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Operations Handbook for the Financial Markets Professional
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Operations Handbook for the Financial Markets Professional
Lex van der Wielen
Operations Handbookfor the Financial Markets Professional
Financial Markets Books
Financial Markets BooksGeelvinckstraat 56, 1901 AJ Castricum, Netherlandswww.financialmarketsbooks.com
Cover by Magenta Designers, BussumPhoto author: Jeanet CochiusPrinted by Boekdrukdeal, Utrecht
ISBN 978-90-816351-1-0NUR 793
© Financial Markets Books, Castricum
All rights reserved. Subject to the exceptions provided by the law, no part of thispublication may be reproduced in any form or by any means without the writtenconsent of Financial Markets Books.
The Financial Markets Academy
The Financial Markets Academy is a Dutch training company that offers a
broad variety of financial markets courses. The mission of the Academy is to be
the leading center of competence for the financial markets in the Benelux.
The markets and instruments courses of the Academy are designed to be as
close to the real day to day practice as possible. To achieve this, the Academy
uses, amongst others, a number of professional simulation tools. The Academy
also offers courses that focus on back office operations and risk management
with banks and other financial institutions.
The Financial Markets Academy is market leader in the Benelux for ACI exam
training courses. It is the only supplier that offers training courses for all three
ACI exams. The Academy operates in close cooperation with the Dutch ACI.
Double Effect
A bank implementing a new international payment system, an insurer setting up
a digital portal, a pension fund seeking for higher returns. Financial service pro-
viders are complex and continuously evolving organizations. Change has an
immediate impact on processes, people and technology. In order to realize
improvements, one must enter into the heart of the organization. And that is
exactly what Double Effect does.
It is our ambition to surpass our clients' expectations with results based on
knowledge, skills and our intrinsic motivation to walk the extra mile. Under-
standing our clients' need is what drives our consultants every day.
Building and actively sharing knowledge is a central theme within Double
Effect. In that respect, we are proud to present you the Operations handbook for
the Financial Markets professional. This book, written by Lex van der Wielen,
is a complete reference guide and a "must have". It covers all operational activi-
ties related to financial instruments trading, from initiation to settlement. We
invite you to discover this book and hope it will help you to strengthen your
business.
Many thanks to the following professionals in the field for sharing their exper-
tise:
� Jaco Buiter
� Betsy Hertsenberg
� Rob van Hout
� Thijmen van Kooij
� Gerda Mooij
� Nicolette Kral
� Sandy Rijs
And a special thanks to June Dwyer-Aerts for reviewing this English edition.
i
Contents
Chapter 1 - The financial markets division of a bank 1
1. The responsibilities of a bank's financial markets division 1
1.1 Cash management 2
1.2 Funding 3
1.3 Foreign exchange risk management 3
1.4 Interest rate risk management 4
1.5 Proprietary trading 4
1.6 Sales 5
1.7 Arranging securities issues 6
2. The internal organization of the financial markets division 6
2.1 Front office 7
2.2 Back office 7
2.3 Product control and middle office 9
2.4 Finance 10
2.5 Risk management 10
2.6 Importance of separation of duties 11
2.7 Internal control 11
Chapter 2 - Alternative ways of closing transactions 13
1. Exchange 13
2. Multilateral trading facility 14
3. The OTC market 14
4. Systematic internalization 15
Chapter 3 - Product mandate and trading limits 17
1. New product approval process 17
2. Limit control sheet 18
3. Trading limits 19
3.1 Nominal limits 20
3.2 Value at Risk limit 21
ii
Chapter 4 - Client acceptance and credit risk 25
1. Customer due diligence 25
1.1 Client acceptance 26
1.2 Identification and verification 26
1.3 Reporting 26
2. Counterparty limits, types of credit risk and risk mitigating measures 27
2.1 Types of credit risk 27
2.1 Risk mitigating measures 29
Chapter 5 - P&L measurement 33
1. The responsibilities of the P&L unit 33
2. Fluctuations in the value of the financial instruments 34
3. Provisions 35
4. Interest costs and revenues 35
5. Broker fees 36
Chapter 6 - Deal capture, confirmations and settlement instructions 39
1. Closing transactions and capturing transaction data 39
1.1 Transaction data 40
1.2 Master agreements 41
2. Verification 43
3. Confirmation 44
4. Settlement instructions 48
4.1 Shadow accounts 48
4.2 Standard settlement instructions (SSI) 49
4.3 Settlement risk 49
5. Event calendar 51
6. Diagrams of processing methods 52
Chapter 7 - Money settlement 57
1. Bank accounts 57
2. Money transfers in the local currency 58
2.1 RTGS systems 59
2.2 Clearing systems 60
3. Money transfers in foreign currencies 61
4. Bank holidays 65
iii
Chapter 8 - Securities settlement 67
1. Central securities depositories 67
1.1 Account holders and responsibilities of a CSD 68
1.2 Role of a CSD with the settlement of securities transactions 68
1.3 Execution conditions 70
1.4 Feedback on the status of settlement instructions 71
1.5 The role of CSDs in the administration of foreign securities 71
2. Clearing institutions 72
2.1 Clearing members 73
2.2 The clearing process for cash transactions 73
2.3 Risk management 75
2.4 The tasks of clearing institutions with derivatives 77
3. Custodians 80
3.1 Local and global custodians 80
3.2 Role of custodians with the settlement of securities transactions 81
3.3 Role of custodians with tri-parti repos 83
4. Overview of the process of an exchange traded transaction 84
Chapter 9 - Nostro reconciliation 85
1. Reconciliation 85
2. Investigations 86
3. Compensation 88
Chapter 10 - Treasury systems 89
1. Front office and back office systems 89
1.1. Information exchange between systems 90
1.2 Static data and standing files 91
2. Capturing deals in the ledger 92
3. Computer systems requirements 93
Chapter 11 - Money market instruments and interest calculations 97
1. Deposit 97
2. Calculation of interest amounts 98
2.1 The duration of the coupon period 98
2.2 Daycount conventions 100
3. Repurchase agreement 105
4. Money market paper 106
5. Money market benchmarks 108
iv
Chapter 12 - Capital market instruments and corporate actions 109
1. Shares 109
2. Fixed-income securities 110
2.1 The yield of a fixed-income security112
2.2 Clean and dirty price 114
3. Special types of fixed-interest securities 115
4. The role of the bank with a securities issue 118
5. Corporate actions 120
5.1 Reasons for corporate actions 120
5.2 Corporate action categories 120
5.3 Implementation of corporate actions 121
5.4 Pending transactions 125
Chapter 13 - FX instruments and settlement of FX transactions 127
1. FX spot 127
2. FX forward 129
3. FX swap 132
4. Settlement of FX transactions 132
4.1 The role of the CLS Bank 132
4.2 The settlement procedure of the CLS Bank 133
Chapter 14 - Derivatives 137
1. General features of derivatives 137
2. Option 138
3. FRA 140
4. Financial future 141
4.1. Shares future and index future 142
4.2. Bond future 143
4.3. Money market future 143
5. Interest rate swap 145
6. Overnight index swap 147
7. Non-deliverable forward 149
8. Contract for difference 150
9. Cap and floor 151
10. Swaption 152
Index 153
1
Chapter 1
The financial markets division of a bank
A bank's financial markets division carries out financial market transactions on
behalf of the bank. These transactions have to do with the various tasks 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 impor-
tant role in the processing of the transactions, the management of risks resul-
ting from the transactions and the drawing up of reports, for instance manage-
ment information reports and reports to the regulators.
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 mar-
kets division has several other tasks. It is responsible for attracting funding,
functions as the 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. This is called
proprietary trading.
In addition to these tasks resulting from commercial banking, the financial mar-
kets 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.
2
1.1 Cash management
Cash management is the daily management of an organization's current account
balances. Dutch banks hold a euro account with the Dutch 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 prin-
cipal account for a foreign currency is usually the account the bank uses for
having payments in that currency processed. For instance, for US dollars, Bar-
clays 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 trans-
ferred to the principal account during the day. One of the employees in the
dealing room, the fund manager, is responsible for ensuring that positive ba-
lances 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 ma-
nager 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 transac-
tions with itself. The fund manager determines to what extent he wants to use
this refinancing facility.
3
1.2 Funding
Part of the money banks lend to their customers is financed through the ba-
lances 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 this 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 of 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.
