Revised Guidelines for Foreign Exchange Reserve Management

The 2013 revision of the Guidelines was carried out by the IMF staff, supported by a small Working Group of central banks and monetary authorities from China, India, Israel, Italy, Mexico, Japan, Russia, Saudi Arabia, Switzerland, the European Central Bank, and the Bank for International Settlements, and The World Bank acting as reviewer in the process. Mr. Franco Passacantando, Managing Director at the Bank of Italy, chaired this Working Group. The revisions to the Guidelines mainly concentrate on: (i) reserve management objectives and strategy, including analyzing and managing risks in the context of reserve diversification; (ii) transparency and accountability, while avoiding reserve management decisions being dictated by the prevailing accounting framework; (iii) institutional and organizational framework issues, especially on avoiding possible inconsistencies between reserve management and other central bank operations; and (iv) the risk management framework, including taking into account ex-ante assessments of the impact of reserve investments on financial markets and building internal credit risk assessment systems to assess counterparty risks

Abstract

The 2013 revision of the Guidelines was carried out by the IMF staff, supported by a small Working Group of central banks and monetary authorities from China, India, Israel, Italy, Mexico, Japan, Russia, Saudi Arabia, Switzerland, the European Central Bank, and the Bank for International Settlements, and The World Bank acting as reviewer in the process. Mr. Franco Passacantando, Managing Director at the Bank of Italy, chaired this Working Group. The revisions to the Guidelines mainly concentrate on: (i) reserve management objectives and strategy, including analyzing and managing risks in the context of reserve diversification; (ii) transparency and accountability, while avoiding reserve management decisions being dictated by the prevailing accounting framework; (iii) institutional and organizational framework issues, especially on avoiding possible inconsistencies between reserve management and other central bank operations; and (iv) the risk management framework, including taking into account ex-ante assessments of the impact of reserve investments on financial markets and building internal credit risk assessment systems to assess counterparty risks

I. Purpose of the Guidelines

1. The Guidelines presented in this paper are intended to assist governments in strengthening their policy frameworks for reserve management so as to help increase their country’s resilience to shocks that may originate from global financial markets or within the domestic financial system. The aim is to help the authorities articulate appropriate objectives and principles for reserve management and build adequate institutional and operational foundations for good reserve management practices.

2. The Guidelines identify areas of broad agreement among practitioners on reserve management principles and practices that are applicable to a broad range of countries at different stages of development and with various institutional structures for reserve management. In doing so, the Guidelines serve to disseminate sound practices more widely, while recognizing that there is no unique set of reserve management practices or institutional arrangements that is best for all countries or situations. In this respect, the Guidelines should be regarded as nonmandatory and should not be viewed as a set of binding principles.

3. In their usage, the Guidelines are intended primarily for voluntary application by members in strengthening their policies and practices. They could also play a useful role in the context of technical assistance and, as warranted, as a basis for informed discussion between the authorities and the Fund on reserve management issues and practices.

4. Although institutional arrangements and general policy environments can differ, surveys of actual practices indicate that there is increasing convergence on what are considered sound reserve management practices that taken together constitute a broad framework for reserve management. In the context of this paper, these practices are reflected in Guidelines that encompass (1) clear objectives for the management of reserves; (2) a framework of transparency that ensures accountability and clarity of reserve management activities and results; (3) sound institutional and governance structures; and (4) prudent management of risks.

II. What is Reserve Management and Why is it Important?

5. Reserve management is a process that ensures that adequate official public sector foreign assets are readily available to and controlled by the authorities for meeting a defined range of objectives for a country or union.1,2 In this context, a reserve management entity is normally made responsible for the management of reserves and associated risks.3 Typically, official foreign exchange reserves are held in support of a range of objectives,4 including to:

  • Support and maintain confidence in the policies for monetary and exchange rate management, including the capacity to intervene in support of the national or union currency;

  • Limit external vulnerability by maintaining foreign currency liquidity to absorb shocks during times of crisis or when access to borrowing is curtailed, and, in doing so;

  • Provide a level of confidence to markets that a country can meet its current and future external obligations;

  • Demonstrate the backing of domestic currency by external assets; assist the government in meeting its foreign exchange needs and external debt obligations; and

  • Maintain a reserve for national disasters or emergencies.

6. Sound reserve management practices are important because they can increase a country’s or region’s overall resilience to shocks. Through their interaction with financial markets, reserve managers gain access to valuable information that keeps policymakers informed of market developments and views on potential threats. The importance of sound practices has also been highlighted by experiences where weak or risky reserve management practices have restricted the ability of the authorities to respond effectively to financial crises, which may have accentuated the severity of these crises. Moreover, weak or risky reserve management practices can also have significant financial and reputational costs. Several countries, for example, have incurred large losses that have had direct, or indirect, fiscal consequences. Accordingly, appropriate portfolio management policies concerning the currency composition, choice of investment instruments, degree of credit risk exposure, and acceptable duration of the reserves portfolio should reflect a country’s specific policy settings and circumstances and ensure that assets are safeguarded, readily available, and support market confidence.5

7. Sound reserve management policies and practices can support, but not substitute for, sound macroeconomic management. Moreover, inappropriate economic policies (fiscal, monetary exchange rate, and financial) can pose serious risks to the ability to manage reserves.

III. The Guidelines

A. Reserve Management Objectives, Scope, Strategy, and Coordination

Objectives

8. Reserve management should seek to ensure that (1) adequate foreign exchange reserves are available for meeting a defined range of objectives; (2) liquidity, market, credit, legal, settlement, custodial, and operational risks are controlled in a prudent manner; and (3) subject to liquidity and other risk constraints, reasonable risk-adjusted returns are generated over the medium to long term on the funds invested.

Scope

9. Reserves consist of official public sector foreign assets that are readily available to and controlled by the monetary authorities.

10. Reserve management activities may also encompass the management of liabilities and the use of derivative financial instruments.

Reserve management strategy and coordination

11. Reserve management strategies should be consistent with and supportive of a country’s or union’s specific policy environment, in particular its monetary and exchange arrangements.

12. Evaluation of alternative reserve management strategies and their respective implications for reserve adequacy are likely to be facilitated by a cost-benefit analysis of holding reserves.

13. Reserve management strategies may also need to take into account strategies for the management of external debt for purposes of reducing external vulnerability.

14. An important component of the reserve management strategy is to decide on the appropriate degree of diversification with the aim of improving the risk-return profile of the portfolio.

15. In choosing strategic asset allocation and investment options, attention should be paid to the risk of possible disruptive impact on credit and financial markets and of excessive liquidation or acquisition costs.

B. Transparency and Accountability

Clarity of roles, responsibilities, and objectives of financial agencies responsible for reserve management

16. The allocation of reserve management responsibilities, including agency arrangements, between the government, the reserve management entity, and other agencies should be publicly disclosed and explained.

17. The broad objectives of reserve management should be clearly defined and publicly disclosed, and the key elements of the adopted policy explained.

Open process for reserve management market operations

18. The general principles governing the reserve management entity’s relationships with counter-parties and other service providers should be publicly disclosed.

Public availability of information on foreign exchange reserves

19. Information on official foreign exchange reserves should be publicly disclosed on a pre-announced schedule.

Accountability and assurances of integrity by agencies responsible for reserve management

20. The conduct of reserve management activities should be included in the annual audit of the reserve management entity’s financial statements. Independent external auditors should conduct the audit and their opinions on the financial statements should be publicly disclosed.

