconciled frequently? confirmations compared to file copies of Are there old or numerous outstanding items contracts? Verify that confirmations contain which could indicate settlement errors or the following information: poor procedures? a. counterparty 3. How are failed securities trades managed? b. instrument purchased or sold a. Do procedures promptly resolve transac- c. trade date tions that are not settled when and as d. value date agreed on (‘‘fails’’)? e. maturity or expiry date b. Are stale items valued periodically and, if f. financial terms any potential loss is indicated, is a par- g. delivery and payment instructions ticular effort made to clear such items or h. definition of any applicable market con- to protect the financial institution from ventions (for example, the interest- loss by other means? determination methodology) c. Are fail accounts periodically reconciled i. date of preparation, if different from the to the general ledger, and are any differ- transaction date ences followed up to a conclusion? j amount traded 4. Is the back office routinely able to reconcile k. reference number its cash accounts against securities accepted or delivered? 2. Are signatures on confirmations verified? 5. Is physical security of trading products 3. Are outgoing confirmations sent not later adequate? than one business day after the transaction 6. To ensure segregation of duties, are person- date? nel responsible for releasing funds specifi- 4. Do outgoing confirmations contain all rel- cally excluded from any confirmation evant contract details? Are incoming con- responsibilities? firmations delivered directly to the back 7. Does the institution prepare adequate aging office for review? schedules? Are they monitored? 5. Does the institution adequately monitor dis- 8. Are netting arrangements correctly reflected crepancies between an incoming confirma- in disbursements and receipts? tion and the financial institution’s own records? 6. Are discrepancies directed to and reviewed RECONCILIATIONS for resolution by an officer independent of the trading function? Obtain copies of reconciliations (for trade, 7. Are all discrepancies requiring corrective revaluation confirmation, and positions) for action promptly identified and followed up traded products. Verify that balances reconcile on? to appropriate subsidiary controls and the gen- 8. Are there any unusual concentrations of eral ledger. Review the reconciliation process discrepancies for traders or counterparties? followed by the back office for adequacy. 9. Has the institution conducted adequate research to determine the standing of legal 1. Are timely reconciliations prepared in con- or regulatory standards for the medium of formity with applicable policies and proce-

Trading and Capital-Markets Activities Manual February 1998 Page 3 2060.4 Operations and Systems Risk (Back-Office Operations): Internal Control Questionnaire

dures of the reporting institution and regula- 4. Are brokers’ statements reconciled by the tory accounting principles? back office with the financial institution’s 2. Are unusual items investigated? Are there records before the payment of commissions? any outstandings? 5. Does the back office routinely report any 3. Is the audit trail adequate to ensure that significant questions or problems in dealing balances and accounts have been properly with brokers? Are discrepancies on brokers’ reconciled? statements directed to someone outside the 4. Are reconciliations held on file for an appro- trading function for resolution? priate period of time? 6. Can the institution justify cases in which the 5. Is the reconcilement of front-office positions broker has not assessed the usual fee? performed by an individual without initial 7. Is an adequate audit trail established for all transaction responsibility? overdraft charges and brokerage bills within the last 12 months? Does the process require retention of all telex tapes or copies and DISCREPANCIES AND DISPUTED recorded conversation tapes for at least 90 TRADES days? (This retention period may need to be considerably longer for some markets.) 1. Is the resolution of disputed trades and determination of compensation for the early unwinding of contractual obligations of the REVALUATION financial institution controlled by the back office? 1. Do the revaluation procedures address the 2. Are the processes and procedures for the full range of capital-markets and trading resolution of disputed trades effective? instruments at the institution? 3. Are customer complaints resolved by some- 2. Is the frequency of revaluation by product one other than the person who executed the and application (use) adequate? contract? 3. Are the source of market rates and the 4. Does the institution’s policy prohibit the use selection process subject to manipulation or of brokers’ points in the foreign-exchange override by traders? Is trader override justi- market and control any brokers’ switch trans- fied and well documented? actions? 4. Are revaluation results discussed with the 5. Is the volume of confirmation and settlement trading management? Is an approval process discrepancies excessive? in place to ensure agreement of positions and profit and loss by back- and front-office staff?

BROKERS’ COMMISSIONS AND FEES PROCEDURES ACCOUNTING

1. Evaluate the volume of trading deals trans- See section 2120.1, ‘‘Accounting.’’ acted through brokers. Are commissions and fees— a. commensurate with the level of trading MANAGEMENT INFORMATION activity and profits? REPORTING b. spread over a fair number of brokers? Is there evidence of favoring a particular or See section 2040.1, ‘‘Management Information group of brokers? Systems.’’ c. reconciled by personnel independent of traders to determine accuracy and distri- bution of expenses? DOCUMENTATION AND 2. Are regular statements received from these RECORDKEEPING brokers? 3. Are incoming brokers’ statements sent directly 1. Is written documentation complete, approved to the accounting or operations department at the appropriate level (with authorized and not to trading personnel? signatures), and enforceable?

February 1998 Trading and Capital-Markets Activities Manual Page 4 Operations and Systems Risk (Back-Office Operations): Internal Control Questionnaire 2060.4

2. Are there procedures in place to ensure 3. Do audit findings summarize all important compliance with section 208.34 of Regula- areas of concern noted in the workpapers? tion H (12 CFR 208.34)? 4. Are audit findings relayed to the appropriate level of management? Is appropriate follow-up and response elicited? AUDIT 5. Is the audit staff adequately trained to ana- lyze the range of capital-markets activities at 1. Does the audit program include a risk assess- the financial institution? ment of all the front- and back-office activities? 6. Is there an opportunity for undue influence to 2. Are comprehensive audits performed, and do be imposed on audit staff? Is audit staff they address areas of concern with appropri- sufficiently independent of control and front- ate frequency? Is the scope adequate and office functions? clearly stated?

Trading and Capital-Markets Activities Manual April 2003 Page 5