1.3 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. 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
note like a certificate of deposit.
A bank would run a currency risk if it did not have liabilities equal to these fo-
reign currency assets. This is because the value of the bank's assets will
decrease 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 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 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
4
for the German bank. The foreign exchange dealer of this bank must then buy
US dollars himself and deposit these into the bank's US dollar Nostro account.
By doing so, there is a asset that balances the US dollar obligation and the cur-
rency 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 cur-
rency position and the bank may run a currency risk without knowing it.
1.4 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 fixed-rate periods of a bank's assets are usually
longer than the fixed-rate periods of 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 Commit-
tee (ALCO).
If the ALCO finds that the bank should reduce the interest risk, it will order the
dealing room to effect interest rate swaps. Large banks have special depart-
ments set up in their dealing room for this very purpose. These departments are
often called Asset & Liability Management (ALM).
1.5 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 pro-
prietary 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 known as a market risk. The market risk of a bond
trader that has 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.
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 a opposite transaction in
5
the market for every transaction it concludes with a client immediately. How-
ever, sometimes this is not possible or prudent and the bank is (temporarily) left
with an open position.
1.6 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 some-
times 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 as an intermediary that passes 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 in the financial markets.
When giving advice on the use, application or outcome of financial instru-
ments, 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 reason-
able 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 juris-
diction.
6
As a precautionary measure against future adverse allegations or assertions of
claims by the customer, many banks draw up a client folder and have it signed
by the client before entering into transactions. In this folder the client is asked
to state that
� he understands the terms, conditions and risks of the traded instruments;
� he makes his own assessment and independent decision to enter into trans-
actions and is entering into the transactions at his own risk and expense;
� 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 re-
gulations (such as the Mifid directive by the EC) would qualify the given
information as an investment advice;
� no advisory or fiduciary relationship exists between the parties except where
laws, rules and regulations would qualify the service provided by the finan-
cial market professional to the customer as an advisory or fiduciary rela-
tionship.
1.7 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 depart-
ment 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 guaran-
tees a certain issue proceeds. In such cases, it undertakes to buy part of the
stocks should the investors have no interest. The supervision of issues is part of
investment or merchant banking.
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 depart-
ments are involved in the process. Every department has a specific responsibi-
lity. At banks, the activities are carried out by the front office, back office, pro-
duct control, finance, market risk management and credit risk management
departments.
7
2.1 Front office
Transactions are closed in the front office, which is also referred to as the deal-
ing 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 closes, for
instance, FX spot transactions. As part of the interest risk management, interest
rate swaps are closed. If a bank is involved in an issue, it will also be involved
in the placement of the securities and thus closes securities transactions.
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 trans-
actions 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, among other matters. In this context, they
enter into both transactions in plain vanilla instruments like deposits and shares
and in the most exotic structured products, which are often tailor-made for their
clients. Client advisors that service large corporations or other financial compa-
nies 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. Client advisors that service smaller rela-
tions often operate from within a regional dealing room or even from within a
local branch office.
2.2 Back office
A bank's back office is responsible for processing the transactions completed.
This processing usually consists of three separate steps:
� verification: checking whether the transaction details are complete;
� confirmation: contacting the counterparty's back office to ensure that the
trans action details match;
� sending settlement instructions: ensuring that the outgoing transfers
associated with the closed 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.
8
In addition to processing transactions, back office departments also have other
tasks. Several specialized groups are formed for this purpose, such as opera-
tions control, cash management and brokerage control.
Operations control
The operations control department is the department that is responsible for
managing the back office's operational risk. Examples of checks that 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 custo-
dians' account statements. Operations control also produces reports on proces-
sing 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 suppor-
ting the cash management task of the fund manager. This cash management unit
provides the forecasts for the end-of-day balances of the Nostro accounts and is
responsible for the sweeping of the balances of the sub-Nostro accounts to and
from the principal 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 balance and automatically generates settlement instructions for the pur-
pose of sweeping the balances to and from the sub-Nostro accounts. The cash
management system receives trade data from the back office systems. Addition-
ally, the system receives data from the central account system, which keeps
track of the clients' accounts. For example, this system provides information on
the payment traffic and credits granted. Finally, the cash management system
has an interface with the SWIFT network. Information is taken from the SWIFT
inbox on the status of the outgoing and incoming payments. If 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 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
9
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 bro-
kerage 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.
2.3 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 manage-
ment 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 valua-
tion 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.
10
2.4 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 instru-
ments 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 con-
verted. 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.
2.5 Risk management
When concluding transactions in financial instruments, financial companies
expose themselves to three type of risk: market risk, credit risk and operational
risk. In order to measure and control market and credit risks, two 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 posi-
tion 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 ma-
nagement. 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 advi-
sors 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
11
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 transac-
tions and securities lending transactions.
2.6 Importance of separation of duties
The different tasks within the financial markets department do not all necessa-
rily have to be performed by different departments or even different emplo-
yees. The functions of the product control, middle office and risk management
departments, for instance, can easily be centred 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 func-
tion, risk management function and results measurement function.
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 separa-
tion of functions was completely lacking in his case.
Exaggerating the separation of functions, however, may also have disadvan-
tages. 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.
2.7 Internal control
Despite the fact that most financial organizations have set up their internal orga-
nization 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, its financial
data are reliable and all the relevant rules and regulations are followed pro-
perly. In order to achieve these goals, every organization has a structure of con-
trol 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
12
of dual control, also known as the four eye principle, which requires a mini-
mum of two employees to be involved in certain specific tasks. A typical exam-
ple is the transfer of large money transfers, whereby one employee prepares the
payment and another sends it.
Dedicated control is a form of control exerted by specially appointed business
units, such as operations control, market risk management, credit risk manage-
ment and compliance.
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 finan-
cing. 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 organi-
sation.
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 then to report these breaches to
management and 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 offi-
cers are mostly occupied with customer due diligence, the duty of care, the pro-
hibition on the use of insider information and the prohibition on market manip-
ulation.
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 audi-
tor assesses the quality of control within the organization, by examining how
control measures are set up and how effectively they function.
13
Chapter 2
Alternative ways of closing transactions
Financial instruments can be traded in different ways. The first way is through a
public market. This is an organized meeting place (usually in the form of a
computer system) where multiple buyers and suppliers of financial instruments
can conclude transactions in these instruments. Examples include exchanges
and multilateral trading facilities. The second way to trade financial instru-
ments is outside a public market. This is referred to as the private market or
over-the-counter (OTC) market. An intermediate form is where banks use their
own system to execute orders from their clients on a large scale. This is called
systematic internalization. In order to gain access to this market place, clients
must employ the services of a financial institution that is active in the conclu-
sion of transactions. This is usually a bank.
1 Exchange
An exchange is a public marketplace where securities and/or derivatives are
traded and where strict rules apply in relation to transparency and stability.
An exchange is operated by an organization that holds a special licence, in
some countries granted by the Minister of Finance. In Europe, exchanges are no
longer hosted on a traditional 'floor', where traders shout in organized chaos to
indicate which transactions they want to conclude. Normally, nowadays, an
exchange is a computer system in which market parties can indicate at what
rates and volumes they wish to conclude transactions (orders). This computer
system is also known as a trading system. The price of exchange traded instru-
ments is calculated in accordance with objective criteria and without discrimi-
nation by the trading system, based on the orders filed.
Exchanges must provide information on the rate, size and time of all transac-
tions concluded. This is called post-trade transparency. In addition, exchanges
must provide a summary of the orders that have not yet been executed, i.e. the
depth of the book. In this respect, they must indicate what the demand is for the
14
five rates that are immediately lower than the last traded rate and what the
offers are for the five immediately higher rates. This is known as pre-trade
transparency.
There is a central counterparty (CCP) connected to nearly all exchanges. A
CCP stands legally between buyers and sellers of financial instruments. Each
transaction is broken down as a sale by the seller to the CCP and a purchase
from the CCP by the buyer.
2 Multilateral trading facility
A multilateral trading facility (MTF) is a public trading system that has to com-
ply with fewer requirements than an exchange, as a result of which the expenses
and the charged fees are lower. The lower requirements are related to informa-
tion on traded instruments and issuers. MTFs nevertheless have a duty of trans-
parency before and after trade. A disadvantage of an MTF is that there is not
always a central counterparty involved. Examples of MTFs are Chi-X and
Turquoise. English, German, French and Dutch shares are traded on Chi-X.
