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Trading and Capital-Markets Activities Manual

Trading Activities: Operations and System Risk (Front-Office Operations)
Source: Federal Reserve System 
(The complete Activities Manual (pdf format) can be downloaded from the Federal Reserve's web site)

The front office is where trading is initiated and the actual trading takes place. It consists of traders, marketing staff, and sometimes other trading-support staff. Front-office personnel execute customer orders, take positions, and manage the institution's market risks. The front office is usually organizationally and functionally separate and distinct from the back-office operation, which is part of the institution's overall operations and control infrastructure. 

The back-office function completes the trading transactions executed by the front office. (See section 2060, ''Back-Office Operations.'') It processes contracts, controls various clearing accounts, confirms transactions, and is typically responsible for performing trade revaluations. Additionally, back-office personnel investigate operational problems which may arise as a result of business activities. The back office provides logistical support to the trading room and should be the area where errors are caught and brought to the attention of the traders. While the dealing room and back office must cooperate closely to ensure efficiency and prevent problems, their duties should be segregated to provide an appropriate level of independence and control. 

While the overall size, structure, and sophistication of an institution's front office will vary, the general functions and responsibilities described in this section prevail across the majority of financial institutions. The following discussion describes a typical front office, but it is important to consider individual instrument profiles and market-specific characteristics in conjunction with the review of front-office activities. 

ROLE AND STRUCTURE OF THE FRONT OFFICE 

The trading operation of a financial institution can be categorized by the various roles the front office performs in the marketplace. The front office's responsibilities may include any combination of the following: market maker (dealer), proprietary trader, intermediary, and end-user. 

A market maker makes two-way markets. When initially contacted, the market maker may not know whether the counterparty wishes to buy or sell a particular product. The market maker quotes two-way prices, reflective of the bid/ask levels in the marketplace. The difference between the bid and the ask is called the spread. 

Dealers are not necessarily obliged to make two-way markets. Many market participants are actively involved in facilitating customer transactions even though they are not considered market makers. In some cases, these institutions act similarly to market makers, hedging incremental transactions derived from their customer base. In other cases, the institution may mark transactions up from the bid/ask levels in the marketplace, enter into a transaction with its customer, and fill the order in the marketplace, effectively taking a spread on the transaction. While it may appear as if the dealer is acting as a broker, it should be noted that both the transaction with the customer and the transaction with the marketplace are executed with the financial institution as principal. 

A proprietary trader takes on risk on the institution's behalf, based on a view of economic and market perceptions and expectations. This type of trader will take a position in the market to profit from price movements and price volatility. Proprietary traders may incur high levels of market risk by managing significant positions which reflect their view of future market conditions. This type of activity requires the highest level of experience and sophistication of all traders in the institution. 

Intermediaries communicate bid and ask levels to potential principals and otherwise arrange transactions. These transactions are entered into on an ''as agent'' basis, and do not result in the financial institution acting as a principal to either counterparty involved in the transaction. An intermediary typically charges a fee for its service. 

End-users are purchasers or sellers of products for investment or hedging purposes. Sometimes an end-user will be a short-term trader, but its volume will usually be lower than that of a proprietary trader. 

An institution may not function in all the above-mentioned roles. Each type of market participant strives to maintain or improve its posture in the market based on its own actual or perceived competitive advantages. The institution may also have a sales force or marketing staff that receives price quotes from the institution's trading staff and represents market opportunities to current and potential clients. Usually, marketing staff is paid based on volume or on the profit margin for the business developed. 

Sound business practices dictate that financial institutions take steps to ascertain the character and financial sophistication of counterparties. These practices include efforts to ensure that the counterparties understand the nature of the transactions into which they are entering. When the counterparties are unsophisticated, either generally or with respect to a particular type of transaction, financial institutions should take additional steps to ensure that they adequately disclose the risks associated with the specific type of transaction. Ultimately, counterparties are responsible for the transactions into which they choose to enter. However, when an institution recommends specific transactions to an unsophisticated counterparty, the institution should ensure that it has adequate information on which to base its recommendation. 