21. General principles for internal governance used to ensure the integrity of the reserve management entity’s operations should be publicly disclosed.

Investment strategy and accounting framework

22. The reserve management strategy should be consistent with the fundamental objectives set by the monetary authorities and supported by an appropriate reporting framework and accounting conventions.

23. The reserve holdings should be properly represented in the monetary authority’s financial statements, using valuation methods that reflect the nature of the holdings and the reserve management objectives.

C. Institutional and Organizational Framework

Legal foundation

24. Sound institutional and governance arrangements should be established through a legislative framework that clearly establishes the reserve management entity’s responsibilities and authority.

Internal governance and organizational structure

25. The internal governance structure of the reserve management entity should be guided by the principles of clear allocation and separation of responsibilities and accountabilities.

26. The governance structure should have appropriate hierarchical levels with clear rules for delegation of authority, often complemented by a committee structure aimed at facilitating efficient decision-making and oversight.

27. The investment management and risk control activities should be adequately separated. This separation facilitates an independent and comprehensive identification, monitoring, and management of risks.

28. The governance structure should include escalation procedures for decisions exceeding delegated authorities as well as for any compliance incident or breach of risk limits.

29. In designing the governance structure, it is important to identify the level of authority that would reconcile inconsistencies or interferences between reserve management activities and other central bank functions. Unwanted signaling effects from reserve management operations should be avoided.

30. An independent internal audit should regularly assess procedures and controls with regard to consistency and compliance with the institution’s policies, and formulate proposals to the Board or top management for improving the governance and organizational structure.

31. Reserve management activities require appropriately qualified and well-trained staff.

32. Staff should be subject to a code of conduct and conflict of interest guidelines.

33. Reserve management activities should be supported by reliable information and reporting systems.

34. Business continuity policies, including effective recovery procedures, should be in place to mitigate the risk that reserve management activities might be severely disrupted by the failure of operating systems, or other catastrophic events.

D. Risk Management Framework

35. There should be a framework that identifies and assesses the risks of reserve management operations and that allows the management of liquidity, market, credit, settlement, custodial, legal, and operational risks within acceptable parameters and levels that reflect the risk tolerance of the institution.

36. The risk management framework should enable a comprehensive and consolidated view of all relevant risks.

37. The management of credit risk should aim at not relying solely and automatically on the assessment of Credit Rating Agencies.

38. Reserve managers should be aware of the various legal risks entailed by holding and managing financial assets,

39. The risk management framework should apply the same principles and measures to externally managed funds as it does to those of a similar nature managed internally. External managers should be selected on the basis of clear principles and a well-defined and documented process.

40. All risk exposures should be monitored continuously to determine whether they have been extended beyond risk tolerance limits.

41. Reserve managers, including their top management, should be aware of and be able to account for potential financial losses and other consequences of the risk exposures they are prepared to accept.

42. The risk management framework should also carefully address the specific risks associated with derivative financial instruments and other foreign currency operations, which may be effectively used to manage risks.

43. To assess the risk and vulnerability of the reserve portfolio, the reserve management entity should regularly conduct stress tests to ascertain the potential effects of macroeconomic and financial variables or shocks, including extreme events.

44. Reserve management, especially of its most liquid component and any related operations, should be conducted in markets that have sufficient depth and liquidity, and can process transactions in a sound and efficient manner.

IV. Discussion of the Guidelines

A. Reserve Management Objectives, Scope, Strategy and Coordination

Objectives

45. Reserve management should seek to ensure that (1) adequate foreign exchange reserves are available for meeting a defined range of objectives; (2) liquidity, market, credit, legal, settlement, custodial, and operational risks are controlled in a prudent manner; and (3) subject to liquidity and other risk constraints, reasonable risk-adjusted returns are generated over the medium to long term on the funds invested. Reserve management forms a part of official economic policies, and specific circumstances will impact on choices concerning both reserve adequacy and reserve management objectives. In order to ensure the availability of reserves, and as part of setting appropriate investment priorities, the reserve manager needs to have an assessment of what constitutes an adequate level of reserves. This assessment should include estimates on foreign exchange liquidity needs and risk/return considerations based on various economic scenarios. Such an assessment may be made by the reserve management entity, or it may involve consultation between the reserve management entity and other agencies. There are no universally applicable measures for assessing the adequacy of reserves and the determination of reserve adequacy falls beyond the scope of these Guidelines. Relevant factors have traditionally included a country’s monetary and exchange rate arrangements, and the size, nature, and variability of its balance of payments and external position. Since the late 1990s, financial risks associated with a country’s external debt position and the volatility of its capital flows have received particular attention, especially for economies with significant but not fully certain access to international markets. In the process, ensuring the availability of reserves will be influenced by the exchange rate system, and the particular objectives for which they are held.

46. To ensure that reserves are available at the times when they are needed most, liquidity—which is the ability to convert quickly reserve assets into foreign exchange—usually receives the highest priority, albeit with a cost that usually involves accepting lower-yielding investment instruments. Liquidity should be analyzed in terms of liquidation time and cost as well as holding costs. Closely following is the need for the management and control of risks to ensure that asset values are protected. Market and credit risks, for instance, can lead to sudden losses and impair liquidity. Finally, returns are an important outcome of the management of reserve assets. For some countries, they play a role in offsetting the costs associated with other central bank policies and domestic monetary operations, which among other things fund the acquisition of reserves as well as in preserving or strengthening central bank capital buffers. In other cases, such as where reserves are borrowed in foreign markets, investment returns play an important role in minimizing the carrying costs of reserve assets. Accordingly, achieving an acceptable level of investment returns should be a priority within clearly defined liquidity and risk constraints.

47. In sum, the reserve management entity should seek to preserve the value of reserves, within the prudent risk limits that form the framework for reserve management, so that reserves are always available when they are needed. As a consequence, reserve asset portfolios tend to be risk-averse, with priority for liquidity and security before profit or carrying cost considerations. This necessarily involves making a trade-off between risk and return in the context of setting reserve management priorities.

Scope

48. Reserves consist of official public sector foreign assets that are readily available to and controlled by the monetary authorities. Reserve asset portfolios usually have special characteristics that distinguish them from other foreign currency assets. First and foremost, official reserve assets consist of liquid or easily marketable foreign currency assets that are under the effective control of, and readily available to, the reserve management entity.6 Furthermore, to be liquid and freely usable for settlements of international transactions, they need to be held in the form of convertible foreign currency claims of the authorities on nonresidents.7

49. Reserve management activities may also encompass the management of liabilities and the use of derivative financial instruments. Depending upon a country’s or union’s specific policy objectives and settings, market conditions, and the level of institutional development, the reserve management entity may also be involved in the borrowing of foreign exchange, or drawing against committed credit lines, as part of its responsibility for maintaining an adequate level of reserves. Managing reserves may also involve liability positions that derive from repurchase agreements, forward exchange and swap agreements, as well as positions arising from operations involving futures and options. In the latter respect, many countries now use derivative financial instruments as an integral part of reserve management operations to diversify, enhance liquidity or hedge risks exposures.8

Reserve management strategy and coordination

50. Reserve management strategies should be consistent with and supportive of a country’s or union’s specific policy environment, in particular its monetary and exchange arrangements. Reserve management strategies will be shaped by the specific reasons for which reserves are held. In the context of monetary and exchange arrangements, the exchange rate regime and the degree to which exchange and capital controls have been liberalized are of particular relevance.

