WIXLIB

An institution should begin FX tradingactivities only if it has the proper documentation in place. The use of industry standarddocuments is strongly encouraged to provide asound mutual basis for conducting financialmarket transactions. A variety of documentsensure the smooth functioning of the marketsand protect participants in these markets: Authority documents address capacity—the right of an institution to enter into atransaction—and authority—permissionfor an individual to act on the institution’sbehalf. Confirmations summarize the significanttrade terms and conditions agreed uponby the parties. Master agreements contain terms thatapply to broad classes of transactions,expressions of market practice andconvention, and terms for netting, termination, and liquidation.2 Standard settlement instructions providefor the exchange of payment instructionsin a standardized, secure, and authenticated format.Each institution is responsible for ensuringthat it has the capacity to enter into a transaction, as well as to monitor and enforcecompliance with its internal proceduresregarding any limitations there may be on the23trading authority of its employees or thirdparties acting on its behalf. Thus, providing todealing firms documentation that includes anumber of investment limitations and restrictions affecting a participant’s ability to trade andinvest is not consistent with best marketpractice.3Before executing a master agreement with acounterparty, an institution should alsoestablish a policy on whether or not it willtrade and in what circumstances. It should alsobe noted that electronic trading often requiresadditional or different documentation.Specifically, customer and user identificationprocedures, as well as security procedures,should be documented.Nondealer participants should be aware thatdealers are likely to be subject to statutory,regulatory, and supervisory requirements for“knowing” their customers. Dealers need toknow the identity of their counterparties, theactivities they intend to undertake with thedealer, and why they are undertaking thoseactivities. While each dealer may havedifferent procedures for implementing theserequirements, nondealer participants shouldcooperate in providing the information thatallows dealers to fulfill these obligations.The Financial Markets Lawyers Group (FMLG), an industry organization of lawyers representing major financial institutions sponsored bythe Federal Reserve Bank of New York, has helped draft documentation for FX activities, including the International Foreign ExchangeMaster Agreement, the International Foreign Exchange and Options Master Agreement, the International Currency Options MarketMaster Agreement, and the International Foreign Exchange and Currency Options Master Agreement. These documents, endorsed bythe Committee, are available on the FMLG’s and the Committee’s websites, www.newyorkfed.org/fmlg and www.newyorkfed.org/fxc , respectively.For related guidance on this issue, see the letter to market participants on the Committee’s website.FOREIGN EXCHANGE TRANSACTION PROCESSING17

Trade Executionand Capturecarefully reconfirm key terms with thecounterparty before ending the call.Process DescriptionThe trade execution and capture function isthe second phase of the FX processing flow.Deals may be transacted directly over arecorded phone line or through Internetbased systems (for example, proprietary tradingsystems or multidealer trading platforms).Trade information captured typically includestrade date, time of execution, settlementdate, counterparty, financial instrument traded,amount transacted, price or rate, and mayalso include settlement instructions.Firms should ensure that all trading isconducted at current market rates. Tradesexecuted at off-market rates can conceallosses, facilitate accounting misstatements, ormask other illegitimate activities. Off-markettrades also involve the extension of creditfrom one party to the other. Nondealerparticipants should establish controls todetect off-market dealing, such as comparingactual trade rates against daily market rangesand reviewing position revaluation results forunreasonable gains or losses.Establish Appropriate TradingPolicies and ProceduresFirms should endeavor to execute transactions in amanner that reduces the possibility of misunderstandings, errors, or unauthorized dealing. Oncecompleted, FX trades constitute binding obligationsfor both parties. Although subsequent processingsteps (for example, confirmation) may uncoverproblems, the best protection from unanticipatedloss is to avoid problems from the outset.In certain cases, valid business purposesmay exist for completing off-market trades.Firms intending to complete off-market trades,including historical rate rollovers, shouldprovide counterparties such additionalinformation as is necessary to establish anunderlying business purpose, as well asevidence that such dealing has been reportedto and approved by senior management.4Responsibilities regarding monitoring andreporting off-market transactions should beclearly defined.Transactions should be executed only byinternally authorized staff who are fullyconversant with market practice andterminology. Firms should avoid the use ofobscure market jargon that may lead toconfusion or miscommunication. Whentrades are verbally executed, traders shouldFirms electing to leave orders with FXdealers should establish a clear mutualunderstanding of how such orders will behandled, particularly with respect to fast ordiscontinuous markets or more seriousmarket disruptions. Firms should clearly agreeon the specific terms of the order, particularlyRecommendation No. 4:418The Committee’s letter on historical rate rollovers, first published in December 1991, continues to offer sound advice to those who needto execute these transactions. The letter, reprinted in the Committee’s 1995 Annual Report, is available on the Committee’s website, www.newyorkfed.org/fxc .FOREIGN EXCHANGE COMMITTEE 2004 ANNUAL REPORT

