The Financial Markets Division of a Bank

Transcription

1 Chapter 1 The Financial Markets Division of a Bank A bank s financial markets division carries out financial markets transactions on behalf of the bank. These transactions have to do with the various tasks that the financial markets division is responsible for. All of these tasks are performed in the front office department. In addition to the front office, there are various other departments within the financial markets division. They play an important role in the processing of the transactions, the management of risks resulting from the transactions and the drawing up of reports, for instance management information reports and reports to the regulators. 1.1 The responsibilities of a bank s financial markets division A bank s financial markets division is in some ways comparable to the treasury department of a non-bank entity. This is because, just like every other treasury department, the financial markets division is, amongst others, responsible for the bank s cash management and the management of the bank s financial risks. In addition to these normal treasury responsibilities, however, the financial markets division has several other tasks. It is responsible for attracting funding, functions as market maker for its clients and advises them on transactions in financial instruments. In order to be able to carry out their role of market maker properly, banks often also take positions in financial instruments. In addition to the above mentioned tasks resulting from the banks commercial banking activities, the financial markets division sometimes also supervises securities issues of its clients. This activity is part of merchant banking or investment banking. Another merchant bank activity is supporting clients with mergers and acquisitions. All tasks described here are executed at the financial markets division s front office department. 13

2 guide to the aci operations certificate Cash management Cash management is the daily management of an organization s current account balances. Banks in the euro area, for instance, hold a euro account with the European Central Bank and foreign currency accounts with foreign commercial banks. Banks also hold cash accounts at the organizations that register their securities, the custodians. The cash accounts that banks hold at other institutions are called Nostro accounts. Banks hold multiple Nostro accounts in every currency. In practice, one of the Nostro accounts in each currency acts as a principal account. For the own currency, this is the account at the central bank. The principal account for a foreign currency is usually the account that the bank uses for having payments in that currency processed. For instance, for US dollars, Barclays uses JP Morgan Chase and for euro, United Bank of India uses Deutsche Bank, for this purpose. The balances of the other Nostro accounts are transferred to the principal account during the day. One of the employees in the dealing room, the fund manager, is responsible for ensuring that positive balances on the principal accounts earn interest by investing them in the money market or that deficits are covered by attracting deposits. Banks make a daily forecast of the final balance of each principal Nostro account. If a fund manager foresees that a surplus in a certain currency will occur by the end of the day, he will try to invest this surplus on the money market gradually during the day. If, on the other hand, he foresees a deficit, he will try to attract the money during the day in order to cover this. At the end of every trading day, the balance of each Nostro account must be zero, in principle. A positive balance on a current account generates hardly any interest income and high interest costs are associated with a negative balance. An exception to this rule is the bank s account at its national central bank. This is because most central banks require commercial banks to maintain a certain average positive balance on their account, the mandatory cash reserve. The fund manager must see to it that the account balance at the central bank account is on average identical to the mandatory cash reserve over a given period. Because the total, combined mandatory cash reserve of all banks is higher than their combined balances at the central bank, the banks have a collective central bank money deficit. The European Central Bank, for instance, gives the banks in the euro area the opportunity to fund this deficit through refinancing transactions with itself. The fund manager determines to what extent he wants to use this refinancing facility. 14

3 the financial markets division of a bank Attracting funding Part of the money that banks lend to their customers is financed through the balances that clients keep in current accounts or saving accounts. These balances are called entrusted funds. Another part is financed on the financial markets using bank deposits or bonds. This is called interbank funding. The dealing room is responsible for attracting the latter type of funding. Some dealing rooms also function as an in-house bank. The dealing room then actually grants inter-company loans to business units that grant loans to their clients. And when a business unit attracts a deposit, the dealing room functions as this unit s borrowing counterparty. The dealing room, in turn, then invests this balance in the money market. Because the financial markets division is well-informed about the interest rates on the financial markets, it is responsible for determining the basic interest rates used by all other business units. This basic rate is called the cost of fund. Account managers that provide credit may only determine the credit surcharge or credit spread they use in addition to the cost of fund. The cost of fund thus functions as the minimum rate for loans. The cost of fund also functions as the maximum rate for deposits attracted Foreign exchange risk management The fact that the foreign currency Nostro accounts have a zero balance at the end of each day as a result of the cash management activities does not mean that the bank no longer has any foreign currency asset. After all, the foreign currency account balances have been invested in the money market. There are, therefore, still foreign currency assets in the form of, for example, a deposit or short-term fixed-income security, e.g. a certificate of deposit. A bank would run a currency risk if it did not have liabilities equal to these foreign currency assets. This is because the value of the bank s foreign assets decreases if foreign currency exchange rates decrease without there being an equal reduction in the bank s liabilities. The foreign exchange trader must see to it that the foreign currency assets and liabilities on a bank s balance sheet equal each other, with the exception of the trade positions he wants to take himself. This is called foreign exchange risk management. Many bank clients hold accounts with their banks in foreign currencies like US dollars with a non US bank, for instance. If a client of a German bank, for instance, wants to create a positive balance on his US dollar account, he can withdraw money 15

