Trading and Capital-Markets Activities Manual
Brokerage Activities and Futures Commission Merchants (Continued)
An FCM should be subject to regular internal audits to confirm that it complies with its policies and procedures and is managed in a safe and sound manner. In addition, the internal-audit function should review any significant issues raised by compliance personnel to ensure that they are resolved. Other staff within the FCM should be able to reach internal audit staff to discuss any serious concerns they might have. Internal audit reports should be forwarded to the FCM's senior management and material findings should be reported to the FCM's board of directors and the parent company. Frequently, the internal audit function is located at the parent company, and audit reports are routinely sent to senior management at the parent company.
EXAMINATION AND INSPECTION PROCEDURES
The review of an FCM's functions should take a functional regulatory approach, using the findings of the FCM's primary regulators as much as possible. Examiners should especially focus on the risks that the FCM poses to the parent company and affiliated banks. These risks should be assessed by reviewing the adequacy of the FCM's policies and procedures, internal controls, and risk-management functions. Compliance with policies and procedures, and with any conditions on the FCM's activities imposed by regulatory authorities (including the Federal Reserve Board), should be fully reviewed.
Bank holding companies, banks, and FBOs may have more than one subsidiary that acts as an FCM in the United States or that engages in futures transactions for customers in foreign markets. To ensure that the FCM/CTA activities of a banking organization are evaluated on a consolidated basis, a cross-section of affiliated futures brokerage and advisory firms should be reviewed periodically-particularly those that present the greatest risk to the consolidated financial organization. Relevant factors to consider when identifying firms for review include (1) the volume of business; (2) whether the FCM has unaffiliated customers; (3) the number of customers; (4) whether the firm provides customer financing; (5) the number of brokers effecting transactions; (6) whether exchange or clearinghouse memberships are involved; (7) whether the FCM provides clearing-only services; and (8) the date and scope of the last review conducted by the Federal Reserve, SRO, or other regulator.
The scope of any review to be conducted depends on the size of the FCM and the scope of its activities. The draft first-day letter should provide an overview of an FCM's authorized activities and conditions, as well as a description of the actual scope of its business. Examiners should review the most recent summary of management points or other inspection results issued by the FCM's SRO or other regulator, as well as any correspondence between the FCM and any federal agency or SRO. If examiners should have any questions about the findings of an SRO's or a regulator's results, they should contact the organization to determine whether the matter is material and relevant to the current inspection. The status of any matters left open after the SRO's or regulator's review should also be inquired about.
An important factor in determining the scope of the inspection is whether the FCM has unaffiliated customers or conducts transactions solely for affiliates. Other factors include whether the FCM is a clearing member of an exchange, particularly of a non-U.S. exchange; it acts as a carrying broker on behalf of other FCMs; it has omnibus accounts with other brokers in markets in which it is not a member (U.S. or foreign); it provides advisory or portfolio management services, including discretionary accounts, or has been authorized to act as a commodity pool operator (CPO); it provides clearing services to locals or market-makers; and it provides financing services to customers.
Examiners are not expected to routinely perform a front- or back-office inspection unless (1) the FCM's primary regulator found material deficiencies in either office during its most recent examination or (2) if front- or back-office operations have not been examined by the primary regulator within the last two years. However, examiners may still choose to review a small sample of accounts and transactions to confirm that appropriate controls are in place. In addition, net capital computations of U.S. FCMs do not need to be reviewed; they are reviewed by the FCM's DSRO, and the FCM is subject to reporting requirements if capital falls below warning levels. Examiners should perform a front- and back-office review of the FCM's operations outside of the United States.
Examiners may rely on well-documented internal-audit reports and work-papers to verify the adequacy of risk management at the FCM. If an examiner finds that an internal audit adequately documents the FCM's compliance with a policy or procedure pertaining to the management of the various risk assessments required by the current inspection, he or she should document the audit finding in the work-papers and complete inspection procedures in any area not adequately addressed by the internal audit report. Examiners should periodically spot check areas covered by internal audits to ensure the ongoing integrity of the audit process. Examiners should also review internal-audit reports and work-papers for their scope and thoroughness in complying with FCM policies and procedures. Finally, examiners should ensure that internal auditors have adequate training to evaluate the FCM's compliance with its policies and procedures and with applicable laws and regulations (both inside and, if applicable, outside the United States).
If an examiner has determined that it is not necessary to perform a routine back-office review, he or she should confirm that the FCM has addressed operations risks in its policies and procedures. Examiners also should review the internal controls of an FCM to ensure that the firm is operated safely and soundly according to industry standards and that it complies with any Board regulations or conditions placed on the FCM's activities. Examiners should be alert to any ''red flags'' that might indicate inadequate internal controls. An FCM must be organized so that its sales, operations, and compliance functions are separate and managed independently. If an FCM engages in proprietary trading, examiners should confirm that the firm has procedures that protect against conflicts of interest in the handling of customer orders (examples of these conflicts of interest include front-running or ex-pit transactions). To make an overall assessment of the FCM's future business, the results of any review should be consolidated with the results of reviews by other FCMs inspected during this cycle.