Turquoise also focuses on European equities.
3 The OTC market
In the over-the-counter market (OTC market), transactions are concluded out-
side an exchange or MTF. The OTC market is also known as the private mar-
ket. Usually, one of the parties involved in an OTC transaction is a bank. Most
derivatives are traded in the OTC market, some are even traded exclusively
over-the-counter, such as interest rate swaps. There are no transparency require-
ments for OTC transactions.
Parties that wish to conclude over-the-counter transactions may sometimes
engage the services of a broker. This is a party that acts as an intermediary in
transactions in financial instruments. Brokers look for a party to act as the coun-
terparty to a specific transaction. When concluding transactions, brokers do not
act as a contracting party. The contracting parties, also called principals, are the
party that the broker has engaged and the designated counterparty. Once a trans-
action is closed, the broker sends a confirmation to both contracting parties.
Brokers also provide their clients with information on the market conditions.
They are able to do so because they are in contact with many market parties and
therefore have a good understanding of the market conditions such as the
liquidity and the sentiments in the market.
15
Transactions in the OTC market are often concluded by telephone, but increa-
singly also through special electronic trading systems. Examples of over-the-
counter trading systems are Reuters dealing 3000 and EBS for foreign exchange
transactions and Tradeweb and Bloomberg for fixed income transactions and
interest rate swaps, amongst others. Market players connected to these systems
can conclude transactions directly with other affiliated parties. Each participant
enters a counterparty limit in the system for each party with whom he wants to
do business. Parties that wish to act as market maker enter their bid and/or offer
prices in the system. Parties that wish to conclude transactions based on these
prices indicate this in the system. These parties are called market users.
A major benefit of OTC contracts is that they can be customized. For every
deal, the negotiating parties must themselves must reach agreements on the
volume, duration, price, market references to be used and legal aspects.
A disadvantage of OTC contracts is that existing contracts are difficult to trade,
there is no secondary market. If a contract party wants to close his position in
an OTC instrument, he can try to unwind the transaction with the existing coun-
terparty or he must find a counterparty to conclude an opposing OTC transac-
tion.
4 Systematic internalization
When a bank enters a large number of securities orders from its clients into a
dedicated system of its own, rather than sending them to an exchange, in order
to match them with other customer orders, it is referred to as systematic inter-
nalisation. The bank acts as central counterparty. In order to keep trade moving
as much as possible, the bank also acts as liquidity provider. The difference
with an exchange or MTF is that in the case of systematic internalization, the
participants in the trading system are clients of the bank, in the case of an
exchange or MTF, the participants are the banks themselves.
With systematic internalization, the duty of transparency applies before and
after the trade. The former means that banks must continuously publish the
rates at which they are willing to conclude transactions.
Figure 2.1 shows the four different ways in which transactions in financial
instruments can be concluded.
16
Figure 2.1 Different ways of closing a transaction
Exchange MTF
Bank
Client
OTCSystematic
Internalization
17
Chapter 3
Product mandate and trading limits
The number of new financial instruments introduced by banks is great. These
instruments are all developed by specialized departments. Before their introduc-
tion, all new instruments are assessed by a committee to value their suitability
for the bank. This process is called the new product approval process.
Once a new instrument has been approved, it is added to the limit control sheet.
This is an overview of all mandates and limits set for all traded instruments.
The limit control sheet is drawn up by a committee including representatives
from market risk management, product control and credit risk management. An
important example of the limits covered by the limit and control sheet are tra-
ding limits. The market risk management department is responsible for moni-
toring compliance with these trading limits.
1 New product approval process
Before a new instrument is introduced, it is assessed in a new product approval
process. This process is designed to assess the suitability of a new product and
includes representatives from a range of the bank's functions, including risk
management, compliance, legal, accounting, IT and finance.
The process should also include a clear definition of whether an instrument is
really new. When determining whether an instrument is new, a bank may con-
sider a number of factors including structural or pricing variations from exis-
ting products, whether the product targets a new group of customers or a new
requirement from customers, whether it raises new compliance, legal or regula-
tory issues and whether it would be offered in a way that would be different
from standard market practices.
18
The following topics, among other things, should be addressed in a new pro-
duct approval process:
� whether the instrument complies with internal and external regulations;
� whether the computer systems are capable of capturing the instrument;
� whether staff and customers are able to understand the features of the instru-
ment;
� the profitability of the instrument;
� policies to make sure the bank creates and collects sufficient documentation
to document the terms of transactions, to enforce the material obligations of
counterparties and to confirm that customers have received any information
they require about the instrument;
� policies and procedures to be followed and controls used by internal audit to
monitor compliance with those policies and procedures.
2 Limit control sheet
A limit control sheet (LCS) is a document in which a bank describes which
instruments will be traded and in which currencies, which departments are
allowed to trade these instruments and whether and the degree to which pro-
prietary trading is allowed, i.e the limit control structure. The limit control sheet
is drawn up by a committee in which staff from market risk management, pro-
duct control, credit risk and departments that are responsible for the valuation
models are represented. The LCS is reviewed periodically, e.g. annually, and on
an ad-hoc basis, in the case of significant changes in market conditions, or with
the introduction of a new instrument.
The first section of the LCS defines the scope of the activities of the financial
markets department. For all business locations and for each instrument, the LCS
indicates whether only client business is allowed or whether proprietary trading
is also allowed and, if so, in what proportion. For all locations and for all instru-
ments, the LCS also defines the systems in which positions are maintained and
the systems in which the market risk is measured.
The first section also contains the product mandate that is split into two parts,
the approved product list and the approved tenors and currencies list. The first
list provides an overview of the ways in which all business units are allowed to
trade in the different instruments, only internally with other business units as
counterparty or also externally, with external counterparties. The second list
provides an overview of all approved currencies and tenors.
The second section of the LCS contains the trading limits that restrict the mar-
ket risk that proprietary traders are allowed to take.
19
3 Trading limits
Market risk is the risk that the market value of the bank's trading positions is
adversely affected by fluctuations in prices and/or interest rates. Banks are
exposed to market risk due to the fact that traders in the financial markets
departments trade at the bank's own risk and expense. The positions they take
are called open trading positions. Since the credit crisis, however, banks have
become more reserved about allowing their traders to hold trading positions.
Open positions may result from proprietary trading activities but they may also
be the result of a bank acting as market maker. Acting as a market maker means
the bank is always prepared to act as counterparty for its clients. Generally, a
bank closes a position that results from a client transaction directly in the mar-
ket. Sometimes, however, this is not possible or advisable, for instance, in an
illiquid market or in the case of a very large transaction. In such cases, the bank
is left (temporarily) with an open position. To avoid this the bank may consider
not to close the transaction with the client but, from a commercial viewpoint,
this may not always be advisable.
A trading limit indicates the maximum open position that a trader is permitted
to hold. Trading limits may apply either for an entire department within the
dealing room (trading desks) or for individual traders. The trading limit for a
trading desk is determined by the same committee that is responsible for draw-
ing up the LCS.
The distribution of limits between individual traders at a specific trading desk is
decided by the desk's departmental head. Junior traders are generally allowed
only minor positions. A trader's limit is raised as his experience and profitabi-
lity increases. Banks use two types of trading limits to manage market risk,
nominal limits and value at risk (VaR) limits.
20
3.1 Nominal limits
Nominal limits impose a limit to the size of a trading position regardless of
market developments. The following are examples of nominal limits
� positions limit: sets an unconditional limit on the market value of a position;
� Greek limit: sets a limit to the value of an option portfolio measured by its
Greek parameters (delta, gamma, rho, vega);
� Basis point value limit (bpv): sets a limit to the market value of an interest
bearing portfolio measured by its bpv, i.e the change in price as a result of a
change in interest rates of one base point;
� credit spread sensitivity limit: sets a limit to the market value of a bond
portfolio measured by its change in price as a result of a change in the credit
spread of the issuer of one base point;
� slope risk limit: sets a limit to the market value of an interest bearing
portfolio measured by the change in this value as a result of a pre-defined
change in the slope of the yield curve;
� event risk limit (stress test limit): sets a limit to the market value of a position
as a result of a pre-defined market disruption.