when such orders are activated, canceled, ormodified by the occurrence of subsequentevents. If certain aspects of an order arecontingent upon the achievement of specificmarket levels, firms should agree in advanceupon the rate or price sources to be used insuch determination.Given the twenty-four-hour nature of theFX market, nondealer participants shouldhave a clear policy on dealing off thepremises or during off-hours. Firms allowingsuch activity should consider institutingprocedures to ensure that trades executedduring off-hours are promptly reported toothers in a prearranged manner (for example,e-mail, voicemail). the organization has been involved inacquisition, divestiture, or restructuringactivity that has led to name changes; and participants are transacting in an agencycapacity.Identification failure raises a number ofpotential risks, including: incorrect assessment of counterparty performance risk; erroneous bookings and/or misdirectedsettlements, creating potential losses foreither counterparty to the transaction; misallocation of collateral; or disclosure of transaction information toincorrect entities.Recommendation No. 5:Clearly Identify CounterpartiesAll participants should clearly identify the legalentity on whose behalf they are undertaking atransaction. Trading on an unnamed basis iscontrary to best market practice.Each counterparty to a transaction shouldensure that its organization recognizes theimportance of clearly and accurately identifyingthe legal entities involved in the transaction.Additionally, firms should encourage staff toprovide their names and affiliation in allcounterparty communication. The benefits ofclear counterparty identification are particularlyevident when: the organization has multiple legal entities(subsidiaries, branches, offices, and affiliates) that are trading in the FX market;The practice of trading FX on an unnamedbasis—also referred to as undisclosed principaltrading—presents an adverse risk to bothindividual market participants and thebroader financial market. Such practicesconstrain a dealer’s ability to assess thecreditworthiness of its counterparties and tocomply with “know your customer” and antimoney-laundering rules and regulations—exposing dealers to clear and significant legal,compliance, credit, and reputational risks aswell as heightening the risk of fraud. It isrecommended that investment advisors anddealers alike implement measures toeliminate the practice of trading on anunnamed basis. Specifically, investmentadvisors and FX intermediaries should developa process to disclose client names to a dealer’scredit, legal, and compliance functions beforethe execution of FX trades.FOREIGN EXCHANGE TRANSACTION PROCESSING19

Recommendation No. 6:Establish and Control System AccessAs alternative technologies continue to emerge inthe FX trading and processing environments,rigorous controls need to be implemented andmonitored to ensure that data integrity and securityare not undermined. Each system should haveaccess controls that allow only authorized individuals to alter the system and/or gain user access.The use of electronic interfaces among FXmarket participants—such as electroniccommunications networks (ECNs) andautomated trading systems (ATSs)—hasincreased significantly in recent years. Useof robust electronic interfaces is encouragedas it reduces trading- and operations-relatederrors, particularly when trade data flowdirectly from the electronic trading platformto the front-end trading system and to theoperations system books and records in orderto achieve straight-through processing.To maximize the benefits of thesedevelopments, access to production systemsshould be allowed only for those individualswho require such access to perform their jobfunction. Lack of adequate access controlsand related monitoring can result inunauthorized trading activity. Without properaccess control, the flow of data between theelectronic trading platform and the tradingsystems or back-office books and records canbe altered, compromising data integrity andsubjecting the firm to the risk of financial loss.their access revoked. Under no circumstanceshould operations or trading functions havethe ability to modify a production system ifthey are not authorized.Recommendation No. 7:Enter Trades in a Timely MannerAll trades should be entered immediately intoappropriate systems and be accessible for bothtrading and operations processing as soon asthey are executed.It is crucial that all trades are entered immediately so that all systems and processes havetimely, updated information. Front-end systemsthat capture deal information may interfacewith other systems that monitor and updatecredit limit usage, intraday profit and loss (P&L),trader positions, confirmation status, settlement instructions, and general ledger activity.An institution’s ability to manage risk may beadversely affected if it does not have accuratetransaction updates in each of the abovementioned areas. The failure to recordtrades promptly misrepresents contractualpositions and can result in: inaccurate accounting records, mismanagement of market risk, misdirected or failed settlement, and the failure of a trade to be booked at all.System access and entitlements should beperiodically reviewed, and users who nolonger require access to a system should have20FOREIGN EXCHANGE COMMITTEE 2004 ANNUAL REPORT

