Foreign Exchange Leading drastic change at investment Contents

Foreword 3

Section 1 4 Enhancements investment banks have made to their foreign exchange control environment

Section 2 10 Improvements to foreign exchange service offering by investment banks

Section 3 11 Activities investment banks are focusing on to improve their foreign exchange control environment

Section 4 12

The tough choices investment banks are facing

How EY can help 13

Contacts 14

Acknowledgements We would like to thank the following individuals for their contribution:

►► Adam Holder ►► Mark Selvarajan ►► Rupal Thakrar ►► Christopher Kainz ►► Oliver Rockley ►► Stuart Johnson ►► Krystyna Murphy ►► Poorva Nangia ►► Leila Khan Babar ►► Rick Mangassarian Foreword

Since the 2007 financial crisis, and in spite of difficult economic and market conditions, investment banks have invested significantly in improving their control environment. The market tremors from the Foreign Exchange (FX)-fixing scandal and subsequent probe — triggering a flurry of fines, litigation cases and prosecutions — have been a critical catalyst for such major changes.

We have collaborated with many But this transformation is not completed EY is appropriately positioned to investment banks on this topic and, yet. We expect that investment banks will support investment banks through their although significant and drastic changes be focusing on five main topics: transformation. We have experience in have been achieved, there is still some working with more than 25 investment 1. Formalizing their progress by explicitly way to go. banks, ranging from backward-looking adopting the new FX Global Code investigation work into misconduct and Indeed, investment banks have already 2. Enhancing efficiencies across their new forward-looking remediation of front- achieved a significant amount of change control and management approach office controls. This experience has in the last five years across four main 3. Reinforcing the accountability of allowed us to develop unique assets and dimensions. They have: the front office and removing the approaches that can support the change. ►► Changed their control approach to unnecessary duplication across the These include: new types of risk (e.g., conflicts of three lines of defense ►► Conflicts of interest register interest) 4. Ensuring that the new approach ►► Control standards (based on industry ►► Clarified and defined their new is implemented globally across all practices, regulatory requirements expectations with regard to culture business units and principles are and FX Global Code) and conduct extended to asset classes (beyond FX) 5. Systematically leveraging the use of ►► Integrated surveillance assistance, ►► Adapted their policies and procedures information to improve the detection of including EY's Odyssey platform to new regulation and client abnormal situations and behaviors expectations ►► Control traceability, testing and optimization ►► Simplified their business model and control environment by increasing the ►► Risk and control management level of trading automation framework/target operating model This has a cost both financially and emotionally; but it is the only way to fully restore the confidence of clients and shareholders, as well as gaining new market share.

Pierre Pourquery Partner, Ernst & Young LLP, London

Foreign Exchange Leading drastic change at investment banks | 3 Section 1

In the last three years, mostly driven by regulators, investment banks have significantly improved their foreign exchange sales and trading control environment

Investment banks have been focusing on implementing “low-hanging fruits” to show quick progress

These changes include:

►► New policies and procedures ►► Development of training across the to manage related to entire front-office population (i.e., benchmarks, order handling, traders and salespeople) covering communications, Personal Account aspects of key policies, procedures (PA) dealing, FX barrier options, and guidance related to business and other risks associated with best practices aligning FX business activities with ►► Tactical surveillance to manage the new FX Global Code.1 the most critical conduct risks (i.e., ►► Updating governance benchmark manipulation, stop loss frameworks to enable the clear orders and defending or triggering documentation of management FX barrier options) and supervisory responsibilities, ►► Enhanced communication and oversight of business risks and monitoring across electronic escalation channels communication platforms (e.g., Bloomberg chat, emails and voice)

1 Global Foreign Exchange Committee, FX Global Code, https://www.globalfxc.org/fx_global_code.htm

4 | Foreign Exchange Leading drastic change at investment banks Investment banks have made significant enhancements to their policies, procedures and guidance across the following five dimensions

