The relaxation of capital and exchange controls and the acceleration of financial innovation have clearly encouraged competition among financial institutions and improved efficiency in financial services worldwide. Increased competition has also presented financial institutions with new risks-including those associated with losses on open positions and with losses resulting from settlement failures. These risks are increased by the speed with which prices change, by the delays inherent in covering exposures and settling trades, and by the extension of credit to counterparties with non-zero bankruptcy probabilities.
Simultaneously, regulators have sought to limit these risks without seriously impairing the efficiency of the markets. Financial institutions have also imposed their own internal controls to keep risks to acceptable levels; in practice, these internal controls are often more stringent than those imposed by the regulators. This annex describes both externally imposed and internal controls on financial institutions’ foreign exchange operations.
Regulation of Financial Institutions’ Foreign Exchange Positions
Banking Regulations
The regulatory constraints on banks’ net open foreign exchange positions (spot and forward) vary considerably across the Group of Ten countries; these are summarized in Table 3. Many of the prudential regulations directed specifically at banks’ open foreign exchange positions were adopted in response to the failures (stemming largely from foreign exchange trading losses) of Bankhaus Herstatt and Franklin National Bank in 1974.
Belgium, Canada, Luxembourg, Switzerland, and the United States require periodic reporting of foreign exchange exposures and monitor banks’ internal risk management practices during routine examinations.1 These countries emphasize the appropriateness of actual foreign exchange positions relative to the adequacy of internal risk management systems. No common standard or ceiling is imposed.
In the Netherlands and the United Kingdom, guidelines limit net open positions to working balances that typically arise from market-making activities. Compliance with the guidelines is monitored through periodic reporting by banks. In the United Kingdom, the guidelines state that net open dealing positions in any one currency should not exceed 10 percent of capital and that the net short open dealing position of all currencies taken together should not exceed 15 percent of capital. More conservative guidelines apply to institutions with only limited experience in foreign exchange markets. U.K. banks file monthly reports on their net foreign exchange positions with the Bank of England.
In the other Group of Ten countries (France, Germany, Japan, and Sweden), daily net open foreign exchange positions are subject to limits expressed in terms of net positions relative to capital, and compliance with these limits is monitored through periodic reporting. In Germany, for example, banks’ net open foreign exchange positions (spot and forward combined) at the end of each business day cannot exceed 30 percent of their capital. German banks file monthly reports on their day-by-day foreign exchange positions.
The Basle Committee on Banking Supervision is currently seeking to broaden the coverage of the accord on international capital adequacy standards to include net open foreign exchange positions (spot and forward) and thereby to treat foreign exchange risk more uniformly. One of the thorny issues in this area is the measurement of foreign exchange risk within a portfolio of currency positions. Here, some allowance needs to be made for correlation among currency movements. To this end, the Committee has developed a proxy measure that tracks the foreign exchange risk of international banks and has proposed an adequate capital charge for that risk measure.
Although foreign exchange risk per se does not yet fall within the domain of the Basle capital adequacy framework, OTC exchange rate contracts do. They are subject to the credit conversion factors for off-balance-sheet items and the credit-risk weights established by the accord. These contracts include cross-currency interest rate swaps, forward foreign exchange contracts, OTC currency options purchased, and similar instruments. Because capital charges are intended to reflect only the risk of counterparty default, exchange-traded derivative instruments (such as foreign currency futures)—which are subject to daily margin requirements—are excluded.
The primary method for converting OTC exchange rate contracts to their credit equivalents involves two steps. First, a bank calculates the total replacement cost of all contracts with positive value by marking them to their current market values. Second, factors are added to reflect potential future exposures over the remaining life of the contracts; a 1 percent factor is used for those contracts with less than one year of residual maturity, and a 5 percent factor for all other contracts.
These credit equivalents (of exchange rate contracts) attract a 50 percent risk weight for calculating a bank’s total risk-adjusted assets. Thus, the effective capital requirements for these contracts are 2 percent of their credit equivalents for tier 1 capital and 4 percent for total capital. However, contracts with an original maturity of 14 calendar days or less are excluded from these capital requirements.