ConfirmationProcess DescriptionThe transaction confirmation is evidence ofthe terms of an FX or a currency derivativetransaction. Therefore, proper management ofthe confirmation process is an essential control.This process is handled in many ways within FXmarkets. For spot, forward FX, or vanilla currency option transactions, counterpartiesexchange electronic or paper confirmationsthat identify transaction details and provideother relevant information. For structured andnonstandard transactions (for example, nondeliverable forwards [NDFs] and exotic currency option transactions), documents areprepared and 1) exchanged and matched byboth counterparties, in the case of most dealers,or 2) signed and returned in the case of certaincounterparties.5All confirmations should be subject eitherto the 1998 FX and Currency Option Definitionsissued by the Committee, EMTA, and the International Swaps and Derivatives Association(ISDA) or to other appropriate guidelines.Recommendation No. 8:Confirm Trades in a Timely MannerBoth parties should make every effort to sendconfirmations or positively affirm trades withintwo hours after execution and in no event laterthan the end of the day.Prompt confirmations are key to theorderly functioning of the marketplacebecause they reduce market risk andminimize losses due to settlement errors. In5the absence of timely confirmation, tradediscrepancies may go undetected, which canlead to disputes, disrupting the settlementprocess and increasing processing costs. Suchdiscrepancies can also result in failed tradesor inaccurate accounting records and canadversely affect any underlying securitysettlement. The incidence of error tends toincrease when non-automated or verbalconfirmations are not followed up withwritten or electronic confirmation. Given thesignificance of the confirmation process, it isimportant that the process is handledindependently of the trading function.Counterparties should have an understanding regarding confirmation practices,that is, whether they will both send out theirown confirmations, or whether one counterparty will sign and return (affirm) incomingconfirmations. It is not recommended thateither party simply accept receipt of thecounterparty confirmation as completion ofthe confirmation process.Confirmations should be transmitted in asecure manner whenever possible. In themost developed markets, confirmations aregenerally sent via electronic message througha secure network. Automated confirmationmatches one party’s trade details to itscounterparty’s trade details. It minimizesmanual error and is the most timely andefficient method because it requires nosubsequent confirmation or manual check.While a significant number of transactionconfirmations are also sent via mail, e-mail, orTypically, the price maker prepares the confirmation and the price taker signs the confirmation.FOREIGN EXCHANGE TRANSACTION PROCESSING21

fax, it is important to note that when theseopen communication methods are usedthere is a greater risk of human error orfraudulent correspondence. When sendingconfirmations by fax or e-mail, or whenconfirming by telephone, counterparties mayagree to take additional steps to ensure receiptby the correct counterparty. Telephoneconfirmations should be used when no othermethod is available. Following the telephoneconfirmation, both parties should exchangeand match written or electronic confirmations.With verbal confirmations, most dealersemploy recorded telephone lines. Nondealer participants may want to consideradopting this practice.Data included in the confirmation shouldcontain the following: the counterparty to theFX transaction, the office through which it isacting, the transaction date (or trade date),the value date (or settlement date), the amountsof the currencies being bought and sold, thebuying and selling parties, and settlementinstructions. Amended confirmations shouldbe sent promptly when necessary. Settlement instructions for forward transactionsshould be reconfirmed two days before thesettlement date.Once a trade between counterparties hasbeen confirmed, such trades may be thesubject of novation or other similar agreements,which should be confirmed in a similarlyvigorous manner.Recommendation No. 9:Block Trades Should Be Confirmed ina Timely MannerThe full amount of block trades transacted byagents should be confirmed as soon as possible,but always within two hours of the trade execution.Investment managers or others acting as anagent may undertake “block” or “bundled”trades on behalf of multiple counterparties.Such trades are subsequently split into smalleramounts and apportioned to specific underlying funds or counterparties. The failure toallocate a block trade on a timely basis couldresult in increased credit, legal, and operationalrisk. Specifically, a delay in allocation hampersthe allocation and management of creditexposure. Trade confirmation will also bedelayed, which in turn may interrupt thesettlement process and, in extreme cases, causepayment failures.The full amount of block trades should beconfirmed as soon as possible but always withintwo hours of trade execution. Allocations andconfirmations to individual obligor accountsshould be completed within four hours andno later than the end of the day on the tradedate. To minimize errors caused by manualintervention, trade allocations should, ifpossible, be provided to the counterpartyelectronically, either through a securenetwork or through authenticated means.Recommendation No. 10:Resolve Confirmation Discrepanciesin a Timely MannerDiscrepancies between a confirmation receivedfrom a counterparty and a firm’s own recordsshould be brought to the counterparty’s attention22FOREIGN EXCHANGE COMMITTEE 2004 ANNUAL REPORT

immediately. Escalation procedures should beestablished to resolve any unco

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