4 guide to the aci operations certificate from his euro account, convert it into US dollars and deposit it into his US dollar account. In this case, an obligation in US dollars is created for the German bank. The foreign exchange dealer of this bank must now buy US dollars himself and deposit these into the bank s US dollar Nostro account. By doing so, he creates an asset that balances the US dollar obligation and the currency position is again balanced. It is important for the foreign exchange dealer to be kept up to date on all changes in foreign currency claims and obligations of the bank. If the foreign exchange dealer is not well-informed, he cannot determine the bank s exact currency position and the bank may run a currency risk without even knowing it Interest rate risk management Interest rate risk is the risk of a bank s net interest income falling as a result of a change in interest rates. The terms for which the interest rate is fixed is usually longer for a bank s assets than for its liabilities. Examples of assets are, for instance, mortgage loans and company loans with long interest maturities. Examples of liabilities are deposits with short interest maturities. As a result, the interest conditions of the assets are adjusted more slowly than the interest conditions of the liabilities. This effect causes the net interest income to fall in the case of an interest rate increase. The management of the interest rate risk is called interest rate risk management. The policy regarding the interest rate risk of a bank is determined by a special committee, the Asset & Liability Committee (ALCO). If the ALCO finds that the bank should reduce the interest risk, it will order the dealing room to conclude interest rate swaps. Large banks have special departments set up in their dealing room for this very purpose. These departments are often called Asset & Liability Management (ALM) Proprietary trading In a dealing room, trading also takes place at the risk and account of a bank. This is called proprietary trading. The employees responsible for the proprietary trading of a bank are called traders. In order to make a profit, traders must run risks. They do this by taking positions in financial instruments. A position is an ownership or claim or a debt or obligation for which a party runs a price change risk, also referred to as market risk. The market risk of a bond trader that has, for instance, bought bonds is the risk that the bond price drops as the result of an increase in the long term interest rate on the capital market. 16

5 the financial markets division of a bank A position can also result from the fact that banks operate as market maker for a large number of instruments. This means that banks are always prepared to be their clients counterparty. A bank usually concludes an opposite transaction in the market for every transaction it concludes with a client immediately. However, sometimes this is not possible or prudent and the bank is then (temporarily) left with an open position Sales Sales involves the advising of clients on transactions in financial instruments and the concluding of these transactions at the expense and risk of these clients with the bank itself operating as counterparty. These transactions are sometimes also called client trade. The front office employees that carry out this task are called client advisors. Client advisors may themselves not take a position, which means that they may not personally run risks by trading in financial instruments. They act merely as an intermediary and pass a client s position on to a trader at their bank or the exchange. The client advisor s task is actually part of the account management of the bank. The client advisor takes on the advisory and sales role for a specialized range of instruments, i.e. the instruments that are traded on the financial markets. When giving advice on the use, application or outcome of financial instruments, client advisors should be mindful of the level of professionalism of their clients. This level is determined by their level of knowledge, sophistication and understanding. One obligation is that, prior to each transaction, a sales adviser should provide all necessary information reasonably requested by the customer so that the customer fully understands the effects and risks of the transaction. The advice should also be given in good faith and in a commercially reasonable manner. This is referred to as duty of care. In many countries this duty of care is included in the applicable laws and/or regulations. These laws, however, differ substantially from jurisdiction to jurisdiction. As a precautionary measure against future adverse allegations or assertions of claims by the customer, many banks draw up a client agreement and have it signed by the client before entering into transactions. In this agreement the client is asked to state that 1. he understands the terms, conditions and risks of the traded instruments; 2. he makes his own assessment and independent decision to enter into transactions and is entering into the transactions at his own risk and expense; 17