51. Under a free float, a public commitment by the authorities not to operate in the foreign exchange market gives the reserve manager greater latitude in structuring the duration and liquidity of the portfolio. In practice, however, the authorities may seek to maintain a capacity to ensure orderly markets during times of very sharp adjustments of the exchange rate or market pressures, or more generally to be able to counter unforeseen internal or external shocks.

52. In countries with fixed exchange rates, including those that operate currency boards, the authorities may need to operate often in the foreign exchange market and will therefore need reserves that can be readily converted into foreign exchange.9 Especially in these cases, reserves are needed to provide confidence in the currency peg and deter speculation. For these purposes, reserves tend to be invested in a form that facilitates their ready availability.

53. Intermediate exchange rate regimes, such as managed float or peg arrangements,10 require the authorities to operate in support of the arrangement. This may call for more or less active operations depending on market evolution and conditions with consequences for the choice of the appropriate level of liquidity that would need to be maintained.

54. Evaluation of alternative reserve management strategies and their respective implications for reserve adequacy is likely to be facilitated by a cost-benefit analysis of holding reserves. Such analysis would aim to place values on the costs and benefits of holding more or less reserves. The accumulation of foreign currency can imply a currency mismatch for the country or the central bank and an earning differential with respect to the investments in domestic currencies. The correspondent risk and opportunity cost has to be evaluated against the expected benefits of less volatile capital flows, increased foreign investor confidence, and reduced risk of contagion.

55. Reserve management strategies may also need to take into account strategies for the management of external debt for purposes of reducing external vulnerability. Mutually consistent and supporting policies for debt and reserve management can be important elements of crisis prevention. At the public sector level, this might involve a coordinated approach that considers the assets and liabilities of several official institutions including, where relevant, the positions of subnational authorities. The aim in these circumstances is to determine whether a country’s official “whole of government” balance sheet has an adequate level of reserves to provide liquidity as needed, and to allow time to absorb shocks in situations where access to borrowing is curtailed or very costly. In some economies, short-term external private debt may also be an additional factor in determining reserve adequacy.

56. In countries where reserve management and debt management responsibilities are entrusted to the same authority, consistent strategies can be achieved through a well-coordinated asset-liability risk management approach. Where reserve management and debt management responsibilities are split between authorities, however, the respective policy objectives may differ. In situations where, for example, the reserve management entity has a primary responsibility for monetary policy, care should be taken to ensure that coordination efforts are not seen as compromising the separation between monetary policy and debt management. In such situations, coordination might also seek to ensure that the authorities’ respective actions send out clear signals and avoid contradictory messages.11

57. An important component of the reserve management strategy is to decide on the appropriate degree of diversification with the aim of improving the risk-return profile of the portfolio. The diversification may relate to currencies, financial instruments, and counterparties. The decision on diversification is usually based on an assessment of the properties of the different currencies and assets and on the correlations among them, since low correlation can improve the overall risk adjusted returns of the portfolio. In addition, trade and capital flows of the country can play a role in the decisions regarding currency diversification. An ex ante, forward looking assessment of how different asset classes and pools of asset classes react under different economic scenarios can help guide investment decisions. This assessment should in particular be able to ensure that reserves maintain or increase their value when they are most needed, in particular in times of adverse market conditions. For many reserve holders, greater portfolio diversification has recently been the necessary response to the reduction of rates on traditional safe assets and growing risks on other commonly held assets.

58. The strategic asset allocation, and thus the composition of the benchmark portfolio, should be consistent with the specific mix of precautionary needs for which the country’s reserves are held—including the potential correlation between the actualization of those needs and the performance or liquidity of particular asset classes. The reserve manager may wish to set a minimum amount of reserves to be held in those approved asset classes with the greatest liquidity; in which case, as the size of reserves declines (in a non-crisis setting), the percentage share of those asset classes will increase. Conversely, a reserve manager whose reserves are ample may be able to increase the percentage of the reserves held in less liquid approved asset classes, potentially increasing the return that can be earned for a given level of (non-liquidity) risk.

59. In choosing strategic asset allocation and investment options, attention should be paid to the risk of possible disruptive impact on credit and financial markets and of excessive liquidation or acquisition costs. The risk of an impact on markets depends on the size of the operations relative to the specific market and on the speed of the portfolio adjustment. It also depends on external market conditions. For instance, in times of rapidly rising or falling prices of particular asset classes, operations in those assets by official reserve holders, in the same direction as the markets are moving, may fuel market trends and imply high liquidation or acquisition costs. Particular attention should also be paid to possible signaling effects, since actions by official reserve holders are followed closely by market participants. A long-term horizon and ex ante assessment of different scenarios can limit sudden ex post adjustments.

B. Transparency and Accountability

60. The main issues of transparency in the context of good governance and accountability in reserve management are addressed in the IMF’sCode of Good Practices on Transparency in Monetary and Financial Policies: Declaration of Principles, September 1999 (MFP Transparency Code) and illustrated in the Supporting Document to the Code. The MFP Transparency Code aims at promoting transparency practices for central banks in their conduct of monetary policy, and for central banks and other financial agencies in their conduct of financial policies (Box 1). In doing so, it contains several elements of good transparency practices relating to foreign exchange policies, reserve management, and related foreign exchange market operations. In addition to identifying a range of general disclosures concerning foreign exchange policies and institutional responsibilities for reserve management, the MFP Transparency Code aims to promote transparency through accountability. The 2.1–2.4 subsections of this section follow the respective headings of the Code that relate to reserve management. It should be noted that within the specific sections of these Guidelines, references to the level of disclosure by a reserve management entity reflect those levels implied by the relevant section of the MFP Transparency Code, and where applicable, other relevant standards.

Foreign Reserves Disclosures Under IMF Standards and Codes

Code of Good Practices on Transparency in Monetary and Financial Policies

(MFP Transparency Code)

The MFP Transparency Code, adopted by the Interim Committee in September 1999, requires specific public disclosures covering (1) the institution with responsibility for foreign exchange policy, paragraph 1.1.4; (2) the responsibilities of the central bank, if any, for foreign exchange reserves, paragraph 1.3.1; (3) rules and procedures for the central bank’s relationships with counterparties in markets where it operates, paragraph 2.1.2, as well as regulations for the operation of organized financial markets (including those for issuers of traded financial instruments), paragraph 6.1.3; (4) information about the country’s foreign exchange reserve assets, liabilities, and commitments by the monetary authorities, according to a preannounced schedule, paragraph 3.2.4; and (5) release of the central bank balance sheet on a preannounced schedule, and selected information on its market transactions, paragraph 3.2. Further detail on the specific disclosure requirements relating to foreign reserves can also be found in Section 1.3.1 of the Supporting Document.

Other more general disclosure requirements that would incorporate information on reserve management include (1) release of summary central bank balance sheets on a frequent and preannounced schedule, paragraph 3.2.1; (2) preparation of detailed central bank balance sheets in accordance with appropriate and publicly documented accounting standards; (3) public disclosure of financial statements on a preannounced schedule, paragraph 4.2, and that have been audited by an independent auditor, paragraph 4.2.1; and (4) internal governance procedures necessary to ensure integrity of operations, including internal audit arrangements, paragraph 4.2.

Special Data Dissemination Standard

The Special Data Dissemination Standard (SDDS) was established in 1996 to guide IMF member countries that have, or that might seek, access to international capital markets in the provision of their economic and financial data to the public. Subscription to SDDS is voluntary, but it carries a commitment by a subscribing member to observe the standard, including the reserves data template, as approved by the IMF’s Executive Board on March 23, 1999.

