The foreign exchange market is one of the oldest money markets in existence. Banks are the predominant players through its many years of operation. The foreign exchange market has undergone significant change in both competition and size. Trading procedures have largely been adopted by market participants over time and not through the publication of specific regulatory documents. Sales & trading system technology has generally kept pace with the expanding number of increasingly complex products and their impact on the foreign exchange market. Equally important is the need for operations, operational technology, and settlement risk management to keep pace with these changes in the market.
Operational risk, unlike credit and market risk, is very difficult to quantify. Clearly, an institution can measure the losses associated with operational errors or resulting from the failure of the operational process to catch errors made in sales & trading. However, determining expected losses and uncertainties surrounding those losses, as most firms do when they measure credit and market risk, are much more complicated. Not only can improper management of operational risk result in compensation payments to counterparts for failed settlement, but they also can lead to larger losses in a bank’s portfolio from managing the wrong position. Further, investigating problems and negotiating a resolution with your counterparty carry additional costs.
Operational risks can range from a natural disaster, which can cause the loss of a primary trading site, to a difference in the payment conventions on a foreign exchange transaction. It includes such matters as inadequate systems, failure to properly supervise, defective controls, fraud, and human error. Risk has become a major issue for banks as technological advances have compressed the time frame for dealing, thereby necessitating timely risk reporting.
Recent market occurrences have also created a particularly strong sentiment for the establishment of strong risk management. Modification of operational procedures and controls are necessary as risk management becomes more challenging in a fast paced market. Failure to adequately manage operational risk can negatively impact P&L, not only resulting from the costs of incorrect settlement of foreign exchange transactions, but also managing incorrect positions or taking unknown credit risks. Further, failure to manage operational risk can also harm a bank’s reputation and cause a loss of business.
A primary risk management practice is the segregation of duties between operations personnel and sales & trading personnel. Operations personnel, who are responsible for confirmation and settlement, must maintain a reporting line independent of sales & trading, where the trade execution takes place. The financial industry has been reminded of this very essential control, first with Barings PLC and again with Daiwa Bank. Barings and Daiwa have alerted all organizations to focus intensely on trader and market practices as well as on operational control. These crises have prompted all levels of management to re-examine in their own organizations what they are doing and what they should be doing to minimize risk.
Operational controls are vital to the risk management process. In particular, effective controls help banks detect and resolve problems before they lead to financial loss. Banks have adopted many such controls already, not because of regulatory pressure, but because they have perceived it to be in their best interest to do so.
A number of controls are identified as best practices that many market participants are implementing to minimize risk and to create effective risk management. Further, although these controls represent best practices in the current environment, future experience and innovation will lead to new best practices over time.
The key best practices generally adopted are:
- separation of duties between sales & trading and the operations group responsible for confirmation and settlement;
- increased understanding of operational risks among management;
- confirmation practices ensuring that all trades are confirmed in a timely manner;
- standing settlement instructions that ensure funds will be transferred to the right place;
- reconciliation practices that ensure that all discrepancies, be they between the sales & trading and operations, operations and the general ledger, or between the FX participant and its nostro banks, are identified and corrected in a timely manner;
- high quality people who understand the FX process flow and understand how the FX process impacts the level of risk an institution takes;
- management and exception reporting so that all appropriate people in the organization know about problems in the FX process flow;
- automation, particularly in the form of straight-through processing; and
- on-line global credit line and availability information, including netting status, available to sales & trading around the clock.