Organizational Structure 

The organizational structure of the front office is usually a function of the particular roles it performs. In general, the broader the scope of a financial institution's trading activities, the more structured the front-office organization. A market maker of various products can be expected to have numerous trading and sales desks, with each business activity managed independently and overseen by the trading manager. Correspondingly, traders acting exclusively in a proprietary capacity may act relatively independently, reporting only to the trading manager. 

TRADE CONSUMMATION 

Trading is transacted through a network of communications links among financial institutions and brokers, including telephone lines, telexes, facsimile machines, and other electronic means. The party initiating the transaction contacts one or more dealers, typically over taped telephone lines, to request a ''market,'' that is, a two-sided quote. More than one institution may be contacted to obtain the most favorable rate or execute several trades quickly. 

The initiating trader does not normally indicate which side of the market he or she is on. In response, the trader receiving the call considers the current market, the institution's actual and desired positions, and the likely needs of the initiating trader. The trader assesses the current status of the market through information obtained from other financial institutions, brokers, or information services, and uses this information to anticipate the direction of the market. Upon determining the most favorable rate, the initiating trader closes the transaction by signifying a purchase or sale on the quoting trader's terms. 

Before closing the transaction, the traders must also ensure that it falls within the institution's counterparty credit lines and authorized trading limits. A trade is usually completed in a matter of seconds and the commitments entered into are considered firm contracts. 

Traders at competing institutions may arrange profit-sharing arrangements or provide other forms of kickbacks without attracting the notice of control staff or trading management. To protect against this occurrence, a daily blotter (price/rate sheet) or comparable record or database should be maintained. The blotter or database should be validated against the daily trading range within a narrow tolerance level. Off-market rates should be recorded in a log with appropriate control justification and sign-off. 

Time-stamping of trade tickets by the trader or computer system permits comparison between the market rates recorded on the rate sheet and the rates at which trades are transacted. This system not only protects against deliberate transactions at off-market rates, but it is also useful in resolving rate discrepancies in transactions with other financial institutions and customers. 

Transaction Flow 

Upon execution of the transaction, vital trade information is captured. The form in which details of trade transactions are captured is contingent on the trading systems of the financial institution. When distinct front- and backoffice transaction systems are used, trade tickets or initial input forms typically provide the input detail for the back office. These trade tickets are usually handwritten by the trader and hand-delivered to the back office. When straight-through or automated processing systems are used, trade input is typically performed by the front office. Details are input onto a computer screen and verified by the back office before final acceptance. In either case, trade details should include such basic information as the trade date, time of trade, settlement date, counterparty, instrument, amount, price or rate, and, depending on the instrument, manner and place of settlement. 

The trader's own principal record is the trading blotter or position book, which is a chronological record of deals and a running record of the trader's position. The blotter may or may not be automated, depending on the sophistication of the computer systems at the institution. 

Transaction Reporting 

Traders track market-risk exposures and profit and loss in the ordinary course of business. These calculations, however, should not form the basis for official risk or profit-and-loss reporting. Management information distributed to senior management should be prepared and reviewed independent of the trading function. 

TRAINING AND TECHNICAL COMPETENCE 

Trading-support functions are technical and require levels of skills and training commensurate with the type of institution and the type and variety of products handled. Back-office personnel should demonstrate a level of competence so that they act as a viable check and balance to the financial institution's front-office staff. Additionally, financial institutions must be able to attract and retain competent personnel, as well as train them effectively. Finally, a sufficient level of staffing is required to ensure the timely and accurate processing, reporting, controlling, and auditing of trading activities. 

ETHICS 

The potential risk of trading transactions to a financial institution emphasizes the importance of management's ascertaining the character of its potential traders. While there are no guarantees as to how a particular trader may react to seriously adverse market conditions, proper personnel screening, internal controls, and communication of corporate policies should reduce the possibility of trading improprieties. 

Additionally, management should establish policies and procedures governing standards for dealing with counterparties. An appropriate level of due diligence should be performed on all counterparties with which the institution deals, even if the transactions do not expose the financial institution to much credit risk (for example, collateralized transactions). 

