Operational risks in FX trading

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.

Effective Cash Management in Banks

Cash is to a business is what blood to a living body. In a business anything done financially affects the cash eventually. A business cannot run without its life blood cash and without cash management there may be no cash remaining to operate.

Cash movement in a business is a two-way traffic. It keeps on moving in and out of business. The inflow and outflow of cash never coincides. Important aspect, which is attached to cash is the fourth dimension – time associated with the movement of cash. Due to non-synchronicity of cash inflow and outflow, the inflow may be in excess of the outflow or vice versa at any particular point of time. Hence there is a direct need to control its movement through skillful cash management. The primary aim of cash management is to ensure that there should be enough cash availability when the needs arise, not too much but never too little.

Effective cash management processes are pre-requisites in banks to execute payments, receivables and manage liquidity. Banks are most significant players in any financial markets. They are the biggest purveyors of credit and they also attract most of the savings from the population. Banks also act as crucial channels of the governments in their efforts to ensure equitable economic development.

Cash management is a broad term that refers to collection, concentration, and disbursements of cash. It encompasses bank’s level of liquidity, its management of cash balance, and its short-term investment strategies. In some ways, managing cash flow is one of the most important jobs in today’s scenario. Efficient cash management involves monitored outflow and inflow of cash to improve liquidity and returns while implementing adequate controls to manage risks. Cash management is achieving tradeoff between liquidity and profitability.

Iraq halts plans to redemoninate dinar

The Government of Iraq has decided to hold off on a plan to knock three zeros off the nominal value of bank notes of its currency because it does not believe the economic climate is suitable. The proposal to restructure the dinar to bring more liquidity into the market has been awaiting parliamentary approval since last year.

The central bank said last August it planned to re-denominate the Iraqi dinar to simplify financial transactions in an economy that is still heavily centralised and dominated by oil, and where deals are often carried out in cash.

Iraq is slowly getting back on its feet after years of war and sanctions. Oil accounts for 95 per cent of government revenues and the country’s banking system is still highly underdeveloped.

CBI tightens rules on buying US dollars

Central Bank of Iraq is tightening access to US Dollars after demand ballooned amid suspicions some of the cash was being smuggled to Iran and Syria, both struggling with intensifying international sanctions.

In February, the central bank asked dealers to submit cheques to identify currency buyers. From 2 April 2012, the rules were tightened further, requiring all commercial buyers of dollars at the central bank’s near-daily auctions to produce tax clearance certificate, previously applied only to orders of $50,000 and above, to show the “genuineness” of their need for dollars.

From June 30, the Iraqi traders will have to submit papers to prove that they are allowed to import the goods into the country.

Demand for greenbacks has doubled since November to about $300mn a day, putting pressure on the nation’s foreign reserves of about $60bn. The central bank also has an economic vested interest in holding daily dollar sales at $200mn or below, in order not to deplete the country’s foreign currency reserves.

Currency dealers are expressing doubts over whether the regulations would work. However, some controls and regulations are must to avoid money laundering and financing of terrorist activities. Iraq still being primarily a cash based economy, the tracking the movement of cash is quite difficult.

Cash as fuel!

Every year Hungary recycles approximately $1 billion worth of worn out forints, and converts the used currency into bricks. These bricks are sent to several charities, so they can burn them as heating fuel. The program allows the organization to cover up to a third of their annual heating costs.

Banknotes undergo a quality check at the logistics centre of the National Bank of Hungary in Budapest. Once they are taken out of circulation, the bank notes are recycled for fuel, and a few charities each year get 20-30 tonnes of paper bricks each. Banknotes are shredded and compressed into heating fuel in the shape of bricks.

As per Reuters, Hungary is the only country to recycle its worn cash for fuel each year.

Is Euro at fault for the current crisis?

One of the principal goals of Europe’s common currency – euro – has always been to promote greater financial market integration between member countries. It was hoped that the common currency would make it easier for investors in one euro country to find good investment opportunities in other euro countries since they would no longer have to worry about fickle exchange rates.

The adoption of the euro as a common currency was designed also to cause large capital flows from the euro zone core to the periphery. Many believe it is those very capital flows that set the stage for the crisis. The problem is that such surges in capital flows depend on the perceptions and fancies of international investors, and therefore have a notorious tendency to come to a sudden stop if investor sentiment changes.

The economic recession that began in 2008 sucked funds from the market and changed the risk perceptions of the investors. The investors started looking for safe havens in cash and treasuries of stronger economies. In the case of the euro zone, the sudden stop to capital flows in 2009 indiscriminately hit all of the periphery countries, regardless of how well they had managed their finances.

Why Greece must continue with Euro

Greece is going to face years of financial struggle even if they manage to restructure their debts. Their prospects are so bleak that, according to one school of thought, they would be better off outside the euro system, despite the immediate costs of leaving.

I doubt, and not just because the immediate costs of an exit would be enormous. Even after that penalty was paid, resurrecting national currencies and regaining control of monetary policy would create as many problems as they solved.