Benchmarks Orders and Pricing FX barrier options

To manage the most critical conduct risks, Most investment banks have defined Investment banks that trade in FX barrier investment banks have implemented policies and procedures to enable fair options have enhanced their business detailed -wide policies and FX markups to be applied to client orders. guidance to include details on how to business guidance that cover the These are supported by detailed threshold execute barrier-related orders, associated following aspects related to managing criteria for escalation, evidencing hedging activities, order thresholds benchmark orders: management review for audit trail for escalation and requirements for purposes and the need to be truthful to monitoring by the desk supervisor. ►► Defined approach to trading during clients when asked about the amount of the fixing calculation window markup applied. PA Dealing ►► Prohibitions on the types of All investment banks have enhanced information that can be shared We have seen examples across a number existing order handling policies and of investment banks of existing personal ► How netting of fixing orders should business guidance. Examples of ► account dealing frameworks being be conducted enhancements include how FX sales and enhanced to provide sales and trading trading should handle client orders, the ►► Execution method with further clarity on what they can types of orders that will be accepted, the and cannot trade and thresholds on ►► Thresholds for reporting types of disclosures that can be made the amount individuals can trade in FX and escalation to clients (e.g., pre-hedging) and how to per month. Communications manage conflicts of interest (e.g., two of the same client orders, or managing All investment banks have either internal and external stop loss orders). enhanced existing or implemented new policies and guidance on business expectations when communicating with clients and competitors, including the types of information and market color that can be shared both internally within the investment bank and externally to clients, counterparties and competitors, and the types of chat rooms that sales and trading can participate in.

Foreign Exchange Leading drastic change at investment banks | 5 Investment banks have been adapting Investment banks have been Most investment banks have been their governance framework focusing on improving culture and developing tactical surveillance developing training across the entire solutions to manage the most critical front-office population conduct risks

A majority of investment banks have ►► Enhanced business training across the ►► Implementation of tactical surveillance strengthened their existing governance front office that includes a balanced to manage manipulating FX and supervision frameworks in order to mix between classroom and online benchmark fixes, which is the number provide sufficient oversight of business based training one conflict for FX businesses and risks and activities. Key governance has contributed to an increase in ►► Delivery of business training by desk improvements that have typically been surveillance budgets by 50% supervisors and senior business implemented include: management ►► In addition to the surveillance of FX ►► FX business forums for FX business benchmark fixes, investment banks ►► Specific scenario-based training on management, desk supervisors and are also focusing their surveillance FX business activities that are other infrastructure groups (e.g., investment on the following five FX considered to be “grey areas” to legal and compliance) in which key business risks strengthen front-office awareness and FX business risks are reviewed and understanding of expectations ►► Layering and/or wash trades discussed, with follow-through actions documented ►► Increasing focus on the supervisor in ►► Stop Loss promoting conduct and identifying ► Defined supervisory processes, ►► Front Running ► inappropriate behaviors in a timely including procedures that outline manner (some investment banks have ►► Hard mark ups supervisory expectations when introduced training for supervisors on providing desk oversight ►► FX barrier option monitoring risk culture) ►► Ensuring escalation channels are ►► To support their surveillance ►► Frameworks to build the clearly defined, documented and capabilities, they have hired former understanding of culture and improve communicated to the business (in FX traders to provide specialist the monitoring of behavior some cases, these are supported by an knowledge within their surveillance online management tool to enable the ►► Evidenced examples of the impact of and control functions when conducting routing of escalation to supervisors good and bad employee conduct on surveillance activities and evidence the steps taken to reach end-of-year performance ratings and, a resolution) ultimately, the remuneration package

All investment banks have implemented enhanced business training across their front office which includes a balanced mix between classroom based and online based training

6 | Foreign Exchange Leading drastic change at investment banks Investment banks have enhanced Investment banks have also changed All these changes have driven communication monitoring across their business models to mitigate and significant investment for electronic communication platforms remove conflicts of interest within their investment banks (e.g., Bloomberg chat, emails and voice) FX business

►► Monitoring of written communication ►► All investment banks have changed ►► We have observed significant is well established, with more than aspects of their business model investment from investment banks half of investment banks monitoring in order to manage conflicts of since 2010 (around US$1b in total more than 80% of their written interest that are inherent within their for the industry globally) across the communication FX business following activities:

►► To support the implementation of new ►► Our industry comparison has identified ►► Implementation of a conflicts electronic communication policies the following key changes: of interest framework by the and business guidance, most have front office ►► More than 75% of investment undertaken the following activities: banks have automated their fixing ►► Enhanced business practices in ►► Introduced procedures for and non-fixing orders response to FX settlements monitoring and processes for the ►► Slightly less than 50% have ►► Embedded controls delivered as ongoing review of lexicon flags implemented a fee-based model part of business-as-usual activities based on trigger events, e.g., FX for certain order types (e.g., industry focus ►► From a recent survey conducted by fixing orders) EY, we estimate that investment banks ►► Implemented comprehensive first ►► One of the benefits of this trend is have spent more than US$500m over and second line of defense the reduction in some critical risks two years to assess and remediate monitoring of communications and conflicts of interest (e.g., by front-office controls in response to ►► Review of control breaches limiting discretion and access to FX settlements and other issues in a monthly sensitive order information) while control forum potentially limiting the need for complex controls (e.g., reduced Most investment banks have ►► Introduced electronic population of transactional activity communication steering or working been developing tactical subjected to surveillance groups to review the escalations surveillance solutions to and monitoring) from communication monitoring manage the most critical and refine monitoring parameters, conduct risks e.g., validation of lexicons