Futures Brokerage Activities and Futures Commission Merchants Examination Objectives
1. To identify the potential for and extent of various risks associated with the FCM's activities, particularly credit, market, liquidity, operations, and reputation risks. 2. To evaluate the adequacy of the audit function and review significant findings, the method of follow-up, and management's response to correct any deficiencies. 3. To assess the adequacy of the risk-management function at the FCM. 4. To assess the adequacy of and compliance with the FCM's policies and procedures and the adequacy of the internal-control function. 5. To evaluate and determine the FCM's level of compliance with relevant Board regulations, orders, and policies. 6. To assess the adequacy of risk management of affiliated FCMs on a consolidated basis.
Futures Brokerage Activities and Futures Commission Merchants Examination Procedures
1. Identify all bank holding company subsidiaries that engage in FCM- or CTA-type activities in the United States or abroad or identify U.S. FCM or CTA subsidiaries of FBOs. Determine which firms should be inspected to provide a global view of the adequacy of management of these activities on a consolidated basis, based on the scope of activities and degree of supervision by other regulators. Complete applicable procedures below for firms selected for inspection.
2. Review first-day letter documents; notices filed under Regulation Y; Board orders and letters authorizing activities; previous inspection reports and work-papers; and previous audits by futures regulators (CFTC, designated self-regulatory organization (DSRO), National Futures Association, foreign futures regulator); and reports by internal or external auditors or consultants.
3. Note the scope of the FCM's activities,
4. Review exchange and clearinghouse memberships here and abroad, noting any financial commitments and guarantees by the FCM or its parent to the exchange or clearinghouse with respect to proprietary, affiliate, or customer transactions.
5. Note any new lines of business or activities occurring at the FCM or any changes to exchange and clearinghouse memberships since the last inspection.
6. Note what percentage of business is conducted
7. Determine the quality of the internal
audit program. Assess the scope, frequency, and quality of the audit program
for the FCM and related activities.
8. Determine the scope of review that is
appropriate to the activities and allocate resources, considering the
adequacy of internal audit work-papers. Complete appropriate front- or
back-office inspection procedures if-
9. Advise the examiner who is in charge of inspection of the parent company if the FCM engages in proprietary trading or over-the-counter futures or derivative business as principal or agent.
BOARD AND SENIOR MANAGEMENT OVERSIGHT
10. Review the background and experience of the FCM's board of directors and senior management, noting prior banking and futures brokerage experience.
11. Determine if the board of directors
of the FCM has approved written policies summarizing the firm's activities
and addressing oversight by the board or a board designated committee
12. Determine if senior management of the
FCM has adopted procedures implementing the board's policies for-
13. Determine if policies and procedures are periodically reviewed by the board of directors or senior management, as appropriate, to ensure that they comply with existing regulatory and supervisory standards and address all of the FCM's activities.
14. Review management information reporting
systems and determine whether the board of directors of the parent company
(or a designated committee of the parent's board) is apprised of-
15. Review the FCM's strategic plan.
16. Review credit-risk policies and procedures.
17. Determine whether the FCM has authority to open customer accounts without parent company approval.
18. Review the customer base (affiliates, third parties) for credit quality in terms of affiliation and business activity (affiliates, corporate, retail, managed funds, floor traders).
19. Evaluate the process for customer-credit review and approval. Determine whether customer-credit review identifies credit risks associated with the volume of transactions executed or cleared for the customer.
20. Evaluate the adequacy of credit-risk-management
policies. Determine that they-
21. Verify this information by sampling customer credit files.
22. Verify that up-to-date customer credit files are maintained on site or are available for review during the inspection. If the customer credit approval was performed by the parent company or an affiliate bank, verify that the FCM's files contain information indicating the scope of the credit review, the approval, and credit limits.
23. Review notifications and approval of limit exceptions for compliance with FCM procedures.
24. Determine whether the FCM has adopted procedures identifying when the FCM should take steps to limit its customer credit exposure (for example, when to refuse a trade, grant a limit exception, transfer positions to another FCM, or liquidate customer positions).
25. Evaluate the adequacy of risk management
of customer-financing activities.
26. Review the instances when the FCM has lent margin to customers on an unsecured basis. If the FCM does not engage in margin financing as a business line, verify that extensions are short term and within the operational threshold set for the customer.
27. Determine whether each clearing arrangement
is in writing and that it-
28. When the FCM has entered into a clearing only agreement with a customer, verify that it has reviewed the creditworthiness of each executing broker or its qualifying clearing firm identified in the agreement.
29. If the FCM acts as the primary clearing firm for locals or other customers, confirm that the firm has adopted procedures for monitoring and controlling exposure. Note whether the firm monitors customer positions throughout the trading day and how this monitoring is accomplished.