The reserves data template is designed to provide information on the amount and composition of reserve assets, other foreign currency assets held by the central bank and the government, short-term foreign liabilities, and on- and off-balance sheet activities that can lead to demand on reserves (such as financial derivatives positions and guarantees extended by the government for private borrowing).

The template consists of four sections: (1) official reserves and other foreign currency assets; (2) predetermined short-term drains on foreign currency assets; (3) contingent short-term net drains on foreign currency assets; and (4) memorandum items. Dissemination of all data categories included in the template is mandatory for SDDS subscribers.

Clarity of roles, responsibilities, and objectives of financial agencies responsible for reserve management

61. The allocation of reserve management responsibilities, including agency arrangements, between the government, the reserve management entity, and other agencies should be publicly disclosed and explained.12 A reserve management entity may perform its functions in a number of ways, acting, for example, either as principal or in an agency capacity. In each case, it is important, therefore, that the ownership of reserves be clearly established. Varying institutional responsibilities for foreign exchange policy may also have implications for reserve management responsibilities. Accordingly, the specific institutional responsibilities for foreign exchange policy and reserve management should also be disclosed. These disclosures help financial markets and the general public understands how exchange rate policy decisions are made, their impact on reserve management objectives, and the accountability framework for reserve management decisions and outcomes.

62. Where the reserve management entity acts as the government’s agent in performing reserve management functions, its role and powers should also be clearly defined, such as in the entity’s enabling legislation, in addition to being publicly disclosed and explained.13 Defining clearly the entity’s agency role and powers avoids confusion over who has the ultimate responsibility for setting and implementing reserve management policy. Public disclosure enables the public to understand the extent of the reserve management entity’s responsibilities and to hold the reserve management entity and government accountable for their respective responsibilities and actions.

63. The broad objectives of reserve management should be clearly defined, publicly disclosed, and the key elements of the adopted policy explained.14 Public disclosure enhances the credibility of reserve management policies, goals, and results and is usually contained in the annual reports of reserve management entities. Information provided concerning, for example, the currency composition of benchmarks or the classes of assets would generally be couched in broad terms rather than by the provision of specific details of underlying assets and operations, which in some circumstances could be destabilizing. Some reserve management entities also include in their annual reports, and in broad terms, information relating to investment performance relative to the benchmarks adopted. Specific disclosure practices vary and may depend on country circumstances, including the stage of market development. Nonetheless, disclosure practices should strive to be consistent with the intent of the MFP Transparency Code.

Open process for reserve management market operations

64. The general principles governing the reserve management entity’s relationships with counterparties and other service providers should be publicly disclosed.15 Disclosure, in this context, serves to assure the public that reserve management dealings are based on objective criteria and are fair and impartial. Examples of particular disclosures could include the criteria used to choose eligible market counterparties and service providers (e.g., dealers, custodians, etc.), and to ensure that reserve management dealings are undertaken at market-determined prices and that these market participants observe recognized codes of conduct. Confidentiality considerations are important, however, and public disclosure should not extend to operational details that may weaken the reserve management entity’s ability to operate effectively in markets. Public disclosure would also not extend to providing specific details concerning relationships with individual counterparties.

Public availability of information on foreign exchange reserves

65. Information on official foreign exchange reserves should be publicly disclosed on a preannounced schedule.16 Public disclosure of a country’s international reserve position and foreign exchange liquidity on a timely and accurate basis helps promote informed decision making in the public and private sectors, in both domestic and global financial markets. Experience also suggests that timely disclosure of such information may allow for a more gradual market adjustment. Periodic standardized public information should be defined such that the publication can be continued during difficult market conditions without jeopardizing other policy goals.

66. The Special Data Dissemination Standard (SDDS), and its associated data template on international reserves and foreign currency liquidity (the reserve data template), provides a comprehensive benchmark standard for the content and timing of public disclosures on foreign reserves and other activities of potential relevance (Box 1). The reserve data template integrates on- and off-balance sheet data of the international financial activities of the country’s authorities,17 and aims to provide a comprehensive account of foreign currency assets and drains on such resources arising from various foreign currency liabilities and commitments. The reserve data template is also used as the basis for the reporting of data to the Fund for purposes of monitoring a Fund program.18

67. In many countries, public disclosure of information on foreign exchange reserves is also made through periodic releases, such as statistical releases on international liquidity and summary balance sheets as well as in the annual reports of reserve management entities. Such disclosures are generally timed so that their release would not interfere with market operations, or that changes to reserve management strategies or priorities would not be publicized ahead of their implementation.

Accountability and assurances of integrity by agencies responsible for reserve management

68. The conduct of reserve management activities should be included in the annual audit of the reserve management entity’s financial statements. Independent external auditors should conduct the audit and their opinion on the financial statements should be publicly disclosed.19 External audits, when performed in accordance with internationally recognized auditing standards, provide an independent opinion on the truth and fairness of disclosures contained in the financial statements and, accordingly, the underlying financial records in respect to reserve management activities and results. An independent external audit of the annual financial statements of the reserve management entity would normally include an examination of the accounting records and controls associated with reserve management activities and also check for consistency between disclosures contained within the financial statements, and those elsewhere in the annual report. Publication of the audit opinion along with the financial statements should also be an integral part of the accountability framework.

69. General principles for internal governance used to ensure the integrity of the reserve management entity’s operations should be publicly disclosed.20 Disclosure in this context is an important element in satisfying the general public and markets as to the competence and performance of the reserve management entity in discharging its responsibilities for reserve management activities as well as for other functions the entity may perform. The disclosures may be made as part of the entity’s annual financial statements, or they can be made in an official register or in other publications, as well as on the entity’s website. In addition to the risk management disclosures, required by accounting standards, they could extend to a broad discussion of the role of the Governing Board and Investment and Risk Committee in setting reserve management policies and parameters, internal audit, the role of an audit committee, and external audit arrangements.

Investment strategy and accounting framework

70. The reserve management strategy should be consistent with the fundamental objectives set by the monetary authorities and supported by an appropriate reporting framework and accounting conventions. Most central banks subscribe to an internationally recognized accounting framework that provides detailed guidelines for fair value measurement and disclosure of financial instruments. For reserve management, it is important to report in a single currency the fair value of the reserves. If the financial accounting framework does not provide for such information, then internal reporting procedures should aim to provide such information.

71. Sound investment decisions should be consistent with the chosen strategy and not be dictated by the reporting and accounting framework. That is, the chosen reserve management strategy should reflect an appropriate investment horizon, based on an evaluation of the adequacy of the reserves, the objectives for holding the reserves, and the risks to which the central bank is exposed. This investment horizon, in turn, helps define how the objective of capital preservation is understood. Concern about reporting a loss over an annual reporting period can cause a reserve manager to choose an inappropriately short investment horizon. This both reduces the long-term average return on the portfolio and also exposes the portfolio to volatility and reinvestment risk (i.e., the risk of reinvesting at a lower return). Similarly, since the reserve manager should focus on the performance of the portfolio as a whole, investment decisions regarding specific assets should not be dictated by accounting issues regarding that specific asset (e.g., not having to sell a given asset because it would result in a book loss).