Labor costs in Greece have risen much faster in recent years than in Germany and the rest of the euro core, making its exports expensive and imports cheap. The result is chronic trade deficits, which must be financed through continued borrowing.

Leaving the euro would be big economic disaster. It would cause a run on Greek banks as depositors rushed to move their euros abroad before the balances could be converted to drachmas. Also, Greek borrowers would still owe euros to foreigners. Because the new drachma would instantly depreciate, the borrowers would have a diminished capacity to service those debts, causing new waves of bankruptcies.

On balance, debt restructuring plus internal devaluation – difficult as it may be – looks preferable. Explicit wage cuts, and the recession needed to induce them, don’t have to carry the whole burden of cost adjustment. A combination of increased value-added tax and lower payroll tax mimics a currency devaluation by raising the price of imports relative to the price of exports, lowering real wage costs by stealth. They should be a part of the mix. They must hold growth in wages to the euro area’s rate of inflation plus any increase in national productivity to remain competitive in future and initiate growth of their economy.

Nevertheless Greece, so slow to learn the new rules, would have been better off not joining the euro system in the first place. But it did join, and its best bet now is to make it work.

Iraqi stamp in Indian currency

With the establishment of the British mandate after World War I, Iraq was incorporated into the Indian monetary system, which was operated by the British, and the rupee became the principal currency in circulation, at a rate of 1 dinar = 13⅓ rupees. 16 Annas = 1 Rupee.

An old 3 Anna Iraqi stamp of 1923

It continued until 1931 when the Iraq Currency Board was established in London for note issue and maintenance of reserves for the new Iraqi dinar.

EBF is planning for a new benchmark to rival Libor

A European banking group are testing a new price benchmark to set the cost of inter-bank and corporate lending, challenging the London Inter-Bank Offered Rate (Libor) pricing scheme and paving the way for a stronger role for continental European banks in money markets. On 26 May 2010, the Euribor Steering Committee Members voted in favour of the creation of a USD Euribor and agreed to create a Task Force in order to develop the new fixing.

The European Banking Federation (EBF) is the driving force behind the project, which will complement an existing benchmark in euros, Euribor, decided upon daily by a committee of 24 banks. On 27 June 2011, the USD Euribor entered the testing phase.

The new project, called ‘US Dollar Euribor’, is set to establish a global benchmark in the American currency in direct competition with the USD Libor benchmark. The USD Euribor is attempting to bring together 24 banks, mostly from continental Europe, but also from Japan, the US, China and Canada. One British bank is also part of the project, according to a source close to the operation.

The plan originates from concerns among continental European banks about what they see as a dominant position by investment banks and other big lenders from the city of London, which have a hold on the price-setting process that dictates the cost of trillions of dollars of bank and company borrowing.

The European challenge to Libor comes at a time when the group backing the British benchmark is in the midst of turmoil over the possible role it played in manipulating Libor rates to cool the financial crisis. The USD Euribor appears to have broad support in continental Europe, although the names of the banks involved are not yet public.

Will SDR be the next global reserve currency?

The recent crisis has brought home the complex challenges arising from the world having a single reserve currency. The economy of US is also making USD a volatile currency. BRICS countries in their recent Sanya summit, decided to drop USD as a currency for their bilateral trades and preferred their own currency as a substitute. In the search for alternative solutions, one option is to have a menu of alternative reserve currencies which fulfill the required criteria – full convertibility; the exchange rate determined by market fundamentals; a significant share in world trade; liquid, open and large financial markets in the currency issuing country; and also the policy credibility to inspire the confidence of potential investors. There is a debate on whether the SDR can be a reserve currency. In principle, it is desirable to develop a multi-currency system with several currencies operating as broad substitutes and reflecting changing economic weights and global realities.

There have been recent efforts by the IMF to promote the use of SDR as a potential reserve asset for the evolving international monetary system. For the SDR to take on this significant role, several prerequisites have to be in place.The SDR has to be accepted as a liability of the IMF, it has to be automatically acceptable as a medium of payment in cross-border transactions, freely tradable and Its price has to be determined by forces of demand and supply. As the SDR, presently, does not satisfy these conditions, it cannot be a reserve currency in the international payment system.In principle, one needs a global central bank to issue SDRs which take the characteristic of unit of global payment and settlement system. Thus, the move towards multicurrency world is a gradual evolution.

Another dimension of this issue is to change the composition of the SDR basket. Going by the recent initiatives, if at all there is a move to alter the composition of the SDR basket, including currencies of those dynamically emerging market economies should be considered that satisfy the existing inclusion criteria: in particular, a fully convertible capital account and a market determine exchange rate. By the volume of trade, Chinese Yuan is a potential candidate, but it cannot be considered to be included in the basket as its rate is administered and not market determined; secondly, it is also not fully convertible. The another important currency is Indian Rupee, although its price is determined by the market, but it is not fully convertible. The currencies of emerging economies, therefore, need time to be considered for inclusion in the basket for SDR.