Event risk limit
In order to set an event risk limit. the market risk management department must
design so-called stress tests. With a stress test, it draws up a future 'disaster sce-
nario' in order to be able to assess the risk associated with future extreme mar-
ket movements. This scenario could be an actual historical scenario such as
'nine eleven' (when the twin towers came down in New York). The disadvan-
tage with this method, however, is that events from the past will most probably
not occur again in the same way in the future.
Market risk management will therefore also usually create its own imaginary
disaster scenarios. For example, it will assume a 10% change in the currency
exchange rates or an interest rate change of 100 basis points. Market risk ma-
nagement will then calculate the possible losses for the traders resulting from
these imaginary disaster scenarios.
Finally, for each trading position, market risk management sets a maximum loss
that would be incurred if the event scenario was actually to happen and thus a
corresponding nominal limit for the position.
21
3.2 Value at risk limit
The value at risk (VaR) method specifies a loss amount that will not be
exceeded with a certain probability during the coming trading day. This loss
amount is also called the value at risk of the position.
The starting point for the VaR method is the market value of a trade portfolio at
the moment of measurement. Each day, market risk management defines a
'worst case scenario' for the market variables that determine the value of each
position based on historical daily market movements. It then uses this scenario
to calculate the possible value change of the position after one trading day, the
result is the value at risk of the position.
To approach the market risk of individual trading positions, many banks use the
historical VaR method. With this method the worst case scenario is determined
by listing the changes in the relevant market variables over a specific historical
period, for example the last 250 trading days, and then selecting a specific
unfavourable price change from this sample. Which scenario is chosen as the
'worst case scenario' depends on the level of probability required. For instance,
market risk management will take the sixth worst scenario from the previous
250 trading days as the worst case scenario where the probability is 98% (five
price movements, that is 2% of 250, are then worse).
A simplified example of the historical VaR method is presented below.
Example
On 15 June 2009, in the front office system of a share trader, the VaR
scenario for the Heineken share is determined based on the following
250 recent daily price movements. First, the system sorts the 250 values
and calculates the probability percentage for each single scenario.
Scenario 250 249 248 247 246 245 244 243 ... 2 1
Price change -4% -3.5% -3% -2.7% -2.5% -1.7% -1.5% -1.4% +3% +3.5%
Probability 100% 99.6% 99.2% 98.8% 98.4% 98% 97.6% 97.2% 0.8% 0.4%
22
The table shows that the probability percentage for scenario 250 is
100%: based on these specific 250 values, theoretically, it is 100% cer-
tain that the price of the Heineken share will not drop by more than 4%.
If this market risk manager, for instance, uses a probability of 97,5%, he
chooses, conservatively, observation 244 as worst-case scenario (97.6%),
i.e. a price decrease of 1.5%.
If the share trader holds a long position of 100,000 Heineken shares at a
current market price of EUR 20, his value at risk can easily be calcu-
lated as follows:
Value at risk = 1.5% x EUR 2,000,000 = EUR 30,000
If a VaR-limit of EUR 22,500 is imposed for the trader in the above example,
he would have to decrease the value of his position by selling shares in order to
reduce his exposure. The maximum allowed market value of his position now is
EUR 1,500,000 or 75,000 shares. With this position, the VaR would equal the
VaR limit: 1.5% x EUR 1,500,000 = EUR 22,500.
Each day the oldest observation is removed from the data set of daily market
movements and replaced by the price movement during the last trading day.
This means that the worst case scenario and thus the trader's allowed position
may change every day. If, for the next trading day with the 97.5% scenario,
there was a price decrease of 1.6% then the maximum allowed market value of
the trader's position would be EUR 1,406,250 or 70,031 shares.
The VaR method is based on historical data. The largest negative peaks, how-
ever, are not included: with the given probability percentage of 97.5%, 2.5% of
the possible outcomes fall outside the scope of the analysis.
Thus, the VaR method may provide a fair picture of the risks under normal mar-
ket conditions but does not provide information about the extent of the possible
losses that fall outside the selected probability interval, i.e. the danger area.
Market risk managers, therefore, also use stress tests to estimate the risk under
extreme market conditions.
Back testing
Each day, risk managers try to 'predict' the maximum loss of a trading position
with a certain probability by using the value at risk method. The results of the
value at risk analyses are frequently tested to see whether these 'forecasts' are
reliable.
23
These tests are referred to as back tests. In these tests, the VaR forecasts for a
given historical period, e.g. 250 days, are compared with the hypothetical P&L.
This is the actual result for the next trading day where trades that are closed on
the day of observation are excluded. Back tests investigate the number of times
that the hypothetical P&L was actually worse than the calculated value at risk
(the prediction) during a specific period.
If a risk manager uses a probability percentage of 98%, the actual hypothetical
loss during the period of investigation may not exceed the calculated VaR value
on more than 2% of the days. If the actual number of times that the VaR was
exceeded is higher or lower than expected, the VaR method used has not pro-
duced the correct results and should be adapted.
24
25
Chapter 4
Client acceptance and credit risk
Banks only wish to do business with clients that do not pose unacceptable legal
or financial risks. Before entering into transactions, banks therefore conduct
thorough client investigations. The investigation of the legal liability of a client
is called customer due diligence (CDD).
Banks also examine the creditworthiness of their counterparts to assess the
counterpart risk. Based on these assessments, they will decide if and to what
extent they would like to do business. During the client relationship, banks
closely monitor the creditworthiness of their counterparties. To mitigate their
counterpart risk, they ask collateral or enter into netting agreements.
1 Customer due diligence
Banks are at risk of becoming involved in money laundering or the funding of
terrorism. If a bank accepts money that it knows, or could reasonably be
expected to know, has been criminally acquired, it may be charged with
handling stolen goods or money laundering. Involvement in the funding of ter-
rorism is lawfully forbidden. In order to avoid involvement in money launder-
ing and the funding of terrorism, banks conduct client investigations.
The customer due diligence (CDD) policy of a bank consist of three parts:
1. client acceptance, 2. client identification and verification, and 3. the monitor-
ing and reviewing of clients, their accounts and the transactions they close.
26
1.1 Client acceptance
Banks are legally required to divide all their clients into categories based on
risk levels with regard to money laundering and terrorism financing. The
client's characteristics and the products or services he uses determine the cate-
gory in which he is placed. The client's country of origin plays a particularly
important role in this respect. An important criterion, for instance, may be the
fact that the client is the citizen of a country on which the bank’s home country
has imposed economic sanctions, such as Iran. In Europe, for instance, institu-
tions are required by the Sanctions Act 1997 to establish whether or not a client
appears on the EU sanctions list as part of their acceptance procedure.
Another criterion is whether or not the client's country of origin is an FATF
member. FATF stands for Financial Actions Task Force. This organization
makes recommendations for legislation and issues guidelines for anti-launder-
ing programmes and programmes aimed at combating the funding of terrorism.
The various risk categories are subject to different acceptance procedures: the
higher the risk, the stricter the procedures.
1.2 Identification and verification
Banks are required to identify all of their clients and to verify their identities.
They are also required to investigate clients' backgrounds. Money launderers
tend to avail themselves of a wide range of strategies in order to conceal the
true origins of their money or value documents. In order to have a clear under-
standing of a client, a financial enterprise must therefore include in its investi-
gation the identification of the ultimate stakeholder of a transaction or money
transfer. Depending on the risk category in which a client is classified, a finan-
cial enterprise may have to verify more data regarding the authorized persons or
entities.
1.3 Reporting
In most countries, banks must report all transactions that may reasonably point
towards money laundering to a special government-appointed organization.
They are also required to install their own internal hotline for breaches. The
compliance department is responsible for this task, in consultation with the
security department. Employees can use the hotline to report transactions they
believe may be criminal. After conducting an internal investigation, the compli-
ance officer or the securities department can forward the issue to the govern-
ment-appointed organization.
27
2 Counterparty limits, types of credit risk and risk mitigating measures
Banks also base the decision about whether to enter into transactions with a
specific counterparty on their assessment of the client’s creditworthiness. In
order to make this assessment, a bank collects as much relevant information as
possible including data about the business, for instance sales, profits and cash
flow statements, trends in the sector in which the enterprise operates and the
quality of the management. Based on this data, an account manager or a spe-
cialized department will draw up a proposal to be assessed by a credit commit-
tee. Based on this assessment, the committee determines the types of
transactions that may be arranged with the counterparty and the maximum
amount of risk the bank is willing to take, the credit limit. This limit is then
entered into a special credit limit system. If the counterparty is another finan-
cial institution this whole process takes place within the financial markets
department.
