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Wednesday, July 23, 2014

Dealing Room Operations: Risks & Their Management

With free flow of capital all around the globe and the resultant rise in volumes, the need for risk identification in Dealing room operations and its management has become quite imperative. Let us take a look at different types of risks associated with forex dealing.

1 Open Position Risk
     Long/overbought/plus     –    means bought more dollars than sold
     Short/Oversold/minus     –    means sold more dollars than bought
If one is overbought and currency weakens, one will be able to square up over bought position by selling the currency at a loss. On the other hand, if one is oversold and currency hardens, he can only cover it at excess cost i.e. by incurring loss.

2 Maturity Mismatch Risk
Gaps arising out of merchant transaction position and other trades pose a mismatch risk. Unmatched forward maturities may cause loss if forward differentials go against the bank.
3 Credit/Counter Party Risk
It arises out of failure of the counter party to honour his side of the contract. It also arises due to Contract Risk: Assume one has sold forward $ to a customer say at Rs.43.30 per $. Before the contract matures, if the customer fails, the dealer has to dispose off the earmarked dollars in the market at the going rate even if it has weakened say to Rs.43.10 per dollar. This is nothing but Replacement Cost or pre-settlement risk.

There is yet another kind of credit risk known as Clean Risk: Assume we have sold Euro against $ and accordingly, we have credited Euro to the Bank A/c – say in Germany and waiting for the German Bank to deposit Dollars in our New York A/c. Till German Bank credits Dollars in our New York A/c., we will be running Clean Risk and if, in between the Bank fails, we have to put up with the  loss. This type of risk, also known as Settlement Risk, may arise in international transactions owing to time-zone differences.

4 Interest Rate Risk
Owing to adverse movements in implied interest rates or actual interest rate differentials relating to foreign currency deposits, forward contracts, currency swaps, FRAs, etc.

5 Legal Risk
If the contracts are of a defective nature, they cannot be enforced. This kind of problems are more under swap deals.

6 Operational Risks
Omissions/commissions in operational procedures viz. – Dealing & Accounting functions: Follow-up of dealings and contract confirmation; Settlement of funds; Pipeline transactions; and Overdue bills and contracts.

7 Sovereign Risk
Risk of Externalisation: The countries may suddenly impose instructions on free movement of forex exchanges. It is basically political in nature. This arises in transactions including banks located in other countries.

2. Management of Dealing Room Risks

Banks, assessing the risk involved in trading and non-trading activities, usually put in operation a well-drafted risk management procedure that could be well understood by Dealers, Back Office staff etc., and execute it with much ease. Such a mechanism shall assist in effective monitoring and limiting risk prone activities across the Dealing Room. Some such time-tested mechanisms are:

2.1 Open Position Risk
Since these positions are taken at a particular rate, any adverse movement in the rate leads to loss. To prevent/minimise such losses, banks prescribe various limits consistent with adequacy of its capital to undertake such activities.

·      Day light Limit – Dealer cannot take a position of more than day light limit prescribed by the Bank.
·     Overnight Limit – Fixes overnight limit for an open position in each currency – usually lesser than daylight limits; Global limit for all the currencies put together is also fixed.
·    Cut-loss Limit – While undertaking transactions, if the rate goes on moving against the bank, one never knows, where the loss would end. Hence, banks fix a cut-loss-limit. Irrespective of the Dealer’s view, if the rate moves so adversely that the resultant loss is equivalent to the limit, the dealer has to liquidate the position and book loss.

All deals done in the day should be accounted for against the corresponding limits. The limits when exceeded should be promptly reported to the Senior Management and got approved. People not connected with Dealing room operations should constantly monitor compliance with these limits through timely, accurate and comprehensive MIS.

2.2 Maturity Mismatch Risk
·   Individual Gap Limit (IGL): Bank prescribes limits on mismatch in the currency bought and sold for a particular month.
·    Aggregate Gap Limit (AGL): Aggregate gap limit for each currency on all the O/B and O/S positions for various months.
·       Total Aggregate Gap Limit: Aggregate of all the AGLs in all currencies for dealing room as a whole.

 2.3 Credit Risk
To minimize credit risk, banks impose exposure limits on customers as well as on other Banks. In general, separate limits are fixed for spot and forward, the latter being lower than the spot. In case of Forwards, the limits are prescribed as the maximum level of the net outstanding Forward contracts.

2.4 Operational Risk
Dealing and execution functions are separated for early discovery of any transgression of the imposed limits – by dividing dealing room into front office solely concentrating on dealings and back office for recording the transactions and pursuing settlements etc. Systems and procedures are put in place to obtain ‘deal-confirmations’ in time and prompt follow-up for execution of ‘funds-transfer’ instructions. Back office is also entrusted with the responsibility to monitor export bills and forward contracts for their delivery in accordance with the tenor.

2.5 Legal Risk
To obviate the risk involved in enforcing compliance with contractual obligations/securities, banks usually enter into the following master agreements with counter party banks/clients:

·       Spot & Forward Exchange – International foreign Exchange Master Agreement.
·       Foreign Exchange Options – International Currency Options Market Agreement.
·       All others – International Swap Dealers’ Association Master Agreement.

     Banks also obtain Board Resolutions from their Corporate Clients, specifically authorising their officials to deal and execute contracts. Back offices obtain specific confirmation for each transaction with full details regarding amount, rate, value date, etc., duly signed by the authorised signatories.

2.6 Sovereign Risks
It is managed by prescribing limits against each overseas party based on ‘countryrisk’ perceptions.


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