6 guide to the aci operations certificate 3. he understands that any information, explanation or other communication by the bank shall not be construed as an investment advice or recommendation to enter into that transaction except in a jurisdiction where laws, rules and regulations (such as the Mifid directive by the EC) would qualify the given information as an investment advice; 4. no advisory or fiduciary relationship exists between the parties except where laws, rules and regulations would qualify the service provided by the financial market professional to the customer as an advisory or fiduciary relationship Arranging securities issues Companies that have large financial requirements can choose to issue securities themselves as an alternative to bank credit. The issues and syndicates department of the financial markets division supervises these issues. They assist in determining the issue price, compiling the prospectus, publishing the issue and often keeping the price stable after the issue. Sometimes a bank even guarantees a certain issue proceeds. In such cases, it undertakes to buy part of the securities should the investors have no interest. The supervision of issues is part of investment or merchant banking. 1.2 The internal organization of the financial markets division The various activities related to closing transactions in financial instruments are kept strictly separate within financial institutions. This is why several departments are involved in the process. Every department has a specific responsibility. At banks, the activities are carried out by the front office, back office, product control, finance, market risk management and credit risk management departments Front office Transactions are concluded in the front office, which is also referred to as the dealing room. In connection with the execution of the cash management, the fund manager takes loans from, for instance, the central bank and other banks. As part of the bank s currency management, the foreign exchange dealer concludes, for instance, FX spot transactions. As part of the interest risk management, interest rate swaps are concluded. If a bank is involved in an issue, it will also be involved in the placement of the securities and thus concludes securities transactions. 18

7 the financial markets division of a bank The traders at many banks also hold positions in a large range of instruments, although this is becoming less common. For this purpose, they enter into transactions at the expense and risk of the bank. Traders only trade in so called plain vanilla instruments. These are instruments in their original form without all the extra features that transform them into structured products. Client advisors advise their clients on covering their risks or on how to invest on the basis of their risk profiles, amongst others. In this context, they enter into both, transactions in plain vanilla instruments like deposits and shares and transactions in more complex products (structured products), which are often tailor-made for their clients. Client advisors that service large corporations or other financial companies carry out their activities from within the central dealing room. They have direct contact with the traders and therefore get first-hand market information and are able to request prices quickly from the trader. Client advisors that service smaller clients often operate from within a regional dealing room or even from within a local branch office Back office A bank s back office is responsible for processing the transactions completed. This processing usually consists of three separate steps: 1. verification: checking whether the transaction details are complete; 2. confirmation: contacting the counterparty s back office to ensure that the transaction details match; 3. sending settlement instructions: ensuring that the outgoing transfers associated with the concluded transactions take place. At large banks, the processing of financial transactions is usually spread over several sub-departments, for example 1. money market and foreign exchange; 2. securities and derivatives and; 3. interest and credit derivatives. At some banks, the processing departments are responsible for sending the payment orders themselves. At other banks, a separate payment group is established within the back office department for this purpose. In addition to processing transactions, back office departments also have other tasks. Several specialized groups are formed for this purpose, such as operations control, cash management and brokerage control. 19