The EC directive on capital adequacy for banks and securities firms calls for an 8 percent capital requirement on net open foreign exchange positions in excess of 2 percent of own funds (capital). Unlike the Basle capital requirements for OTC exchange rate contracts, the EC proposal is intended to capture the market risk of foreign exchange positions. The measurement of open positions involves three steps: first, add the net spot position in each currency, the net forward position (i.e., all amounts to be received less all amounts to be paid under outright forward, futures, and currency swap transactions), and a fraction of the total book of foreign currency options;2 second, the net short or long position in each currency would then be converted to the reporting currency and then summed separately to form the total of the net short and net long positions; and third, take the higher of the two totals as the net foreign exchange position subject to a capital requirement.
Securities Regulations
The European Community has also made some headway in establishing a common capital adequacy standard for banks and for securities firms that captures various types of market risk, including interest rate risk, exchange rate risk, and position risk (in traded equities).
The U.S. Securities and Exchange Commission (SEC) sets capital adequacy standards for broker/dealers using the so-called haircut methodology.3 Many of the effective capital requirements for U.S. broker/dealers arise from deductions from capital that reflect the assets’ liquidity and market risk. An illiquid asset, for example, requires a 100 percent charge, while marketable securities that are not hedged attract fractional charges—or haircuts—that reflect their historical price volatilities. For net open foreign exchange positions (spot positions and swap, forward, futures, and options contracts), the haircut is 6 percent for positions in the major reserve currencies, and 20 percent for those in all other currencies. However, broker/dealers are not required to hold dedicated capital against open foreign exchange positions. Also, U.S. securities firms have traditionally held substantially more capital than is required by SEC regulations.
Regulation of Other Financial Institutions
Mutual funds, pension funds, and insurance companies are typically subject to some form of prudential regulation that impinges on their foreign-currency-denominated investments. Practices vary among the Group of Ten countries.
In the United States, the Investment Company Act provides the main regulatory framework for mutual funds. It states that open-end investment companies may not invest more than 15 percent of their assets in illiquid securities (defined as any security that cannot be disposed of within seven days at approximately the price at which the investment company has valued it); this tends to restrict the foreign investments of mutual funds to relatively liquid securities. Investment companies are also subject to certain diversification requirements on the filing of prospectuses with the SEC and on their tax treatment under the Internal Revenue Code. These regulations apply to all investments, domestic and foreign. The Employee Retirement Income Security Act (ERISA) also sets diversification and liquidity requirements for pension funds. In the United States, insurance companies are regulated at the state level.
The EC Directive on Undertakings for Collective Investment in Transferable Securities (UCITS) provides an overarching regulatory framework for the European mutual fund industry. This directive introduced the single-license principle, allowing an investment company registered in one member state to operate in any other member state; it also intended to coordinate the relevant laws of member states. The directive requires that no more than 10 percent of a unit trust’s assets may be invested in nontransferable (illiquid) securities and that the investments must satisfy certain diversification requirements. Again, these requirements apply to all investments, domestic and foreign. The EC’s Pension Fund Directive establishes similar principles for pension funds, as well as limiting member states’ ability to restrict funds’ selection of assets and their currency composition. Similarly, the directive on life and non-life insurance harmonizes the rules on insurance companies’ investments and removes legal barriers to the creation of a single European market for insurance products.
Margin Requirements on Exchange-Traded Exchange Rate Contracts
A futures contract has two types of margin: an initial requirement at the contract’s inception, and a maintenance requirement as the contract is marked to market on a daily basis. These requirements are essentially performance bonds to guarantee cash settlement of the futures contracts at their maturity if settlement is demanded. In the United States, minimum margin requirements are set by the exchanges. They are charged by the exchange’s clearinghouse to its clearing members (futures clearing merchants). In general, the initial margin requirement for a currency futures contract is related to the volatility of the underlying exchange rate. The daily payments adjust the amount held against the contract by the change in the contract’s current market value. The margin requirements set by futures clearing merchants and brokers for their customers are negotiable. Margin requirements for currency futures contracts traded on the London International Financial Futures Exchange (LIFFE) are set by the exchange and are comparable to those for currency contracts traded on the Chicago International Monetary Market.