When a bank concludes a transaction with a counterparty this is entered in the
credit limit system. The available space under the credit limit is reduced by the
amount of the credit risk that the transaction carries.
2.1 Types of credit risk
In the financial markets department, the several types of credit risk are distin-
guished.
Lending risk
Lending risk is the risk of a borrower defaulting on interest and redemption
obligations. Lending risk exists from the moment that a credit agreement is
entered into or an interest-bearing security is purchased and ceases to exist at
the moment the credit or interest-bearing security is paid back.
Investment risk
Investment risk comprises the credit default risk that is associated with a bank's
investment portfolio.
Money market risk
Money market risk arises when a bank places short term deposits with a coun-
terparty in order to manage excess liquidity and the counterparty may not be
able to return the amount.
28
Pre-settlement risk
Pre-settlement risk or replacement risk is the risk of a counterparty defaulting
on a derivatives contract. Contract parties are exposed to pre-settlement risk
from the moment a derivatives contract is signed until the expiry date of the
contract. If a counterparty goes bankrupt within the contract period, the bank
must close a new transaction in order to replace the existing contract (replace-
ment). The loss the bank may incur in this process is called replacement cost.
Example
A bank has closed an FX forward contract EUR/USD with a client, sel-
ling one million US dollars. The term of the contract is three months.
The forward price is EUR/USD 1.5350. After two months, the client
goes bankrupt. The one-month EUR/USD forward rate at that moment is
1.5600.
The administrator of the bankrupt counterparty arranges the termination
of the contract. The bank must therefore conclude a new FX forward
contract to replace the old one. Let us compare the amounts in euros that
the bank would have received according to the original FX forward con-
tract with those it will receive according to the new FX forward contract:
Amount in euros according to original contract: 1,000,000/1.5350 =
EUR 651,465.80.
Amount in euros according to replacement contract: 1,000,000/1.5600 =
EUR 641,025.64.
Thus the bank loses 10,440.16 euros on the value date.
For derivatives, the exposure at default is measured by taking the market value
of a contract as the starting point. If a counterparty goes bankrupt, a financial
enterprise misses out on all future cash flows including the part of any next
interest coupon that is already booked as accrued interest. The exposure calcu-
lated in this way is called current exposure at default. Based on the volatility,
the banks then make an assessment of the possible future changes in this mar-
ket value over the remaining term of the contract. This assessment is then used
to adjust the exposure at default with a so-called add-on for potential future
exposure.
Settlement risk
The risk of a counterparty defaulting on the settlement of a transaction is called
settlement risk or delivery risk. Banks are exposed to this risk, for instance,
when dealing with FX spot transactions and cash security transactions. This has
to do with the fact that the two counter transfers involved in these types of
transactions are often performed separately at separate institutions.
29
2.2 Risk mitigating measures
Banks undertake a number of measures to reduce their credit risk. One of the
most commonly known is the demand for collateral. For transactions in finan-
cial markets, the collateral generally takes the form of a sum of money or secu-
rities. Another measure is the cancelling out of claims and liabilities arising
from different contracts with the same counterparty. This is called contractual
netting. With the intervention of a central counterparty such as LCH.Clearnet, it
is possible to net contracts with various counterparties simultaneously.
Collateral
A common way of reducing counterparty risk is to demand collateral. Colla-
teral is a pledge that provides security against default by the counterparty.
Whether a financial institution asks for collateral may depend on the creditwor-
thiness of the counterparty. There are however also parties such as clearing
institutions and governments that always demand collateral, regardless of the
counterparty's creditworthiness. Since the start of the credit crisis, it has also
become more common for banks to demand collateral for all derivative transac-
tions.
The most important forms of collateral are cash collateral, i.e. a sum of money,
and securities. The collateral is entered into a separate collateral system linked
to the counterparty limit system. Entering the value of the collateral into the
counterparty limit system decreases the use of the counterparty limit.
� Cash collateral
Collateral in the form of cash is used for derivative transactions and securities
lending transactions where the cash represents a pledge for the borrowed securi-
ties. The settlement of cash collateral usually takes place daily based on fluctua-
tions in the value of the covered contract over the previous trading day. Cash
collateral for derivatives is sometimes called margin and the daily telephone
calls or e-mails to the counterparty asking them to transfer cash are referred to
as margin calls. Cash collateral is quite common among financial institutions.
When concluding derivative transactions with non-financial institutions nowa-
days, however, banks ask cash collateral more frequently than before the credit
crisis.
When demanding collateral, financial institutions usually apply a threshold, that
means that the counterparty is not required to deposit collateral until the market
value of a contract exceeds a specific pre-agreed limit value. From this moment
onwards, the margin is settled on a daily basis. Since the credit crisis, the
thresholds have, in many cases, been abolished.
30
Even when banks demand 100% cash collateral for derivatives in the form of
margins, they will impose a charge of a certain amount on the counterparty limit
at the beginning of the transaction. This charge is known as add-on for poten-
tial future exposure. There are two reasons for this. First, there is the risk that
the counterparty may go bankrupt and ceases to deposit margins that may result
in the event of further fluctuations in the value of the contract during the time
until the contract is legally terminated. The second reason is related to the
replacement risk. Once it is clear that a counterparty is defaulting on its obliga-
tions, the bank is required to enter into an identical transaction in the market to
replace the first one and the chance exists that, for some reason, the bank is not
able to close this transaction at the prevailing market price. If this is the case,
the value of the collateral will not be sufficient to compensate fully for the loss.
The add-on for potential future exposure can be compared to the initial margin
used in exchange transactions.
� Collateral in the form of securities
In repurchase agreements and sell/buy back transactions, securities are used as
collateral. Financial institutions generally only accept securities issued by a
creditworthy party. They often use ratings for this purpose. In addition, they
prefer securities whose value does not fluctuate too much, i.e. low volatility
securities. This has to do with the chance of under-coverage during the contract
period. The saleability of the securities in the event of a counterparty default is
another factor that they take into consideration. The securities therefore have to
be traded in a liquid market. Furthermore, financial institutions only accept
securities for which they can easily assess the value themselves and that can
easily be registered by their custodian.
The risk of under-coverage exists since depreciation can cause the value of the
collateral to drop below the volume of the exposure with the counterparty. In
order to limit this risk, financial institutions may apply a haircut. For example,
if 90% of the value of the collateral applies then there is a 10% haircut. The
applied haircut percentage is based on the volatility of the collateral.
31
Example
A pension fund closes a securities lending transaction with the hedge
fund Centaurus. The pension fund transfers 1,000,000 Royal Dutch
shares to Centaurus with the agreement that they will return the shares
after one month.
The market price of Royal Dutch is EUR 30 making the value of the
loaned shares: 1,000,000 x EUR 30 = EUR 30,000,000. The pension
fund only accepts Dutch state bonds as collateral and applies a haircut of
2%.
The value of the collateral must therefore be 100/98 * EUR 30,000,000 =
EUR 30,612,245.
If the price of the Dutch state bonds is 100.37, Centaurus must provide
EUR 30,612,245 / EUR 1,003.70 = 30,500 bonds as collateral.
Contractual netting/close-out netting
Another way of reducing exposure at default is contractual netting also known
as close-out netting. Contractual netting is an agreement between two parties to
net the positive and negative values of all of their contracts should one of the
two go bankrupt leaving just a single net exposure. Contractual netting is often
included in master agreements such as an ISDA or an IFXCO agreement. The
contractual netting agreement is recorded in the counterparty limit system.
Example
A bank has closed an interest rate swap and an FX forward contract with
one and the same counterparty.
� The interest rate swap has a positive market value of EUR 500,000.
� The FX forward contract has a negative market value of EUR 300,000.
Without contractual netting, the counterparty's bankruptcy would mean
that the bank would have to fulfil its FX forward contract obligations
while the counterparty would have the interest rate swap terminated. The
bank would thus lose 500,000 euros. With contractual netting, the mar-
ket values of the two contracts are set off against each other and the
bank's loss in this case would only be 200,000 euros.
Sometimes two parties agree to cancel all existing contracts and replace them
with a new one. This is known as netting by novation.