Finally, management should ensure that the marketing practices of its salespersons are ethical. Standards addressing the sales of complex products should be established to ensure that customers are not entering into transactions about which they have no understanding of the potential risks. Management should remain cognizant of the risk to the institution's reputation at all times. Once an institution's reputation is damaged, it can be very difficult to restore. (See section 2150, ''Ethics.'') 

UNACCEPTABLE PRACTICES 

Certain trading practices are considered unacceptable and require close supervision to control or prevent. In the foreign-exchange market, in which prices will probably change before a dispute or counterparty can be settled, the practice of brokers' points has evolved. The use of brokers' points involves one side agreeing to the other's price in a disputed trade, but with the caveat that the discrepancy will be made up in the future. The parties keep an unofficial list of owed or lent monies. The party agreeing to the other's price can then call in the favor at a later date. This practice may be used to hide losses in a trading portfolio until there are sufficient profits to offset them. The practice of brokers' points is considered an unsafe and unsound banking practice, and a financial institution should have a policy forbidding it. 

Another unacceptable practice is adjusted-price trading. This practice is used to conceal losses in a trading portfolio and involves a collusive agreement with a securities dealer from which the institution previously purchased a security that has now dropped in value. The security is resold to the dealer at the institution's original purchase price, and the institution purchases other securities from the dealer at an inflated price. This practice could also involve ''cross parking,'' whereby the collusive parties are both attempting to conceal trading losses. Adjusted-price trading is further described in the Municipal Securities Activities Exam Manual.

Transactions involving off-market rates (including foreign-exchange historical-rate rollovers) should be permitted only in limited circumstances with strict management oversight. The use of off-market rates introduces risks above and beyond those normally faced by dealing institutions in day-to-day trading activities. Because off-market rates could be used to shift income from one institution to another or from one reporting period to another, they can serve illegitimate purposes, such as to conceal losses, evade taxes, or defraud a trading institution. All financial institutions should have policies and procedures for dealing with trades conducted at off-market rates. 

Customers may give a financial institution the discretionary authority to trade on their behalf. This authority should be documented in a written agreement between the parties that clearly lists the permissible instruments and financial terms, collateral provisions and monitoring, confirmation of trades, reporting to the client, and additional rights of both parties. For institutions that have discretionary authority, examiners should ensure that additional policies and procedures are in place to prevent excessive trading in the client's account (account churning). Close supervision of sales and marketing staff and adequate client reporting and notification are extremely important to ensure that the institution adheres to the signed agreement. 

From a management standpoint, inappropriate trading and sales practices can be avoided by establishing proper guidelines and limits, enforcing a reporting system that keeps management informed of all trading activities, and enforcing the segregation of responsibilities. Experience has shown that losses can occur when such guidelines are not respected. 

SOUND PRACTICES 

Capital-markets and trading operations vary significantly among financial institutions, depending on the size of the trading operation, trading and management expertise, the organizational structure, the sophistication of computer systems, the institution's focus and strategy, historical and expected income, past problems and losses, risks, and the types and sophistication of the trading products and activities. As a result, practices, policies, and procedures expected in one institution may not be necessary in another. 
Evaluating the adequacy of internal controls requires sound judgment on the part of the examiner. The following is a list of some of the practices examiners should look for.

