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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?
Continue to OPERATIONS
AND SYSTEMS RISK (BACK OFFICE OPERATIONS)
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