►► Challenges remain in the monitoring of voice channels. A number of investment banks have undertaken proof of concepts with third-party IT vendors that have not delivered desired standards and expectations

►► At this point, a majority of investment banks are undertaking a risk-based sample approach when it comes to monitoring voice channels, or reviewing voice channels as part of an overall suspicious transaction investigation

Foreign Exchange Leading drastic change at investment banks | 7 This change has had some impact on ►► Examples of regular activities we the FX business, including a significant have observed across investment increase in the cost of conduct and banks include: controls, and the formalization of control ►► Risk and control self-assessments: and : business risks are assessed and the ►► There has been a lot of pressure on adequacy of controls to mitigate the front office to conduct ongoing risks are evaluated and regular assessments of business ►► Conduct material risk assessments: risks and controls forward-looking conduct risks ►► A key regulatory driver for the and the financial impact on the formalization of control and risk business if materialized management frameworks is the ►► On average, we have observed that Senior Managers and Certification traders and desk supervisors are Regime in the United Kingdom, which spending 30% to 50% of their time on requires most senior individuals in these activities, which could instead be firms who hold key roles to have a spent on building client relationships statement of responsibilities setting and generating business out the areas for which they are personally accountable

8 | Foreign Exchange Leading drastic change at investment banks Below, we have outlined a typical phased approach adopted by a Tier 1 investment bank.

Phase 1. Conflict of interest 2. Front office remediation 3. Business as usual

Objectives Establish a framework, including Enhance controls across the Embed controls and ensure identifying and mitigating front office through assessment ongoing controls are in line conflicts of interest and remediation delivery with short term and long term objectives

Activities ►► Identifying scope of business Control assessments ►► Ongoing enhancement of activities (e.g., products, ►► Assessment of business business controls clients and services) controls against a defined ►► Control testing and ►► Identifying business set of control standards validation to identify gaps scenarios ►► Identifying control gaps ►► Ongoing assessment of risks ►► Organizing workshops to for remediation and conflicts identified in engage and socialize with Remediation delivery Phase 1 and 2 business stakeholders ►► Design and deploy controls ►► Ongoing business training ►► Developing a business ►► Communication, training ►► Business advisory support conflicts register and and embedding of controls framework for ongoing monitoring and review ►► Validation and test

Estimated Four years Four years Ongoing duration

We estimate that investment banks have spent over

US $500m over two years to assess and remediate front office controls in response to the FX settlements

Foreign Exchange Leading drastic change at investment banks | 9 Section 2

Client pressure has also been a critical driver of change

Due to client demand, investment ►► An increasing number of client banks have been focusing on improving demands for electronic trading their service offerings: and agency execution is resulting in limited trader discretion and ►► More than 60% have been manual intervention — or none at enhancing their electronic trading all — thus reducing human error and offering to enable the full and conflicts of interest accurate execution of trades. Examples that we have seen in the ►► More than half of investment market include: banks are working on building transparency through the following ►► Automating execution of fixing activities: and non-fixing orders (75%) ►► Enhanced client disclosures ►► Investing in innovating in areas such as pre-hedging, new aggregators and determination of pricing algorithms (57%) components (e.g., trade ►► Offering agency execution execution charge, added value, capabilities (18%) markup and markdown) and how client orders are handled.

►► Moving trading activity away from voice execution desks and on to electronic trading platforms

More than

60%of investment banks have been enhancing their electronic trading offering to enable the full and accurate execution of trades

10 | Foreign Exchange Leading drastic change at investment banks Section 3

Investment banks are continuing their efforts and are now focusing on three main activities

Alignment with the FX Global Code Improvement of surveillance and Extending the FX control environment monitoring capabilities to the rest of the investment bank