  Every organization should have comprehensive policies and procedures in place that describe the full range of capital-markets and trading activities performed. These documents, typically organized into manuals, should at a minimum include front- and backoffice operations, reconciliation guidelines and frequency, revaluation guidelines, accounting guidelines, descriptions of accounts, broker policies, a code of ethics, and the risk-measurement and management methods, including the limit structure. 
  For every institution, existing policies and procedures should ensure the segregation of duties between trading, control, and payment functions. 
  The revaluation of positions may be conducted by traders to monitor positions, by controllers to record periodic profit and loss, and by risk managers who seek to estimate risk under various market conditions. The frequency of revaluation should be driven by the level of an institution's trading activity. Trading operations with high levels of activity should perform daily revaluation. Every institution should conduct revaluation for profit and loss at least monthly; the accounting revaluation should apply rates and prices from sources independent of trader input. 
  Taping of trader and dealer telephone lines facilitates the resolution of disputes and can be a valuable source of information to auditors, managers, and examiners. 
  Trade tickets and blotters (or their electronic equivalents) should be created in a timely and complete manner to allow for easy reconciliation and appropriate position-and-exposure monitoring. The volume and pace of trading may warrant the virtually simultaneous creation of records in some cases. 
  Computer hardware and software applications must accommodate the current and projected level of trading activity. Appropriate disaster-recovery plans should be tested regularly. 
  Every institution should have a methodology to identify and justify any off-market transactions. Ideally, off-market transactions would be forbidden. 
  A clear institutional policy should exist concerning personal trading. If personal trading is permitted at all, procedures should be established to avoid even the appearance of con-flicts of interest. 
  Every institution should ensure that management of after-hours and off-premises trading, if permitted at all, is well documented so that transactions are not omitted from the automated blotter or the bank's records. 
  Every institution should ensure that staff is both aware of and complies with internal policies governing the trader-broker relationship. 
  Every institution that uses brokers should monitor the patterns of broker usage, be alert to possible undue concentrations of business, and review the short list of approved brokers at least annually. 
  Every institution that uses brokers should establish a firm policy to minimize name substitutions of brokered transactions. All such transactions should be clearly designated as switches, and relevant credit authorities should be involved.   Every institution that uses brokers for foreign exchange transactions should establish a clear statement forbidding lending or borrowing brokers' points as a method to resolve discrepancies. 
  Every organization should have explicit compensation policies to resolve disputed trades for all traded products. Under no circumstances should soft-dollar or off-the-books compensation be permitted for dispute resolution. 
  Every institution should have ''know-your-customer'' policies, and they should be understood and acknowledged by trading and sales staff. 
  The designated compliance officer should perform a review of trading practices annually. In institutions with a high level of activity, interim reviews may be warranted. 

Operations and Systems Risk 
(Front-Office Operations) 

Examination Objectives 

1. To review the organization and range of activities of the front office. 

2. To determine whether the policies, procedures, and internal systems and controls for the front office are adequate and effective for the range of capital-markets products used by the financial institution. 

3. To determine whether the financial institution adequately segregates the duties of personnel engaged in the front office from those involved in the back-office-control function. 

4. To ascertain that the front office is complying with policies and established market and counterparty limits. 

5. To determine that trade consummation and transaction flow do not expose the financial institution to operational risks. 

6. To ensure that management's reporting to front-office managers, traders, and marketing staff is adequate for sound decision making. 

7. To evaluate the adequacy of the supervision of trading and marketing personnel. 

8. To determine that front-office personnel are technically competent and well trained, and that ethical standards are established and respected. 

9. To ascertain the extent, if any, of unacceptable business practices. 

10. To determine that traders and salespeople know their customers and engage in activities appropriate for the institution's counterparties. 

11. To recommend corrective action when policies, procedures, practices, internal controls, or management information systems are found to be deficient, or when violations of laws, rulings, or regulations have been noted. 

Operations and Systems Risk 
(Front-Office Operations) 

Examination Procedures 

These procedures represent a list of processes and activities that may be reviewed during a full-scope examination. The examiner-in-charge will establish the general scope of examination and work with the examination staff to tailor specific areas for review as circumstances warrant. As part of this process, the examiner reviewing a function or product will analyze and evaluate internal audit comments and previous examination workpapers to assist in designing the scope of examination. In addition, after a general review of a particular area to be examined, the examiner should use these procedures, to the extent they are applicable, for further guidance. Ultimately, it is the seasoned judgment of the examiner and the examiner-in-charge as to which procedures are warranted in examining any particular activity. 

GENERAL PROCEDURES 

1. Obtain the following: 
a. policies and procedures 
b. organization chart 
c. resumes of key trading personnel 
d. systems configuration 
e. management information reports 

2. Determine the roles of front office in the marketplace. 

3. Ensure that the terms under which brokerage service is to be rendered are clear and that management has the authority to intercede in any disputes that may arise. Additionally, ensure that any exclusive broker relationships in a single market do not result in an overdependence or other vulnerability on the part of the financial institution.