8 guide to the aci operations certificate operations control The operations control department is the department that is responsible for managing the back office s operational risk. Examples of checks that may take place at operations control are the reconciliation of settlements and the comparison of balances of internal shadow securities accounts with the balances on the custodians account statements. Operations control also produces reports on processing errors, like the number of errors in confirmations and settlements. A separate group within operations control is responsible for determining the cause of incorrect settlements. This group is called investigations and is tasked with assessing who is responsible for an incorrect settlement. If it is an error on the part of the counterparty, another group, sometimes called compensation, produces an interest claim and holds the counterparty liable. If an internal department, the front office or back office for instance, is to blame for the error, this department will be held liable for the damage. cash management A separate department that belongs to the back office is responsible for supporting the cash management task of the fund manager. This cash management unit firstly provides the forecasts for the end-of-day balances of the Nostro account. The cash management department uses a separate cash management system for this purpose that provides real-time updates throughout the day on the expected final overall balance of the bank. The cash management system receives trade data from the back office systems regarding expected transfers as a result of the concluded transactions. The system is also fed with information of the bank s payment system about all incoming or outgoing client payments. Finally, the cash management system has an interface with the SWIFT network. Information is taken from the SWIFT inbox about the status all the payment transfers resulting from financial markets transactions. If, for instance, it appears that a settlement instruction has, unexpectedly, not been carried out, the final balance prognosis of the principal Nostro account in question is adjusted. The back-office is also responsible for making sure that all balances of sub-nostro accounts are set at zero. After all, if a certain sub-account has a positive balance, this balance will bear barely no interest while the bank normally would have to pay a high debit interest rate for any deficit balance that it holds simultaneously on an account with another bank. If, for instance, the US dollar account of Deutsche Bank with JP Morgan Chase shows a deficit of 25 million US dollars and, at the same time, the US dollar account of Deutsche Bank with Bank of America shows a surplus of 25 million US dollars, the back-office must transfer 25 million from BOA to Chase. This process is called sweeping and is normally executed automatically by the cash 20

9 the financial markets division of a bank management system. The back-office is thus responsible that at the end of each trading day all balances of the sub-accounts are set at zero. As we already have mentioned, the front-office is, in turn, responsible for investing any positive balances on the principal account or finding cover for any deficits on the this account. Figure 1.1 gives an overview of the cash management support process. Figure 1.1 Cash management forecast and sweeping The cash management department in the back office follows the opening and closing times of the central bank systems around the world. The first shift employees at a European bank in this department, for example, start work early in the morning in order to be present at the end of the trading day in the Pacific zone and the last shift employees finish late in the evening in order to be present for the end of the trading day in the Pan-American zone. brokerage control Brokerage control is a department that is responsible for checking brokers invoices. At some banks, this department is part of the back office department. At other banks, this activity takes place at a middle office department. The brokerage control department checks whether a broker is actually listed on the list of brokers with which dealers are allowed to do business and checks the amounts charged by the brokers. 21

10 guide to the aci operations certificate Product control and middle office Banks periodically determine the value of the financial instruments they have in their portfolios. They have several reasons for doing this. The first reason is that traders results are largely determined by the changes in the market value of the financial instruments in which they hold a position. The second reason is that financial contracts are sometimes cancelled, whereby the value of the contracts has to be settled between the contract parties (unwinding). The third reason is that banks that need to adhere to the IFRS accounting rules in their external reports must report the fair value of all financial instruments. The calculation of the market values of the financial instruments takes place in the traders front office systems. However, it is unwise to let the front office employees perform the valuation of their positions unsupervised. The valuation is thus checked at a separate department. At banks, this department is often called product control. The product control department is part of the finance department at some banks and at others it is part of the market risk management department. The product control department monitors the prices and interest rates that are imported into the front office systems from data feed systems like those of Thomson Reuters or Bloomberg. However, not all data needed for the valuation of the value of a financial instrument can be imported from these systems without having integrity concerns. This applies to volatilities and the prices of unlisted shares, for instance. In such cases, traders are allowed to use their own data to value their positions. However, product control checks this data at least once a month. In addition to product control, a separate group is responsible for determining the traders daily P&L Finance Every transaction that is conducted in the front office must be accounted for in the bank s balance sheet and its profit and loss account. This is performed by the finance department at banks. All the data on the concluded financial instruments are sent from the back office system into the bookkeeping system (legder) of the bank. In order to be able to convert transaction data like term, price and transaction size into journal entries, they usually need to be converted. A separate system called an accounting entry generator is often built for this purpose. Most banks must report in accordance with the International Accounting Standards Board (IASB) reporting regulations. The regulations for reporting on financial instruments are given in standard IAS39. Finance is also responsible for creating the reports for the central bank. 22