►► There has been a lot of effort at a ►► Establishment of such capabilities ►► Investment banks have applied lessons global level to produce the FX Global and responsibilities within the first learnt from remediating their FX Code, which represents a set of line of defense (e.g., T+1 basis for business across other business areas principles that are considered to be material risks) within their markets, including rates, good practice in the wholesale foreign rate options, commodities, credit ►► Focus on identifying the most material exchange market derivatives, index-related businesses risks related to conduct, conflicts of and electronic trading ►► The code is designed to promote a interest, and unauthorized trading robust, fair, liquid and transparent ►► The FX remediation activities identified ►► Develop intelligent and new market that helps investment banks a core set of control standards surveillance capabilities (incorporating build and maintain market confidence that need to be adopted across a structured and unstructured data and and, in turn, improve efficiency and markets business. Controls related focusing on “join the dot”) to replace functionality in the FX market to the following themes can typically tactical surveillance for key risks be adopted and adapted by other ►► 74% have incorporated the FX Global ►► Establishment of cross-line of defense business areas: Code into their control framework; the governance to enable the identification remaining 26% are working on it ► Communications and escalation of material surveillance ► ►► Any gaps identified since the issues to front-office management ►► PA dealing publication of the FX Global Code (e.g., monthly benchmark ►► Order handling in May 2017 may be considered as execution forums) incremental enhancements to the ►► Pricing frameworks changes that have already been made ►► Training by a majority of investment banks ►► Governance ►► The benefit of lessons learnt is to create a single set of control standards across the front office

Foreign Exchange Leading drastic change at investment banks | 11 Section 4

While these specific changes to the control environment are crucial for investment banks in their quest to restore client and regulator confidence, they still have to make some tough choices around several dimensions

Radically changing the three lines of Reducing the overall cost of control by Increasing preventative controls to defense to make the control environment 50% while improving effectiveness 50% of all controls more efficient and effective

►► Investment banks have had to be ►► Spending on control has been driven ►► So far, enhancements to preventative reactive in enhancing and addressing by a “improve at any cost” approach to controls have taken the form of gaps in controls; this has meant address gaps quickly improvements to awareness, training, repetition, overlap and even confusion management information and, in some ►► However, low returns, limited revenue in ownership of control activity across cases, considerations of behavior in growth and the resulting pressures on the traditional lines of defense model remuneration and reward return on equity have brought control ►► Investment banks are beginning to spend under the spotlight ►► However, regulators are actively evaluate a “holistic activity-based encouraging investment banks to ►► To date, much of the focus has been approach” to control by defining go further in addressing behavior on directive (procedures and guidance) key control activities required and and reward, and implement systems and detective (e.g., surveillance and the standard to which they are to be and controls to prevent rather than monitoring) controls, often supported performed, and ensuring that activity detect misconduct by manual processes. While the control is executed by an appropriate team, activity so far has been crucial, its ►► Preventative system-based controls whether front office, compliance or effectiveness is still open to debate are likely to be more effective in addressing misconduct and also less ►► Now that a minimum standard costly to run (greater automation and has been achieved, the focus is on limited manual intervention) achieving greater value through increased automation, reduced ►► However, improvements to controls repetition and prevention without adequate consideration of behavior may be expensive or ineffective, or even worse, both

12 | Foreign Exchange Leading drastic change at investment banks How EY can help

Risk and control assessments Conflict of interest and operational risk registers

►► Risk and control prioritization ►► Conflict of interest register ►► Gap assessment governance and methodology ►► Operational risk register ►► Attestation and testing services

FX Code of Conduct adherence Integrated Surveillance

►► Assessment against 250+ control standards ►► FX risk scenarios ►► FX global industry comparisons ►► Advanced analytics and "Join the dots" use cases across data sources, risk types and asset classes ►► FX remediation and "read across" programs

First and second lines of defense reorganization Digital service for control and compliance

►► Front Office Controls surveys and industry practices ►► Dashboards and risk-based reporting ►► Three lines of defense analysis and target ►► Metrics and monitoring operating model ►► Traceability and evidencing functionalities ►► Control optimization and Centers of Excellence ►► Automated control management

ForeignForeign Exchange Exchange Leading Leading drastic drastic change change at atinvestment investment banks banks | | 13 Contacts

For further information, please contact:

EMEIA

Pierre Pourquery Mark Selvarajan Rick Mangassarian Partner Director Senior Manager Ernst & Young LLP Ernst & Young LLP Ernst & Young LLP London London London +44 207 951 6750 +44 207 951 3441 +44 207 951 9066 [email protected] [email protected] [email protected]

Americas

Tom Campanile Michael Patterson Mary Lou Peters Partner Partner Executive Director Ernst & Young LLP Ernst & Young LLP Ernst & Young LLP New York New York New York +1 212 773 8461 +1 212 773 2824 +1 212 773 2941 [email protected] [email protected] [email protected]

APAC David Scott Luke Shepherd Partner Senior Manager Ernst & Young Advisory Pte. Ltd Ernst & Young Advisory Services Ltd Singapore Hong Kong +1 65 6309 8031 +1 852 2849 9483 [email protected] [email protected]

14 | Foreign Exchange Leading drastic change at investment banks

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