32
Contractual netting by clearing houses / multilateral netting
For exchange transactions, a clearing house always acts as a central counter-
party. In the contract between the member and the clearing institution, a con-
tractual netting agreement is automatically included. Banks also increasingly
make use of the services of central counterparties for derivatives transactions.
One clearing house that handles the clearing of derivatives is LCH.Clearnet.
The system they use for this is Swapclear. When banks are connected to Swap-
clear, all bilateral contracts between two members are converted into two sepa-
rate contracts each between one member and LCH.Clearnet.
Because of the bilateral contractual netting clause with LCH.Clearnet, all con-
tracts of a specific member with the various other members are now netted
simultaneously. As a consequence, the credit exposure is significantly reduced.
Another advantage is that the daily settlement of the collateral takes place
exclusively with the central counterparty instead of with each counterparty se-
parately.
33
Chapter 5
P&L measurement
The managers of the various trading desks need daily information about the risk
and the results of their traders. At some banks, supplying this information is the
responsibility of a special department called middle office. At other banks, it is
part of the product control department's responsibilities. All banks keep these
departments separate from the front office financial markets department.
1 The responsibilities of the P&L unit
The P&L measurement is carried out by a special department within the finan-
cial markets division. Sometimes it is part of the responsibilities of the product
control department, with other banks it may be carried out by the middle office.
The following components are taken into account in the daily P&L update:
� fluctuations in the value of the financial instruments;
� provisions;
� interest costs and revenues;
� broker fees.
The department that is responsible for measuring the daily P&L should comply
with several control measures. First, the P&L should be signed-off by the tra-
ders each day. Second, every unusual movement in the P&L figures needs to be
explained. In this respect, the results for all closed deals should be checked. For
any deal with a major negative or positive result, the price has almost certainly
been entered incorrectly. This check is known as off-market price testing. In
these cases, the trader in question must be contacted immediately to find out
what went wrong. Finally, adequate information about other factors that could
have had a material impact on the P&L should be collected, for example, late
booked trades.
34
2 Fluctuations in the value of the financial instruments
The market value of financial instruments is calculated on a real-time basis in
the front office systems. The pricing models which are used in these systems
are verified and approved by the market risk department. Once each day, usu-
ally at the end of the trading day, the value is fixed for the daily results mea-
surement. In order to determine the value of exchange traded instruments, the
closing price on the exchange where the instrument is traded is used. For OTC
instruments, the bank calculates the value itself based on self-compiled yield
curves and exchange rate data. Every bank has its own policy regarding the
screens from where it imports interest rate and exchange rate data and regar-
ding the moment at which the values are fixed.
Independent price verification and curve policy
The accuracy of the valuation of financial instruments depends on the quality of
the valuation models used and the accuracy of the imported market data used
for the daily fixing. This data is therefore subjected to a strict examination. The
task of checking and approving this data belongs to the product control depart-
ment and is known as independent price verification (IPV). The traders them-
selves must also give their approval for the imported data but product control
has the final say in the event of any dispute.
Sometimes there is no clear or reliable market data available. Clear data is
absent, for instance, in the case of volatilities for which there is no benchmark.
Reliable data may be unavailable for illiquid instruments which was the case for
the securitized mortgage portfolios during the credit crisis. In these situations,
traders are initially authorized to use their own data. However, the product con-
trol department regularly, at least once per month, checks the market data used
by the traders. The product control department maintains its own data set for
this purpose.
The interest curves that are used for the valuation of interest bearing instru-
ments are constructed by a special unit of the market risk department. This
activity is called curve policy.
35
3 Provisions
Some financial instruments are so complex that it is virtually impossible to
determine their exact value. In these cases, banks make a provision for possible
inaccuracies in the valuation. These provisions are referred to as model
reserves.
The valuation of financial instruments is based on mid-market prices. These
prices/exchange rates are the exact average of the bid and ask prices. Long posi-
tions, however, should in principle be based on bid prices, and short positions
on ask prices. This is because a trader can only close a long position by selling
the values he holds in position. As a market user, he will only be able to sell at
bid prices. And a trader with a short position has to buy the values he holds in
position in order to close his position. As market user he has to pay the ask
price in the market.
To lessen the negative influence of this on the accuracy of the results, banks
also make provisions. In order to establish the size of the provision, the depart-
ment responsible for calculating the P&L periodically receives data regarding
the prevailing spreads in the market from the market risk management depart-
ment.
All provisions are subtracted from the results of the traders. If a trader closes
his position and the released price in fact turns out to differ negatively from the
last fixing, the relevant provisions will be activated and the trader’s result will
not be negatively influenced.
4 Interest costs and revenues
For some traders, it is evident that a part of their result is determined by inte-
rest costs or revenues. This applies to those trading interest rate instruments
such as fixed-income instruments or interest rate swaps. For example, if a bond
trader has a long position on Government bonds, he is entitled to the coupon
revenues. The opposite applies for a bond trader with a short position. He has
sold a bond that he did not possess and will have to buy it back in the future. He
will then have to pay the clean price on the purchase date plus the interest
accrued up until that moment. When opening the short position, he has received
the accrued interest up to the sale date. In this case, the accrued interest during
the time the position was held is booked as a negative contributor to the trader's
result, i.e. interest costs.
36
Interest costs and revenues do not just affect traders in interest rate instruments.
They contribute to the trading result of anyone trading in financial instruments
because going long on a financial instrument - such as a share - requires a trader
to borrow money. The P&L department books interest costs for this purpose
every day. This is also known as cost of carry. If a trader goes short e.g. on a
security, he can use the revenues from the initial sales transaction to generate
interest revenues. These interest revenues will contribute positively to his result.
Interest is thus booked twice for bond traders: on the one hand as coupon inte-
rest and on the other as cost of carry.
To calculate the cost of carry, normally the benchmark for the overnight inte-
rest rate, for example, EONIA, SONIA or fed funds is used.
5 Broker fees
If a trader uses the services of a broker, he has to pay a broker fee. Most banks
have drawn up standard agreements with brokers, describing how the broker's
fee should be calculated. Different calculation methods are used for currency
transactions and derivatives.
Fee per million calculation
The fee per million calculation is a method whereby the broker fee is expressed
as a fixed amount for each million in nominal value, the rate. For instance, the
rate may be 2 US dollars per million. This method is frequently used for FX
transactions.
The total fee charged by a broker for a transaction is calculated by multiplying
the nominal amount of a transaction (stated in millions) with the rate, as in the
following formula:
Fee = nominal amount / 1,000,000 x rate
The rate depends on the maturity of the FX contract and the currency involved.
Figure 5.1 shows how the rate is influenced by the maturity of the contract and
by the market liquidity of the traded currency pair. In order to determine the
rate, one must always look at the column of the least liquid currency of a cur-
rency pair.
37
Figure 5.1 Broker rates for FX forward and FX swaps
Example
The rate for an FX forward contract in EUR/NOK with a nominal value
of 10 million euros and a term of two weeks is 2 euros.
The broker fee for this transaction is 10 x EUR 2 = EUR 20.
The rate for an FX swap EUR/CSK (Czech crown) with a nominal of
EUR 30 million and term of 1 week is 1.50 euros.
The broker fee for this transaction is: 30 x EUR 1.50 = EUR 45.
Flat calculation
Flat calculation is a method in which the broker rate is expressed as an interest
rate percentage, for instance 0.2 basis points (= 0.002%). This method is often
used for interest rate derivatives.
The broker fee is determined by means of the general equation used for calcu-
lating interest amounts:
Fee = nominal x rate x days / 360
In this method, too, the rate depends on the currency being traded. The term of
the contract is already taken into account in the formula itself.
Term Major
(EUR, USD, GBP,
JPY, CHF, CAD)
Non Major
(AUD, NZD, NOK,
DSEK, DKK)
Other
=< 1 week 0,15 0,35 1,50
1 week < 1 month 1,00 2,00 7,50
1 month < 3 months 2,00 4,00 13,00
38
Figure 5.2 Broker rates for interest rates derivatives (IRS, OIS, FRA)
Example
The rate for an OIS (overnight index swap) in USD with a nominal value
of USD 40 million and term of six months (183 days) is 0.1 bp. First the
nominal value in euros must be calculated, on the basis of the EUR/USD
exchange rate valid on the value date: EUR/USD = 1.3333. The nominal
amount in euros is thus EUR 30 million.