72. The reserve holdings should be properly represented in the monetary authority’s financial statements, using valuation methods that reflect the nature of the holdings and the reserve management objectives. Achieving a true and fair opinion requires that the financial information and other disclosures contained in the financial statements adhere to internationally recognized accounting standards, such as International Financial Reporting Standards (IFRS).21 The adoption of high quality accounting standards is an essential element in facilitating market understanding of the role and risks of a reserve management entity, and that its financial position and performance have been measured on a consistent and comparable basis. Reserve management activities are generally represented in the financial statements reflecting the by fair value principle requiring that securities held for ready sale are properly reported at their market value. 22 Deviations from fair value may be observed in the foreign currency reserve when is translated into domestic currency, including for gold. However, the foreign currency value of reserves matter, as they are used for intervention and repayment purposes, for which the value in domestic currency is less relevant. To the extent that market-based valuation gains for these assets may be included in net profits, some reserve management entities may require supporting rules to avoid premature distribution of such profits.

C. Institutional and Organizational Framework

Legal foundation

73. Sound institutional and governance arrangements should be established through a legislative framework that clearly establishes the reserve management entity’s responsibilities and authority. An institutional framework that contains a clear identification of responsibilities helps ensure good governance and accountability as well as ensuring that reserves are managed effectively and efficiently in a manner appropriate to a country’s needs. Legal assignment of institutional responsibilities, supported by delegation of appropriate authority to a reserve management entity, is particularly important for ensuring effective coordination and performance where reserve management responsibilities and functions are allocated across more than one institution.23 Clearly establishing the reserve management entity’s authority in legislation and appropriate documentation such as secondary legislation or regulations, coupled with public disclosure, enhances transparency and accountability, and also assures counterparties of the reserve management entity’s mandate.24

Internal governance

74. The internal governance structure of the reserve management entity should be guided by and reflect the principles of clear allocation and separation of responsibilities and accountabilities. A clear distinction should be made between reserve management responsibilities on one side and institutional responsibilities, such as the conduct of monetary policies or the pursuit of financial stability, on the other. A well-defined organizational structure from the very top to operational levels of the reserve management entity requires a clear definition of the goals and a clear separation of responsibilities and accountabilities for their attainment at the various levels.

75. The governance structure should have appropriate hierarchical levels with clear rules for delegation of authority, often complemented by a committee structure aimed at facilitating efficient decision-making and oversight. The decision-making hierarchy is aimed at ensuring the integrity of reserve management operations, facilitating effective decision making, and maintaining control over reserve management activities. The governance structure comprises a system of unambiguous and formally documented delegations of authority. This system ensures that the roles of organizational units, committees, and individual members are clearly defined and that operations only occur within the limits of delegated authority.

76. At the very top level of the reserve management entity, the governing board or similar body, or the governor makes decision of a strategic nature and exerts overall oversight. The strategic decisions typically comprise preferences with regard to the trade-off between risks and returns and the broad composition of assets under management. In addition, the top hierarchical level established the framework for implementation of the reserve management strategy (e.g., policies, delegations of authority). The top level oversight responsibilities imply a requirement for a regular review of investment activities including risk and performance monitoring. Such a review should occur at least annually but can also be more frequent, such as semiannually or quarterly depending on market conditions. Typically, some of these responsibilities are delegated to a high level committee (e.g., risk management or “strategy” committee); alternatively, the top level decision maker is supported by such a committee.

77. Decisions concerning the implementation of strategies are usually delegated to an investment committee. The committee typically is chaired by the board member or high ranking official with responsibility for reserve management. The committee is usually responsible for detailing the operational framework for reserve management activities, including the investment strategy implementation and portfolio benchmarks, and for reviewing operations and performance on a regular basis. The committee typically also has a responsibility for approving the inclusion of new specific types of investment operations and instruments within the criteria set by the top level decision maker. Such approval would also encompass the procedures for assessing new investment proposals, particularly in terms of their risks and the ability of existing staff and systems to handle the operations proposed.

78. The investment management and risk control activities should be adequately separated. This separation facilitates an independent and comprehensive identification, monitoring, and management of risks. At the operational level, decision making and responsibility for day-to-day reserve management operations are usually separated between the investment and risk control functions.

79. Generally, the investment function refers to the entire spectrum of reserve management activities. This includes those who initiate reserve management transactions (front office); those who control and ensure that risk limits are observed, assess performance, and provide reports for management (middle office); those who arrange settlement of transactions (back office); and those who maintain the financial accounting records that form the basis of public disclosures (accounting department). Within the investment function, some reserve management entities have established units that are tasked with the selection and monitoring of external providers of asset management services.

80. Within the risk control operational framework, the risk management unit has the responsibility to identify risk, set up an appropriate system of guidelines and limits, establish risk management measures and monitor day-to-day operations and controls. Examples of such controls include breaches of delegated authorities and limits, errors and operational failures. While the main decision on risk taking is taken by the board, the risk management unit is often involved in the preparation of the strategy proposals and the benchmark selection. In the case of organizationally independent risk management units, close cooperation between risk taking and risk management functions should be encouraged in order to avoid an overly restrictive environment for the reserve management entity and encourage sharing of cross-functional expertise.

81. In some cases, full organizational separation is not possible. This may, for instance, occur when risk management is integrated across various activities and reserve management is part of a wider asset and liability management function. Some organizational units and individual staff members involved in the reserve management process may have roles in the management of domestic assets and in the implementation of monetary policy. In some cases, there is also organizational overlap with functions assigned to central banks in the fields of financial stability and banking supervision. This necessitates the establishment of detailed policies that govern the use of information and provide guidance on the resolution of possible conflicts of interest at the respective hierarchical levels. Also, a rule-based investment style could be an effective way to mitigate the risk. In any case, the risk or the perception of risk that reserve management could use non-public information should be avoided.

82. The governance structure should include escalation procedures for decisions exceeding delegated authorities as well as for any compliance incident or breach of risk limits. The front office and risk management units usually operate within certain risk limits or within margins of maximum deviation with respect to a benchmark. In certain situations, the limits set may lead to suboptimal investment decisions. Clear guidelines for escalation procedures could clarify at what level decisions should be taken depending on the size of the deviation with respect to pre-established limits. The same guidelines should also clarify the steps to be followed in case of incidents or errors.

83. In designing the governance structure, it is important to identify the level of authority that would reconcile inconsistencies or interferences between reserve management activities and other central bank functions. Unwanted signaling effects from reserve management operations should be avoided. The design of the governance structure should take into account the interaction between reserve management and other central bank operations. Particular challenges may arise if reserve management activities interfere with or are inconsistent with the activities of other central bank functions. For example, this may occur when the reduction of exposures to certain counterparties or issuers in crisis situations is assessed differently from an investment or financial stability perspective. Governance structures may need to be specified in a way that these interferences are identified and addressed at the right hierarchical levels.

84. Conflicts of interest may arise from the existence of nonpublic information possibly emanating from policy areas. Unwanted signaling effects may arise when counterparties are in a position to extract the views of the reserve management entity from their trading activities, and it is assumed that the views are based on non-public information. Typically, central banks avoid these interferences through organizational separation of the reserve management function from policy areas as well as through rules and policies that limit the exchange of information between organizational units. These firewalls could restrict the flow of information from policy areas to the reserve management function, but allow the dissemination of market intelligence gained in the reserve management area to the policy areas.