11 the financial markets division of a bank Risk management When concluding transactions in financial instruments, financial companies expose themselves to three types of risk: market risk, credit risk and operational risk. In order to measure and control market and credit risks, several departments are created that are separate from the financial markets division and supervised by central risk departments. Operational risk, however, is controlled directly by the line managers, supported by the operational risk management department. The market risk management department records whether traders are operating within their trading limits. A trading limit indicates the maximum open position a trader is allowed to take. The trading limits are set by the line manager in consultation with the risk manager. Market risk also calculates the degree of risk traders run on their positions and reports any limit excesses to the line management. The market risk management department also plays an important role in the approval of pricing models and has an important say in the decision of whether a new instrument will be traded. The credit risk management department records whether traders and client advisors remain within their counterparty limits. A counterparty limit imposes a maximum on the credit risk that may be run on a certain counterparty. The counterparty limit is set by a credit commission, usually on the basis of a request from an account manager. This committee bases the limit mainly on the risk of the counterparty defaulting. This is one of the difficult risks to estimate, yet also one of the most important tasks performed at a bank. An additional challenge for the credit risk management department of financial markets is determining the exact degree of exposure on a certain counterparty. This is easy in the case of a deposit, yet it is often difficult in the case of a derivative or structured product. A final task of the credit risk department is to control the collateral that the bank requests in the case of, for instance, derivative transactions and repurchase agreements. 1.3 Control and compliance The different tasks within the financial markets department do not all necessarily have to be performed by different departments or even different employees. The functions of the product control, middle office and risk management departments, for instance, can easily be centered within one department. Some tasks, however, should remain separate under all circumstances. The front office function, for instance, should always be kept separate from the payment function, risk management function and results measurement function. 23

12 guide to the aci operations certificate example In the case of Barings Bank, Nick Leeson was able to pass on entirely wrong positions to the head office. Not only was he allowed to capture his own deals, he was also able to authorize them. As head of the back office, moreover, he was able to authorize payments as well. The separation of duties was completely lacking in his case. Exaggerating the separation of functions, however, may also have disadvantages. There are a lot of organizations in which certain specific tasks are only performed by one or two employees or certain information is only known to one or two staff members. Problems may arise the moment these persons leave the organization, fall ill or take leave. This is referred to as key staff exposure Internal control Despite the fact that most financial organizations have set up their internal organization with the utmost care, a large share of their losses can still be attributed to a weak control structure or the fact that the control measures are not strictly enforced. Internal control refers to the complete range of measures taken by an organization to ensure that it operates effectively and efficiently, that its financial data are reliable and that all the relevant rules and regulations are followed properly. In order to achieve these goals, every organization has a structure of control measures in place and assesses the effectiveness of those measures. The control structure consists of three layers: self-control, dedicated control and operational audits. Self-control is a form of control by which departments keep track of the quality of their own activities, for instance by checking daily whether all transactions have been processed. Self-control is often based on the organizational principle of dual control, also known as the four eye principle, which requires a minimum of two employees to be involved in certain specific tasks. A typical example is the transfer of large money transfers, whereby one employee prepares the payment instruction and another one sends it. Dedicated control is a form of control exerted by specially appointed business units, such as operations control, market risk management, credit risk management and compliance. 24

13 the financial markets division of a bank Compliance Banks and their employees must comply with many rules. In the first place, the rules of criminal law. For example, they may not act fraudulently. They must also comply with the law with regard to money laundering and terrorist financing. Also, a number of employees must comply with the code of conduct as laid down in the financial supervision act. Additionally, all employees of a financial enterprise are obliged to comply with the internal rules of the organisation. Each bank must appoint a compliance officer. The task of a compliance officer is to encourage employees to comply with the external and internal rules, to function as a contact point for breaches and to report these breaches to management and to the external regulators. Compliance officers need to know exactly which laws are applicable within the organization and must follow all changes in the relevant legislation. With regard to financial markets, compliance officers are mostly occupied with customer due diligence, the duty of care, the prohibition on the use of insider information and the prohibition of market manipulation Internal Audit Service The Internal Audit Service (IAS) is the capstone of the control framework and is often called the third line of defence, after self-control and dedicated control. The IAS performs operational audits. These are risk analyses whereby the auditor assesses the quality of control within the organization, by examining how control measures are set up and how effectively they function. 25