Management of Operational Risk in Foreign Exchange: 2004 Changes

95 2004 Changes Management of Risk Operational in Foreign Exchange In 1996, the Foreign Exchange Committee published its first version of Management
of Operational Risk in Foreign Exchange, or the Sixty Best Practices. As the industry
evolves and trading processes change, the Committee periodically updates this
paper. In 2004, the changes indicated below have been introduced to the Sixty Best
Practices. The most recent version of the Sixty Best Practices can always be found on
the Foreign Exchange Committees public website at <www.newyorkfed.org/fxc>. Best Practice no. 12: Closely Monitor Off-Market and Deep-in-the-Money Transactions Amend the first paragraph to state: All dealer institutions that permit requests for
historical rate rollovers (HRRs) should have written procedures to guide their use
and should detail the added controls required in the trading and reporting of off-
market transactions. Operational responsibilities should be clearly defined in
regard to monitoring, reporting, and special confirmations, if any are needed. Such
special confirmations may be necessary to identify the market forward rate in effect
when the HRR was executed. The sale of deep-in-the-money options warrants special
attention and specific procedures applicable to sales and trading staff (and, if necessary,
senior management). Add a final paragraph to read: The sale of deep-in-the-money options warrants special attention and specific procedures applicable to sales and trading staff (and, if
necessary, senior management). There may be legitimate reasons for the sale of such Management of Risk Operational in Foreign Exchange 97 2004 Changes 98 FOREIGN EXCHANGE COMMITTEE 2004 ANNUAL REPORT optionsfor example, the sell back of an
option or the implied delta within a separate
derivatives product. However, it should also be
recognized that the sale of deep-in-the-money
options can be used to exploit weaknesses in a
counterpartys revaluation or accounting process
that could create erroneous results. Procedures
should ensure an appropriate level of reviewif
necessary, by senior trading management or risk
management outside the sales and trading
areasto guard against potential legal,
reputational, and other risks. Best Practice no. 41: Conduct Daily Position and P&L
Reconciliation Revise the final sentence of the second para-
graph to read: Because a discrepancy in P&L
between sales and trading and operations can
indicate a difference in positions or market
parameters (that is, rates or prices), all differ-
ences should be reported, investigated, and
resolved in a timely manner. Best Practice no. 42: Conduct Daily Position Valuation Amend the fourth paragraph to read: Illiquid
markets present additional risk to a bank
because illiquid instruments are infrequently
traded, making them difficult to price. Often,
it is hard for a bank to obtain market quotes,
thereby preventing timely and consistent
position monitoring. P&L may be distorted
and risk may not be properly managed. In
such instances, a bank should seek to obtain
quotes from other counterparties active in the
market. Management should be aware of
these procedures so that they may effectively
manage and evaluate illiquid market posi- tions. These procedures allow a bank to mark
to market its positions and to evaluate associated
risks. All market participants should be aware that
an FX option portfolio is not effectively marked to
market unless the valuation reflects the shape of
the volatility curve. With consideration given to the
size of the portfolio and daily activity, positions
should, whenever possible, be revalued to reflect
the smile effect when the firm wishes to mark to
market. Where appropriate, firms should reserve
against liquidity and pricing risk. Best Practice no. 43: Review Trade Prices for Off-Market
Rates Revise the first paragraph to state: Trade
prices for both internal and external trades
should be independently reviewed to ensure
reasonableness within the market prices that
existed on the trade date. Best Practice no. 52: Ensure Proper Model Sign-off and
Implementation Amend the first paragraph to read: Quantitative
models often support FX trading activities. As a
result, their implementation and management
should be a coordinated effort among the vari-
ous FX business lines. Model implementation
and maintenance should ensure that all FX
business lines (sales and trading, operations,
financial control, risk control, technology,
audit, and others) approve, support, and
understand the model purpose and capabili-
ties, as well as the roles and responsibilities of
each business line. Further, to maintain
appropriate segregation of duties, model vali-
dation, model technical development, and
data input and output reporting should all be 99 MANAGEMENT OF OPERATIONAL RISK IN FOREIGN EXCHANGE performed independently from sales and
trading. Best Practice no. 54: Establish Strong Independent
Audit/Risk Control Groups Revise the first paragraph to state: Market
participants should have sophisticated and
independent audit/risk control groups. It is
recommended that market participants per-
form rigorous self-assessments and publish
regular reporting of such to management, the
business line, and audit/risk control groups.
Firms should implement policies and proce-
dures that enable employees to raise concerns
anonymously.

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