85. An independent internal audit should regularly assess procedures and controls with regard to consistency and compliance with the institution’s policies and formulate proposals to the Board or top management for improving the governance and organizational structure. An effective and independent audit unit plays an important role in providing independent assurance to the senior levels of the reserve management entity (such as the audit committee, or the governing board) that reserve management operations and internal control and reporting systems are operating properly to safeguard reserve and other assets.25 The role of internal audit now tends to focus on a risk-based approach in assessing that the operating framework is adequate, and that control procedures have no gaps in addressing key reserve management and operational risks. Particular aspects of reserve management operations on which internal audit review might focus include (1) the degree of success in achieving reserve management objectives; (2) determining whether all relevant risks have been identified; (3) the adequacy of the system of internal controls in addressing risks and monitoring compliance with procedures and controls; (4) the existence of proper safeguards to protect assets; (5) the reliability, security, and integrity of Electronic Data Processing (EDP) communication and other information systems; and (6) the accuracy of accounting records and processes.

86. Reserve management activities require appropriately qualified and well-trained staff. All aspects of reserve management operations require well-trained staff. First and foremost, staff should have a firm grounding in market practices and instruments to undertake respective reserve management activities. Supporting this, the procedures that staff follow for settlement and, where necessary, resolution of disputes or differences should be based on sound business practices. Staff should also fully understand the risks and the control environment in which they operate. Failure of staff to observe controls, as well as failure of the control environment, can lead to significant financial losses and may tarnish the reputation of the reserve management entity. An added complexity for many reserve managers is the difficulty of retaining high quality staff in a highly mobile foreign exchange and investment market environment. The ability to recruit and retain highly qualified staff is particularly crucial where reserve management entities aim to make investments in a broader range of markets and/or generate returns in excess of the benchmark by means of active portfolio management. Some reserve management entities might seek to provide adequate additional remuneration or financial incentives to match market offers. This may not always be an option, however, and other nonfinancial options such as providing a challenging work environment, including increased levels of responsibility commensurate with skill and experience, and a well-structured staff training program, may assist in retaining qualified staff and in developing resources to cover the unexpected departure of a key member of staff. Staff members should also be encouraged to obtain professional qualifications in the fields of financial analysis, and portfolio and risk management.

87. Staff should be subject to a code of conduct and conflict of interest guidelines.26 Such codes help to allay concerns that staff’s actions or personal financial interests may subvert reserve management practices. These arrangements should also include a requirement that staff adopt and comply with professional codes of conduct that apply in the markets in which reserve management operations are undertaken. Similar arrangements might also be extended to staff of external managers through the contractual arrangements with such managers.

88. Reserve management activities should be supported by reliable information and reporting systems. Inadequate control over operational aspects can threaten the ongoing performance of reserve management operations and the ability of the reserve management entity to safeguard the assets under its control. Reserve managers need to be aware of the main operational risks they face in day-to-day operations and the appropriate procedures to control such risks.27 Equally important, they need to be sure that the control measures adopted are being observed. In this context, reserve managers require access to reliable information and reporting that enables them to monitor risks and performance as well as any breaches of controls. Performance reports need to consider risk-adjusted measures calculated for the portfolios and its benchmarks. Ideally, transaction processing and information systems should be fully integrated to reduce the risk of error and to improve the speed at which management information is available. Establishing such systems can, however, involve a significant investment in the operating infrastructure of a reserve manager. Evaluation of particular systems may need to have regard to the size and complexity of the reserve management entity’s operations, and the skills of staff, to ensure an appropriate balance between the costs and benefits of the chosen system.

89. Business continuity, including effective recovery procedures should be in place to mitigate the risk that reserve management activities might be severely disrupted by the failure of operating systems, or other catastrophic events. Reserve management systems now typically depend upon the continuous operation of efficient and secure EDP and communications systems. Such systems require controls that protect against major interruptions to business from events such as equipment or power failure, unauthorized access, natural disaster, or other external acts. These controls should also include comprehensive business recovery procedures including backup systems and contingency plans to ensure that operations can be resumed with a minimum of delay should a catastrophic event occur. Reserve Management entities should have onsite and offsite disaster recovery infrastructure, and periodic tests of this infrastructure should also be conducted.

D. Risk Management Framework

90. There should be a framework that identifies and assesses the risks of reserve management operations and that allows the management liquidity, market, credit, settlement, custodial, legal, and operational of risks within acceptable parameters and levels that reflect the risk tolerance of the institution. Reserve management involves a number of financial and operational risks. A summary of external market-based and operational risks, which have been faced by reserve management entities, is provided in Box 2. A risk management framework seeks to identify the possible risks that may affect portfolio values and to manage these risks through the measurement of exposures and, where necessary, supporting procedures to mitigate the potential effects of these risks.

Adverse Reserve Management Experiences

External market-based risks

Liquidity risks. The pledging of reserves as collateral with foreign financial institutions as support for loans to either domestic entities or foreign subsidiaries of the reserve management entity has rendered reserves illiquid until the loans have been repaid. Liquidity risks have also arisen from the direct lending of reserves to such institutions when shocks to the domestic economy led to the borrowers’ inability to repay their liabilities, and impairment of the liquidity of the reserve assets.

Credit risk. Losses have arisen from the investment of reserves in high yielding assets that were made without due regard to the credit risk associated with the issuer of the asset. Lending of reserves to domestic banks, and overseas subsidiaries of reserve management entities, has also exposed reserve management entities to credit risk.

Currency risk. Some elements of currency risk may be unavoidable with reserve asset portfolios. There have, however, been instances where large positions were taken in other countries’ currencies in anticipation of favorable future changes in major cross-rates, but where subsequent adverse exchange rate movements led to large losses.

Interest rate risks. Losses have arisen on reserve assets from increases in market yields that reduced the value of marketable investments below their acquisition cost. Losses have also arisen from operations involving derivative financial instruments, including the taking of large positions, which have been subject to the effects of sharp and large adverse movements in market yields. In some instances, reserve managers may have had an inadequate understanding of all the characteristics and risks of the instruments used, and may also have lacked the technical skills required to manage exposures.

Operational risks

Control system failure risks. There have been a few cases of outright fraud, money laundering, and theft of reserve assets that were made possible by weak or missing control procedures, inadequate skills, poor separation of duties, and collusion among reserve management staff members.

Financial error risk. Incorrect measurement of the net foreign currency position has exposed reserve management entities to large and unintended exchange rate risks, and led to large losses when exchange rate changes have been adverse. This has also occurred when risk has been measured only by reference to the currency composition of reserves directly under management by the reserve management unit, and has not included other foreign-currency-denominated assets and liabilities on and off the reserve management entity’s balance sheet.

Financial misstatement risk. In measuring and reporting official foreign exchange reserves, some authorities have incorrectly included funds that have been lent to domestic banks, or the foreign branches of domestic banks. Similarly, placements with a reserve management entity’s own foreign subsidiaries have also been incorrectly reported as reserve assets.

Loss of potential income. A failure to reinvest funds accumulating in clearing (nostro) accounts with foreign banks in a timely manner has given rise to the loss of significant amounts of potential revenue. This problem arises from inadequate procedures for monitoring and managing settlements and other cash flows, and for reconciling statements from counterparts with internal records.