The broker fee for this transaction is:
USD 30 million x 0.00001 x 183/360 = EUR 152.50.
The brokerage control department is responsible for checking the invoices sent
by brokers. At some banks, this department is part of the back office depart-
ment. At other banks, this activity takes place at a middle office unit. The first
thing the brokerage control unit does is to check whether a broker appears on
the list of brokers with whom dealers are allowed to do business. Then it checks
the amounts charged by the brokers. In a separate reconciliation system all bro-
ker invoices are compared with the amounts calculated by the bank. In the case
of deviations, the brokerage control department will contact the broker in ques-
tion.
Term Major
(EUR, USD, GBP,
JPY, CHF, CAD)
Non Major
(AUD, NZD, NOK,
DSEK, DKK)
Other
=< 1 month 0,125 bp 0,2 bp 0,35 bp
1 month < 1 year 0,1 bp 0,15 bp 0,35 bp
>= 1 year 0,1 bp 0,15 bp 0,35 bp
39
Chapter 6
Deal capture, confirmations and settlement instructions
Transactions in financial instruments are processed according to a fixed proce-
dure. This procedure involves the following consecutive activities: concluding
the transaction, authorization, entering the transaction data, verification, confir-
mation and providing settlement instructions. The departments performing
these operations functions are sometimes called Operations or Service Centres.
In this book, the universal term back office is used.
The processing of transactions normally takes place in various computer sys-
tems, such as a dealing system, front office system, back office system or con-
firmation-matching system. Financial institutions strive to maximize
automation when it comes to exchanging information between these systems.
This is referred to as straight-through processing.
At different stages of processing, financial institutions will send information to
other parties. In order to do so, they often use SWIFTNet. SWIFTNet is a com-
puter network used exclusively for sending financial messages.
1 Closing transactions and capturing transaction data
Transactions in financial instruments are concluded by telephone, via dealing
systems or via electronic brokers. Traders are only allowed to close transac-
tions if they are properly authorized. Authorization means that the legality of a
transaction is ensured. A transaction is authorized if the front office employee
� is entitled to trade in the instrument concluded;
� only concludes trades in amounts for which he has approval;
� remains within his trading limits;
� does not exceed the counterparty limit.
40
Often a front office employee will enter the transaction data into his or her front
office system prior to concluding a transaction in order to check whether the
transaction will be authorized. The trade limit is checked in the front office sys-
tem. The counterparty limit is checked in a separate counterparty limit system,
which is linked to the front office system. These checks are referred to as pre-
trade compliance.
It is also important that the front office employee checks the counterparty's
authorization. There is no problem if he has his regular contact person on the
line, but if this person is sick or on leave, the front office employee must check
whether his replacement is also authorized to close transactions.
All telephone conversations made by front office staff are recorded on tape.
This tape is used to provide evidence in case of disputes.
1.1 Transaction data
Once a transaction has been agreed, the transaction data are entered into the
front office system. If the transaction is concluded by telephone, the data are
entered manually. If the transaction is concluded via a dealing system, the trans-
action information is fed into the front office system by means of an interface.
A trader can then keep track of the market value and the risk associated with his
position in the front office system.
If no pre-trade compliance was carried out and it turns out following authoriza-
tion that the front office employee has exceeded his trade limit, he must, in
principle, offset the transaction, unless the line manager approves the transac-
tion afterwards. If the counterparty limit turns out to have been exceeded, the
necessary action depends on the nature of the counterparty. If, for instance, the
counterparty is an asset manager or an enterprise, the client advisor must
request post hoc permission for this transaction from the account manager. Usu-
ally, the account manager will grant this permission so that the transaction does
not have to be offset. If, on the other hand, the counterparty is a bank, the deal
most likely should be offset.
41
The following data must typically be entered into the front office system:
� the name of the counterparty;
� the type name of the financial instrument and, in the case of a security, also
the ISIN code (international securities identification number);
� whether it is a purchase or sale;
� the currency, often referred to by means of a 3-letter ISO code, e.g. EUR or
USD;
� the notional amount or amounts (in the case of FX transactions);
� the term of the contract;
� price, FX rate or interest rate;
� the daycount convention in the case of an interest instrument;
� the reference of the variable interest (e.g. EURIBOR or LIBOR), in the case
of an instrument with a variable interest;
� the trade date and time;
� the name of the trader;
� the settlement date;
� the settlement instructions.
Banks try to register data in such a way that these do not have to be entered
again and again with every transaction. These fixed data are called static data.
Examples of the static data of clients are personal data and account numbers.
Static data are also entered for each new financial instrument, such as the inte-
rest calculation of the instrument and the currencies the instrument will be
traded in. The use of static data reduces the risk of entry errors. Static data are
entered into the relevant systems by a separate department within the back
office department.
1.2 Master agreements
Many financial instruments are traded over-the-counter. This means that the two
parties do not have the comfort of the standard regulations of a central counter-
party. To overcome this disadvantage, banks often use master agreements with
over-the-counter transactions. These are agreements that set out all the agree-
ments and conditions pertaining to all transactions concluded by an organiza-
tion with one and the same counterparty within a certain instrument. For each
42
new transaction with this counterparty, the bank can then refer to the master
agreement, while only specific transaction details are dealt with in a separate
contract. Here are some examples of master agreements:
� ISDA Agreement (International Swap Dealers Association) Agreement:
for interest rate derivatives, credit derivatives, equity derivatives and some-
times also for some FX derivatives like FX forwards;
� GMSLA Agreement (General Master Securities Lending Agreement):
for securities lending transactions;
� GMRA Agreement (General Master Repurchase Agreement):
for repurchase agreements (repos);
� IFEMA (International Foreign Exchange Master Agreement):
for currency transactions.
The most frequently used master agreements is the ISDA Agreement, made up
by The International Swaps and Derivatives Association (ISDA). The ISDA
agreement consists of a master agreement, a supporting schedule, individual
transaction confirmations and a credit support annex.
The ISDA Master Agreement
The master agreement is the principal document in an ISDA transaction that
contains the standard terms and conditions that apply to all individual transac-
tions agreed to between the counterparties. Examples of standard terms are pro-
visions governing events of default, termination events and law.
The ISDA Schedule
The schedule to the master agreement amends and supplements that agreement
by customizing some standard terms and conditions. The schedule is far more
likely to be subject to negotiations and modifications between the counterpar-
ties. The ISDA schedule may contain articles on the following issues:
� joint and several liability between parent-subsidiary groups;
� cross-default provisions, stating that any default by the customer in the
payment of any other debt obligation (regardless of whether such obligation is
owed to the bank) constitutes a default under the ISDA master agreement;
� netting agreements. ISDA schedules also typically describe the set-off rights
of the parties against each other with respect to payments that may be
required under the ISDA master agreement. The ISDA schedule typically
gives a bank the right to set off against amounts held by the customer in
deposit accounts for any payment owed to it by the customer;
� the duty to deliver documents like annual/quarterly reports or a list of
authorized staff.
43
Confirmations
For each individual transaction that is closed under an ISDA Agreement, a se-
parate confirmation has to be made up that contains the trade details of this
transaction. The general terms contained in the master agreement, as well as the
more specifically negotiated provisions contained in the schedule, will still
apply unless the parties to the confirmation explicitly agree otherwise. It is
important that the back office or middle office monitors each new transaction
confirmation to ensure that it has not introduced new or unexpected terms or
modifications to the master agreement.
Credit Support Annex (CSA)
Nowadays, collateral requirements play an important role in the negotiations of
an ISDA agreement. The agreements on these requirements are stated in the
credit support annex (CSA). In a CSA, parties must agree on the following
issues regarding collateral:
� what type of collateral they accept, for instance cash or securities and, in the
latter case, which securities are eligible;
� the frequency of the reconciliation of the transactions;
� the frequency of the margin calls;
� the possibility of extra margins calls;
� threshold and/or minimum transfer amount;
� who is responsible for establishing the value of mutual receivables and
payables: the calculation agent.
2 Verification
Once a deal has been authorized, the data are sent from the front office system
to the back office system, where they are checked for completeness. This is
called verification. Verification is important because front office employees are
often exclusively occupied with concluding transactions and may therefore pay
less attention to entering transaction data. Also, they may not always see the
value of verifying details regarding the processing of a transaction. This
explains why they sometimes make mistakes in entering transaction data.