 POLICIES AND PROCEDURES 

1. Check that procedures clearly indicate under what conditions, if any, market-risk limits may be exceeded and what authorizations must be obtained. (See section 2010, ''Market Risk.'') 

2. Check that procedures clearly indicate under what conditions, if any, counterparty risk limits may be exceeded and what approvals must be obtained. If netting agreements exist for any counterparties, determine that transactions are appropriately reflected. (See section 2020, ''Counterparty Credit Risk and Pre-settlement Risk.'') 

3. Ensure that comprehensive policies and procedures covering the introduction of new trading products exist. A full review of the risks involved should be performed by all relevant parties: trading, credit- and marke-trisk management, audit, accounting, legal, tax, and operations.

4. Determine that policies and procedures adequately address the following: 
a. The financial institution complies with regulatory policy regarding brokers' points. 
b. The financial institution has policies addressing traders' self-dealing in commodities or instruments closely related to those traded within the institution. A written policy requires senior management to grant explicit permission for traders to trade for their personal account, and procedures are established that permit management to monitor these trading activities. 
c. The financial institution does not engage in adjusted-price trading. 
d. The financial institution has adequate policies regarding off-market-rate transactions. All requests for the use of off-market rates are referred to management for policy and credit judgments as well as for guidance on appropriate internal accounting procedures. Specifically, review and assess the financial institution's policies and procedures regarding historical-rate rollovers. 
e. Adequate control procedures are in place for trading that is conducted outside of normal business hours-either at the office or at traders' homes. Personnel permitted to engage in such dealing should be clearly identified along with the types of authorized transactions. Additionally, procedures ensure that off-premises transactions will not exceed risk limits. 
f. The financial institution has adequate procedures for handling customer stop-loss orders. Documentation related to both the agreed-on arrangements as well as the individual transactions is available for review.
g. The financial institution requires that the appropriate level of due diligence be performed on all counterparties with which the institution enters into transactions, even if the transactions do not expose the financial institution to credit risk (for example, delivery versus payment and collateralized transactions). 
h. The marketing practices of the institution's salespersons are ethical. Standards address the sales of complex products to ensure that customers are not entering into transactions about which they have no understanding of the potential risks. 

TRAINING AND TECHNICAL COMPETENCE PROCEDURES 

1. Evaluate key personnel policies and practices and their effects on the financial institution's capital-markets and trading activities. 
a. Evaluate the experience level of senior personnel. 
b. Determine the extent of internal and external training programs. 
c. Assess the turnover rate of front-office personnel. If the rate has been high, determine the reasons for the turnover and evaluate what effect the turnover has had on the financial institution's trading operations. 
d. Review the financial institution's compensation program for trading activities to determine whether remuneration is based on volume and profitability criteria. If so, determine whether controls are in place to prevent personnel from taking excessive risks to meet the criteria. 
e. Determine the reasons for each trader's termination or resignation. 

2. Determine whether the financial institution has a management succession plan. 

3. Evaluate the competence of trading and marketing personnel. Determine whether information on the organization, trading strategy, and goals is well disseminated. 

4. Determine if management remains informed about pertinent laws, regulations, and accounting rules. 

SEGREGATION OF DUTIES PROCEDURES 

1. Ensure that all transactions are promptly recorded by the trader after the deal has been completed. 

2. Ensure that the financial institution has established satisfactory controls over trade input. 

3. Confirm that a separation of duties exists for the revaluation of the portfolio, reconciliation of traders' positions and profits, and the confirmation of trades. 

TRANSACTION-CONSUMMATION PROCEDURES 

1. Ensure that traders and marketers check that they are within market- and credit-risk limits before the execution of the transaction. 

TRANSACTION-FLOW PROCEDURES 

1. Ensure that trade tickets or input sheets include all trade details needed to validate transactions. 

2. Ensure that transactions are processed in a timely manner. Check that some type of method exists to reconstruct trading history. 

3. Ensure that the transaction-discrepancy procedure is adequate and includes independent validation of the back office. 

TRANSACTION REPORTING 

1. Ensure that management information reports prepared for front-office management provide adequate information for risk monitoring, including financial performance and transaction detail, to ensure sound decision making. 