91. The first elements of a risk management framework are a definition of the institution’s risk tolerance, the quantification of the size of the overall risk budget, and the identification of possible deviations from the benchmark. These parameters should be included in Investment Guidelines and sometimes an Investment Policy document.28, 29

92. Although there is no set formula that suits all situations, in practice, many reserve management entities draw upon generally accepted portfolio management principles in determining the strategy for asset selection and allocation to control exposures to external risks. Typically this involves establishing parameters for (1) the currency holding and mix necessary to maintain the ready availability of convertible currencies, and also to maintain cross-rate exposures within acceptable limits; (2) the permissible range of investment instruments that meet liquidity and security requirements; and (3) maturity or duration requirements for limiting exposure to interest rate or market price risks. Regarding the second point, risk parameters should include the minimum acceptable credit ratings or level of default probability for the issuers of those instruments.

93. The strategic asset allocation objective is typically embodied in a benchmark portfolio that represents the best or optimal portfolio given the reserve management objectives and risk constraints (Box 3). In order to guide investment operations, the benchmark portfolio needs to be well defined,30 including in terms of the notional size, security composition, and rebalancing rules. Considerations in the selection of the currency mix within the benchmark portfolio include liquidity as well as currency risk. The reserve management entity may, for example, wish to hold some additional liquidity in the main intervention currency, or in specific currencies to facilitate debt servicing. It may also wish to consider whether other major liquid currencies should be held for purposes of hedging currency risk in the portfolio vis-à-vis other liabilities.

Benchmark Portfolios and Risk Management

Senior management needs to specify a strategic long-term portfolio that represents the best available trade-off between the different risks that the reserve management entity is facing. This is the entity’s investment benchmark, which is made operational through the construction of actual benchmark portfolios that include the chosen currencies with desired weights, investment instruments with appropriate credit characteristics, and duration that reflects the desired level of interest rate risk. The benchmarks should not include transient factors or reflect short-term market expectations, but their appropriateness should be reviewed regularly. Changes to the benchmark would be triggered by changes in market structure or characteristics that alter the investment environment. The adoption of investment benchmarks is a sound practice that brings discipline to the investment process.

There are various approaches to measuring risk and controlling exposures as a result of deviations from the benchmark. Typically, such exposure is limited by the setting of quantitative limits on the size of any deviation from the benchmark in terms of currency, duration, or credit that may be permitted by those responsible for the investment of reserves. Currency risk is usually managed through quantitative limits on how much each individual currency, or all currencies in the benchmark taken together, may deviate from the benchmark structure. Interest rate risk can be managed by establishing benchmarks with a given duration and by limiting the actual portfolio’s deviation both in terms of duration and yield curve mismatches. Credit (default) risk has traditionally been managed by placing limits on eligible issuers or counterparties based on their capital and ratings.

VaR methodologies and Expected Shortfalls (ES) can also be used to provide an estimate of the maximum potential loss, with a given probability and time horizon, resulting from deviations from the benchmark portfolio and an estimate of the expected loss over a certain horizon, conditional on the facts that VaR is exceeded. Stress tests using data based on representative historical periods, or extreme risk scenarios should be an important element in evaluating risks exposures.

Investment benchmarks are an important tool for assessing performance and enforcing the accountability of reserve managers. Where managers are permitted to deviate from the benchmark portfolio, performance assessment and accountability will occur through the comparison of performance of the actual portfolio with that which could have been generated by holding the benchmark portfolio. Where portfolio managers seek to replicate the benchmark, assessment of performance would also be based on comparison of actual performance versus the benchmark. In both cases, the benchmark establishes the reference point for the reserve management entity’s accountability in terms of its choice of risk tolerance.

94. A number of reserve management entities also subdivide their reserves portfolio into “tranches” according to liquidity and investment objectives and policy requirements. Sometimes, each tranche is allocated a specific component of the overall risk budget. A “liquidity tranche” would reflect transaction and/or intervention needs based on the assessment of potential need for liquidity on demand. Such portfolios are typically invested in the most liquid and risk-averse instruments with an aim to have this part of reserves available for interventions.31 For reserves that are held to provide an additional cushion, but are less likely to be drawn upon, an “investment tranche” may be created where greater emphasis is placed on return as well as safety and liquidity. The relative size of each tranche may be determined as part of an assessment of reserves adequacy, and each tranche would have a separate benchmark reflecting the different objectives. In some countries, tranching is also used to immunize market and foreign exchange risks on the reserve balance sheet, by establishing characteristics for a particular asset portfolio that match those of a group of counterpart foreign liabilities.

95. The risk management framework should enable a comprehensive view of all relevant risks. The risk management framework should offer an integrated view of the whole range of risks faced by the reserve management entity with respect to foreign reserves, to broader investment portfolios, and to policy constraints as dictated by country specific institutional arrangements and policies. In crisis situations, central banks might take additional assets on their balance sheets in the pursuit of financial stability objectives or in order to support the economy. The risks arising from these additional assets should be included in the risk-assessment of the balance sheet. A significant change in the risk profile might prompt a review of the reserves asset allocation, whereby the correlation between the risks of the additional assets and those deriving from the reserves portfolio should be accounted for. These developments have heightened the importance of adequate capital buffers for central banks and of reserve strategies aimed at longer term capital accumulation. The assessment of foreign reserve risk, as well as of the other risks faced, and the long-term capital needs of the institution may benefit from an asset and liability management (ALM) approach that considers all relevant risks, including those generated by off-balance sheet and latent items.

96. The management of credit risk should aim at not relying solely and automatically on the assessment of Credit Rating Agencies. Reserve Managers that have the capacity need to internally analyze and understand the amount of credit risk to which they may be exposed as a result of reserve management activities, in order to avoid overreliance on Credit Rating Agencies. Accordingly, they may put in place internal credit risk assessment systems (ICAS) for assessing and monitoring their counterparties—both sovereign and non-sovereign. Reserve managers may also have a system of assessing credit risk arising from the various instruments in which they invest.

97. Reserve managers should be aware of the various legal risks entailed by holding and managing financial assets. Legal risk may be defined as the possibility of losses arising primarily from uncertainty about or shortcomings in the legal conditions for managing reserves, and from inadequate control of those legal conditions. Examples of such legal conditions include the division of responsibility between the contracting parties (e.g., reserve manager and external asset managers or custodians), provisions on dispute resolution, and the governing law of the contract. As an illustration, it is often possible that, while the agreement signed between the reserve manager and external manager is subject to the law of one jurisdiction, the legal title of, or the terms governing the assets under management (e.g., sovereign or corporate securities), may be subject to the law of another jurisdiction. The risk involved in subcustody arrangements is another example.

98. Legal risks are closely related to other risks, and should be managed as part of a comprehensive risk management strategy. In particular, identification and control of legal risks requires understanding by reserve managers of the legal structures (the national legal system, the foreign legal systems and agreements). Reserve managers should thus seek expert legal advice, including if necessary from external experts, before going ahead with external asset management arrangements. Reserve managers may also consider analyzing regulatory filings and audit reports of the custodians and other counterparties. Reserve management entities should also use standard legal agreements for managing their credit and counterparty risk: for example, International Securities Dealers Association (ISDA) agreements including credit support annexes (CSA) for full collateralization of exposures.

99. The risk management framework should apply the same principles and measures to externally managed funds as it does to those of similar nature managed internally. External managers should be selected on the basis of clear principles and a well-defined and documented process. Many reserve management entities allocate part of their reserves to one or several external institutions for management. External managers may have skills that the reserve management entity lacks, or they may provide a level of safety to foreign operations that the entity is unable to achieve. They may, for example, have skills and established systems for undertaking investment activities in specialized instruments and markets for it is not convenient to develop an in-house operational capability. Alternatively, they might provide access to new markets and activities or new investment strategies in which the reserve management entity is seeking to expand its operations. Finally, they may also assist smaller reserve management entities in managing or reducing the costs of maintaining a reserve management operation in a particular market or instrument.