CARRYING BROKERS, EXECUTING BROKERS, AND PIT BROKERS
30. If the FCM uses other brokers to execute or clear transactions, either on an omnibus or a fully disclosed basis, determine that it has adequately reviewed the creditworthiness and approved the use of the other brokers. If the FCM uses non-affiliated executing brokers, confirm that it also has considered the reputation of the broker's primary clearing firm. If the other broker is likely to use another broker, determine whether the broker has given the FCM an indemnification against any loss that results from the performance or failure of the other broker.
31. If the FCM uses other brokers to execute or clear transactions in non-U.S. markets, determine whether senior management understands the legal risks pertinent to doing business in those markets and has adopted policies for managing those risks.
32. When the FCM utilizes third-party ''pit brokers'' to execute transactions, verify that the FCM has reviewed and approved each broker after considering the reputation of the pit broker's primary clearing firm.
EXCHANGE AND CLEARINGHOUSE MEMBERSHIP
33. Verify that the FCM completes a due
diligence study of each exchange and clearinghouse before applying for
membership in the organization.
34. Verify that the FCM has apprised its parent company of the results of its study of the exchange or clearinghouse and that it has written authorization from the senior management of its parent company to apply for membership.
35. Verify that the FCM monitors the financial condition of each exchange and clearing organization for which it is a member.
36. Review all guarantees, letters of comfort, or other forms of potential contingent liability. Verify that the parent company has not provided a guarantee to the clearinghouse for the performance of the FCM's customer obligations. Note any guarantees against losses the parent bank holding company incurred from the failure of the FCM and advise the examiner who is in charge of the parent company's examination, who can confirm that guarantees are included in the bank holding company's calculation of consolidated risk-based capital.
37. If an FCM engages in proprietary trading, determine whether policies and procedures are in place to control potential conflicts of interest between its brokerage business and trading activities.
38. Verify that the FCM has established and monitors daily settlement limits for each customer to ensure that its liquidity is sufficient to meet clearinghouse obligations.
39. Determine whether the FCM has established back-up liquidity facilities to meet unexpected shortfalls.
40. Verify that the FCM monitors by product the amount of open interest (concentrations) that it, holds at each exchange either directly or indirectly through other brokers. If positions are held on foreign exchanges in which concentrations are not monitored, verify that the FCM is able to monitor its positions and manage its potential liquidity risks arising from that market.
41. Review liquidity contingency plans for dealing with dramatic market changes.
42. Review management information reporting systems to determine whether the FCM is able to assess the extent of any material exposure to legal or reputation risk arising from its activities.
43. Review management information reporting systems to determine whether the parent company receives sufficient information from the FCM to assess the extent of any material exposure to litigation or reputation risk arising from the FCM's activities.
44. If the FCM provides investment advice to customers or commodities pools, determine whether it has procedures designed to minimize the risks associated with advisory activities. Procedures might address the delivery of risk disclosures to customers, the types of transactions and trading strategies that could be recommended or effected for retail customers, compliance with the know-your-customer recordkeeping and other sales practice rules of the SROs, and conformance to any trading objectives established by the customer or fund.
45. If the FCM acts as a commodities pool operator, verify that it has obtained prior Board approval and is in compliance with any conditions contained in the Board order.
OPERATIONS, INTERNAL CONTROLS, AND COMPLIANCE
46. Review the most recent summary of management points or similar document issued by the FCM's DSRO or other primary futures regulator. Discuss any criticism with FCM management and confirm that corrective action has been taken.
47. Review the organizational structure and reporting lines within the FCM, and verify separation of sales, trading, operations, compliance, and audit functions.
48. Determine that FCM policies and procedures address the booking of transactions by affiliates and employees and other potential conflicts of interest.
49. If the FCM is authorized to act as a commodity pool operator, review the most recent NFA or other primary futures regulator's audit, including any informal findings by examiners. Discuss any criticism with FCM management and confirm that corrective action has been taken.
50. If the FCM executes and clears non-financial futures, verify that it has procedures to avoid taking physical possession of the non-financial product when effecting ''exchange for physical transactions'' for customers.
51. When the FCM takes physical delivery of commodities due to the failure or unwillingness of a customer to make or take delivery of its contracts, determine whether the FCM has and follows procedures to close out its position. Note if the FCM frequently takes delivery of physical commodities.
52. Assess the adequacy of customer-complaint review by reviewing the complaint file and how complaints are resolved. Note if the FCM receives repeat or multiple complaints involving one or more of its activities or employees.
53. Determine whether the FCM has developed contingency plans that describe actions to be taken in times of market disruptions and whether plans address management responsibilities including communications with its parent bank holding company, liquidity, the effect on customer credit quality, and communications with customers.
54. Prepare inspection findings and draw conclusions on the adequacy of the FCM's risk-management, compliance, operations, internal controls, and audit functions.
55. Present findings to FCM management and submit inspection findings to the examiner who is in charge of the parent company's inspection.
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