ETHICS PROCEDURES 

1. Evaluate the level of due diligence performed on counterparties. 

2. Evaluate the code of ethics and staff adherence to it. 

3. Evaluate ''know-your-customer'' guidelines and staff adherence. 

4. Evaluate the management of trading and marketing staff. Evaluate the seriousness of any ethical lapses. 

 CORRECTIVE ACTION 

1. Recommend corrective action when policies, procedures, practices, internal controls, or management information systems are found to be deficient, or when violations of laws, rulings, or regulations have been noted. 

Operations and Systems Risk 
(Front-Office Operations) 

Internal Control Questionnaire 

POLICIES AND PROCEDURES 

1. Do policies and procedures establish market-risk limits, and do the policies and procedures clarify the process for obtaining approvals for excessions? 
2. Do policies and procedures establish credit-risk limits, and do the policies and procedures clarify the process for obtaining approvals for excessions? 
3. Do policies address the approval process for new products? 
4. Is an appropriate level of approval obtained for off-market transactions and for additional credit risk incurred on off-market trades? 
5. Does management make sure that senior management is aware of off-market trades and the special risks involved? 
6. Does management inquire about a customer's motivation in requesting an off-market-rate trade to ascertain its commercial justification? 
7. Do procedures manuals cover all the securities activities that the financial institution conducts, and do they prescribe appropriate internal controls relevant to those functions (such as revaluation procedures, accounting and accrual procedures, settlement procedures, confirmation procedures, accounting and auditing trails, and procedures for establishing the sequential order and time of transactions)? 

ROLE OF THE FRONT OFFICE 

1. Do policies clarify the responsibilities of traders as to market making, dealing, proprietary, and intermediary roles? 
2. Are the financial institution's dealings with brokers prudent? 
3. Is the financial institution's customer base diverse? Is the customer base of high credit and ethical quality? 

SEGREGATION OF DUTIES 

1. Is there adequate segregation of duties between the front and back office? 

TRANSACTION CONSUMMATION 

1. Do traders ensure that transactions are within market- and credit-risk limits before the execution of the transaction? 

TRANSACTION FLOW 

1. Do trade tickets or input sheets include all necessary trade details? 
2. Does the institution have procedures to ensure the timely processing of all transactions? 
3. Does the institution have a method with which to resolve trade discrepancies on transactions, regardless of communication medium used? 
4. Do traders include an adequate amount of trade details on blotters, input sheets, and computer screens to enable reconciliation by the front and back office? 
5. Do automated systems for input appear adequate for the volumes and range of products transacted by the institution? 

TRANSACTION REPORTING 

1. Are reports prepared for front-office management to allow the monitoring of market- and credit-risk limits? 

TRAINING AND TECHNICAL COMPETENCE 

1. Does the financial institution have a management succession plan? 
2. Does the financial institution have an appropriate program for cross-training of personnel? 
3. Does the financial institution provide for the adequate training of front-office personnel? 
4. Are traders technically competent in their existing positions? 
5. Does management remain informed about pertinent laws, regulations, and accounting rules? 

ETHICS 

1. Is an appropriate level of due diligence performed on all counterparties with which the front office enters into transactions, regardless of collateralization? 

2. Is there a code of ethics? Do traders and marketers appear to be familiar with it? 

3. Are there ''know-your-customer'' guidelines? Do traders and marketers appear to be familiar with them? 

4. Do internal memos detail any ethical lapses? If so, how were they resolved? Does senior management take its guidance role seriously? 

5. Are customer relationships monitored by senior management in the front office? How are customer complaints resolved? Are the back office, control staff, and compliance involved in the process? Are overall controls for customer complaints adequate? 

6. Were any unacceptable practices noted by internal or external auditors? Has management addressed these actions? From examiner observation, are there any ongoing unacceptable practices? Is management's response to deficiencies adequate? 

7. Does the financial institution have discretionary authority over client monies? Are policies and procedures adequate to control excessive trading by sales and marketing staff? Is front-office supervision adequate? Does the back office have additional controls to alert senior control staff and the compliance department of deficiencies? Is discretionary trading activity included in the institution's audit program? 

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