100. Sound risk management of externally managed funds begins with the careful selection of reputable external managers, and a clear mandate for the managers to follow, together with agreed understandings of expected performance and tracking error. External managers should be chosen among those committed to observing the best standards of integrity that have been adopted by the industry. They should be selected on the basis of properly defined selection criteria, which are focused on the assessment of investment related services using a balance of quantitative and qualitative criteria. Additionally, external managers should be monitored on a regular basis using the same criteria as in the selection process. These arrangements should be set out clearly in separate written contracts with each appointed manager to ensure accountability. It is also important that appointment of an external manager not result in the reserve management entity accepting operations and risks that would not normally be considered, or are not fully understood. Appointment of external managers can also have implications for the reserve manager’s choice of a custodian for its foreign securities. Generally, there should be a clear “firewall” separation between any external management and custodial functions performed by any one entity. External service providers of operational services (e.g., custodians, transition managers,32 automatic securities lending agents) should be chosen and tendered according to properly defined selection criteria. Reserve managers should also examine and address risks arising out of any sub-custodian arrangements.

101. In principle, and in practice, there should be no difference between the risk management and performance-monitoring framework that is applied to externally and internally managed portfolios. Most likely it will, however, be necessary to establish a separate unit, or assign a position within the middle office, to enable the reserve management entity to fully monitor the activities of the external manager and custodians.

102. All risk exposures should be monitored continuously to determine whether they have been extended beyond risk tolerance limits. Monitoring is essential in identifying and limiting any cumulative losses associated with deviations from the benchmark, any underperformance of the portfolio vis-à-vis the benchmark, and any increases in exposures associated with the benchmark itself due to market developments or structural changes. Since risk is inherent in both benchmark33 and actual portfolios, monitoring should occur regardless of whether “passive” or “active” reserve management approaches are adopted.34 VaR or other simulation methodologies may also form an integral part of the risk management and monitoring framework. Return reports should consider risk adjusted measures calculated for the portfolio and its benchmarks at the same risk level.

103. Reserve managers, including their top management, should be aware of and be able to account for potential financial losses and other consequences of the risk exposures they are prepared to accept. Active management based on expectation of movements in interest rates or exchange rates, or a choice by the reserve management entity to accept a higher risk tolerance in its benchmark portfolios, requires that management is able to monitor and control any cumulative financial losses. Implicit in such an environment is the need for specific and monitorable risk limits on the extent to which managers can deviate from the benchmark, and a reliable and timely accounting system for measuring and reporting exposures and losses. In addition to possible financial losses, other consequences can occur, such as the risk of adverse signaling to participants with respect to monetary and exchange policies, damage to the reputation of the reserve management entity, and, possibly, a breach of a country’s obligations in terms of the Fund’s Articles of Agreement. In this latter context, reserve management entities need to be aware of their country’s obligations to collaborate with the Fund and other member countries to ensure orderly exchange arrangements (Article IV.1) and consistency of policies on reserve assets in promoting better international surveillance of international liquidity (Article VIII.7). Accordingly, governance arrangements to avoid such instances might include the requirement for investment committee approval of changes to benchmark parameters or portfolio allocation policies.

104. The risk management framework should also carefully address the specific risks associated with derivative financial instruments and other foreign currency operations, which may be effectively used to manage risks. As noted earlier, derivative instruments may be used as part of reserve management operations, particularly in reducing risk exposures. Effective risk management requires that the reserve management entity is aware of and understands the risks and benefits of these instruments, and that staff has a sound knowledge of the underlying risks and the modalities of particular instruments used. Key aspects to address in the framework include leverage, counterparty risk, legal risk and robustness of processes and operations. In addition, the framework has to ensure that derivative positions are included in the calculation of the different risk figures as well as in the measurement of performance. It also requires reserve management systems that are sufficiently developed to properly measure the values and exposures associated with operations. Limits should be set to restrict maximum leverage and stress test scenarios used to estimate extreme outcomes. As the use of derivatives and other structured financial instruments grows, legal risk issues become particularly relevant. In this regard, risk mitigation could involve the use of standardized legal documentation and the performance of periodic reviews of documentation. For those central banks whose operations include the transfer of over-the-counter derivative instruments to a central counterparty clearing house (CCP), the user standards of the CCP should be included and examined within the credit risk framework. Appropriate collateralization and adequate bilateral margining processes should be specified in the internal procedures and legal certainty applied with respect to documentation, including the counterparty’s jurisdiction of location, account segregation, and client money protection.

105. Beyond their reserve management operations, some reserve management entities also have other functions that involve foreign-currency-denominated assets and liabilities both on- and off-balance sheet.35 While such operations do not fall within the definition of reserve management operations, per se, they may, nonetheless, represent an important part of a reserve management entity’s broader mandate and involve policy choices in the utilization of the country’s foreign exchange resources.

106. The reserve management entity, therefore, may be exposed to a range of additional risks that need to be managed in a coordinated and consistent manner. In this regard, a comprehensive asset and liability risk management framework could be used to address the overall risk exposure of the reserve management entity’s entire balance sheet and, in doing so, reduce the risk of loss or impairment of reserves.

107. To assess the risk and vulnerability of the reserve portfolio, the reserve management entity should regularly conduct stress tests to ascertain the potential effects of macroeconomic and financial variables or shocks, including extreme events. Stress testing can have several objectives and is often conducted using financial models ranging from simple scenario-based models to more complex models involving sophisticated statistical and simulation techniques. One objective typically is to determine the exposure of the portfolio to changes in market factors, such as changes in exchange rates or interest rates, often by using VaR models.

108. A second objective concerns assessing the possible impact on the level of official foreign exchange reserves of external shocks, contingent obligations that might materialize with such shocks, and sudden calls on reserves that may result from a reversal of short-term capital flows or closing out of the open foreign exchange position of the commercial banking system. Stress testing in this context is qualitatively different from measuring changes in the market value of the portfolio, and can be particularly useful in the formulation of asset and liability management and strategic asset allocation policies to ensure reserve availability during times of external stress.

109. Reserve management, especially of its most liquid component and any related operations, should be conducted in markets that have sufficient depth and liquidity, and can process transactions in a sound and efficient manner. Reserve managers need to be certain that reserves can be liquidated in a prompt and efficient manner to provide the necessary foreign exchange for the implementation of policy objectives relating to, for example, market intervention, meeting balance of payments or debt-servicing needs, or limiting external vulnerability. Policy actions, on the other hand, can also involve the purchase of foreign exchange that should be placed promptly into investment portfolios. In these situations, undertaking the relevant investment transactions in deep and liquid markets serves to ensure that they can be easily absorbed by these markets and without undue impact on investment prices received, or paid, by the reserve manager. Policy actions invariably, however, involve transactions initiated in the reserve management entity’s domestic foreign exchange market, and that have a consequential implication for the reserve manager. In these circumstances, the effectiveness of the policy action will be dependent upon the efficiency and soundness of the domestic market. Furthermore, and of particular relevance for reserve levels, any failings or operating weaknesses in that market can directly impact either the amount of reserves required to support the policy action or the amount of foreign exchange added to reserve holdings.

110. Undertaking transactions in deep and well-established markets ensures that reserve-related transactions can be easily absorbed at market-determined prices without undue distortions or adverse impacts on the level and availability of foreign exchange reserves.