The margin required from the writers of exchange-traded currency options also consists of an initial and a maintenance requirement. In the United States, margin requirements on options are set by the Federal Reserve and are enforced by the SEC. If a cash margin is posted, the initial margin is the current market value of the option (i.e., the premium for which it was sold) plus 4 percent of the value of the underlying currency.4 The daily variation payments adjust the amount held against the contract by any change in the value of the underlying currency.
Internal Risk Management Controls
Given both the volatility of exchange rates and the large average sizes of trades, it would be quite easy either for a dealer to commit the bank to exposures far in excess of the bank’s capital, or for a bank to accumulate large obligations from uncredit-worthy counterparties. Dealing operations are therefore organized and controlled to ensure that foreign exchange trading is carried out in accordance with management directives, and to protect the bank against excessive risk. Control is exercised through two mechanisms: the structure of authority and trading limits.
A standard control mechanism is the segregation of activities between the dealing room—where orders to buy and sell foreign currency are taken—and the back office—where the contracts agreed by the dealers are confirmed and settled. Since trades are executed by the back office, and only after the details have been confirmed with the counterparty back office, each dealer’s activity can be monitored. The dealing-room management also assigns rules of authorization for transactions and extension of credit and maintains a list of approved counterparties. For management to monitor foreign exchange trading activity successfully, there must be timely and accurate order processing, settlement, recording, and reporting by the back office.
The dealers themselves are constrained by limits on their trades. These limits are defined and enforced by means of an exchange ladder. This is simply an organizing framework in which all positions are recorded according to maturity and currency. Thus, purchases and sales will be recorded for spot transactions, and for each maturity of forward contracts. The exchange ladder provides an indication of the aggregate position of the dealing room (total purchases minus sales of all currencies measured in the home currency—the foreign exchange book) and of the net exposure (mismatch or gap) in each currency for each maturity.
An example of a deutsche mark exchange ladder follows. The different contracts are organized by maturity into spot, one-month forward, two-months forward, and so on. The amounts purchased and sold at each maturity are entered, and the net purchase is found in the fourth column. The total net position is referred to as the dealer’s book.
| Maturity | Purchase (Long) | Sale (Short) | Net Position |
|---|---|---|---|
| Spot | + 100,000 | — | + 100,000 |
| One month | — | -1,000,000 | -1,000,000 |
| Two months | + 2,000,000 | — | + 2,000,000 |
| Three months | — | -2,000,000 | -2,000,000 |
| Six months | + 1,000,000 | — | + 1,000,000 |
| Twelve months | + 500,000 | — | + 500,000 |
| Twenty-four months | — | -500,000 | -500,000 |
| Total | + 3,600,000 | -3,500,000 | + 100,000 |
| Maturity | Purchase (Long) | Sale (Short) | Net Position |
|---|---|---|---|
| Spot | + 100,000 | — | + 100,000 |
| One month | — | -1,000,000 | -1,000,000 |
| Two months | + 2,000,000 | — | + 2,000,000 |
| Three months | — | -2,000,000 | -2,000,000 |
| Six months | + 1,000,000 | — | + 1,000,000 |
| Twelve months | + 500,000 | — | + 500,000 |
| Twenty-four months | — | -500,000 | -500,000 |
| Total | + 3,600,000 | -3,500,000 | + 100,000 |
This dealer’s deutsche mark book is long DM 100,000. It has gaps or mismatches in each maturity; for example, it is long DM 100,000 spot and short DM 500,000 in the 24-month forward contract.
Position limits are placed on the intraday and overnight positions of the dealers in each currency and for each maturity. A limit is also placed on the aggregate position of the dealing room. These limits are imposed to reduce the exchange risk arising from uncovered exposure to exchange rate changes. Traders are typically required to obtain special authorization for trades that would cause them to exceed these limits.5 Constraints are also placed on the activities of forward traders, requiring them to observe limits on maturities, maturity gaps, mismatches, and the total size of the forward book.6
Limits are also usually placed on credit extended to specific counterparties or, equivalently, on the total volume of trade with a given customer.7 In addition, a daily settlement limit is placed on the volume of transactions maturing on a given day—to control settlement risk and to prevent illiquidity arising from adverse exchange rate changes. Stop-loss rules are typically imposed to limit the losses arising from adverse exchange rate changes.
Operations of the dealing room and of the back office are audited periodically to ensure compliance both with management’s directions and with statutory/regulatory provisions.