For simple financial instruments such as deposits, securities and currency trans-
actions, verification nowadays is for the most part automatically performed in
the back office system. For more complex instruments, such as interest rate
derivatives and special investment products, verification is still frequently per-
formed manually by specialized back office employees. In the latter case, the
44
back office has to try to pinpoint possible errors, so as to ensure that the trans-
action can be processed smoothly. In this context, a back office employee may
ask the follo-wing questions:
� Do the settlement instructions appear to be correct?
� Is there anything about the transaction that seems unusual, for example:
� a client concluding an unusual transaction;
� a client buying a certain currency it usually sells;
� the use of a broker not normally used?
� Is the agreed price in accordance with the current market level?
This last check is called a reasonability check. If the price appears to deviate
from what is normal, a back office employee must go to the dealer to check
whether the price is in fact correct.
With more and more transactions being processed by STP, a reasonability check
by a back office is not always possible. Besides that, a reasonability check
requires a considerable amount of knowledge. This is why daily checks for off-
market pricing are performed by the product control department.
3 Confirmation
Confirmation refers to the reconciling of the contract details of a transaction
with the counterparty. Confirmation must take place quickly, so that possible
errors can be corrected at an early stage. The confirmation procedure followed
depends on the type of transaction. Here are several common methods of confir-
mation:
1. An exchange transaction between a member and the exchange is immedi-
ately confirmed electronically by the exchange’s trading system.
2. In the case of a transaction between two banks, the two parties send each
other a SWIFT message. These SWIFT messages are automatically created
by the banks' back office systems. Examples of SWIFT confirmation mes-
sages are MT 300 for currency transactions (Figure 6.1), MT 320 for depo-
sits and MT 340 for FRAs. If a transaction has been arranged through a bro-
ker, the broker will send an additional SWIFT message of confirmation to
both contract parties.
3. A transaction between a bank and a client (investor, asset manager, institu-
tional investor or enterprise) is usually confirmed by a fax or an e-mail sent
by the bank to the client. These fax messages or e-mails are created in sepa-
rate systems fed by the back office systems.
45
4. Financial instruments concluded by Markit wire (Swapswire) are confirmed
electronically and directly. Markit wire can be used for interest rate deriva-
tives and for credit derivatives.
In most countries, banks are legally required to send their counterparty a confir-
mation. This rule also applies when a client concludes a transaction via the
bank's auto-dealing system. The confirmation message automatically generated
by this system does not count as a formal confirmation.
Figure 6.1 SWIFT MT300 confirmation message of an FX forward transaction between ING and
UBS
Type of information SWIFT format Relevance of the information
Message header
Reference code WCHZ0A1234INGB2a Code used to reconcile
the confirmations
SWIFT-code of sender INGBNL2A ING Bank is the sender
of the message
SWIFT-code of receiver WXHZH80A UBS is the receiver
Message text
Trade date 20090522 Trade date 22 may 2009
Value date 20090824 Settlement date 24 august
2009
Exchange rate 1.3222 FX forward rate
Currency, amount bought USD 13,222,000
Receiving agent BOFAUS3N ING wants to receive
the US dollars on its account
with Bank of America
Currency, amount sold EUR 10,000,000
Receiving agent DEUTDEFF UBS wants to receive
the euros on its account
with Deutsche Bank
46
Matching of confirmations
The way in which counterparties must act with regard to confirmations is usu-
ally laid down in an agreement. In the case of a transaction between a bank and
a client, e.g. the bank sends a confirmation to which the client must then
respond. Banks often expect their clients to respond directly by e-mail or fax. If
a client does not respond immediately - at least in the case of FX and money
market transactions - the bank will contact the client immediately by telephone
to confirm the transaction. This telephone conversation is stored in a separate
computer system that is sometimes referred to as conversation checker. In some
cases, however, a confirmation is considered accepted if the client has not
responded by the end of the day.
In the case of a transaction between two banks, it is common for both parties to
send each other a confirmation. Banks use separate systems to match these con-
firmations. Some banks use an internal matching system. Others use external
systems such as SNA, which is operated by SWIFT. These matching systems
send an electronic status update of each confirmation to the back office system.
If the confirmations match, the matching systems label the deal as such. If a
confirmation is missing or does not correspond with that of the counterparty, it
is marked with the status 'unmatched' and placed in a queue in the back office
system.
If a confirmation doesn’t match, this may have to do with the transaction's set-
tlement instructions or with the actual transaction data. If there is a difference in
the settlement instructions, the back office must contact the counterparty's back
office. If a comparison of the settlement instructions brings to light a mistake,
the back office of the party responsible for the mistake must correct the infor-
mation in its own back office system. A confirmation of this correction is then
sent to the counterparty, after which the transaction can be given the status
‘matched' and be processed further.
If there is a mismatch of transaction data, the back office employees of both
parties must contact their front offices as quickly as possible. If on inspection
by the front office the data turn out to have been entered incorrectly, the front
office must cancel the original transaction in the front office system. For this,
the permission of the line manager is required. The transaction must then be re-
entered correctly, following which the back office sends a new confirmation to
the counterparty. The error will then have been corrected administratively,
although significant costs may have been incurred.
Example
A salesperson concludes a transaction with a corporate client. The sales-
person incorrectly understands that the client wishes to sell 12.5 million
US dollars to the bank. The exchange rate quoted by the spot dealer is
EUR/USD 1.2500. The client accepts and the salesperson immediately
47
passes the transaction on to the spot dealer, who immediately closes his
position by selling 12.5 million US dollars at a market rate of EUR/USD
1.2500.
The salesperson enters the transaction into the front office system as a
purchase of US dollars. As this information corresponds with the infor-
mation provided orally by the salesperson, the spot dealer has no reason
to assume anything is wrong.
After the client has returned the confirmation, however, it turns out he
wanted to buy rather than sell US dollars. Therefore, the transaction data
in the confirmations do not match. The back office employee inquires
with the salesperson, who concludes that he has indeed entered an incor-
rect deal. The salesperson now has to cancel the original transaction and
must enter the correct transaction at the original exchange rate: the bank
sells 12.5 million US dollars at an exchange rate of EUR/USD 1.2500.
The original transaction is also cancelled in the trader's position over-
view. After the salesperson has re-entered the transaction, the spot dealer
now has sold an amount of 12.5 million US dollars at an exchange rate of
1.2500 twice, without a purchase to counter the sales. The spot dealer
thus finds himself in a short position in dollars with a volume of 25 mil-
lion US dollars, for which he received 20 million euros.
In order to close the short position, the spot dealer must sell USD 25 mil-
lion immediately. If at that moment the exchange rate e.g. is EUR/USD
1.2400, he will have to pay the following sum:
25 million/1.2400 = EUR 20,161,290.32.
As a result of the mistake made by the salesperson, the spot dealer there-
fore incurs a loss of 161,290.32 euros. He will recover this amount from
the sales desk.
In the above example, the bank's own salesperson made a mistake. If the sales-
person turns out to have entered the transaction data correctly, the counterparty
is responsible for the above scenario.
In some cases, the front office employee of the bank and the counterparty may
both be convinced that they have registered the deal correctly. If this is the case,
they must re-contact one another in order to establish what precisely was agreed
upon. If this contact does not result in a solution, they must listen to the tele-
phone tape that was made of their conversation as quickly as possible to find
out who is right.
48
4 Settlement instructions
Settlement is the final transfer of money and/or securities following transac-
tions in financial instruments. Settlements take place at banks, central banks,
custodians and central securities depositories or at specialized settlement insti-
tutes, such as the CLS bank. The date on which a settlement occurs is called the
settlement date or value date.
In order to make a withdrawal from its own account and in favour of another
account, a party must issue an order to the institution at which it holds its
account. This order is called a settlement instruction. Banks send settlement
instructions via SWIFTNet. Clients of banks enter settlement instructions into
the payment systems of a bank or the custodian at which they hold their securi-
ties accounts. Settlement instructions are usually drawn up automatically in a
back office system. They are sent by a separate payment department or a spe-
cialized group within the back office, but only after a transaction has been con-
firmed by both parties and given the status 'matched' by the matching system.
As banks manage accounts themselves, there may be cases in which a bank
merely has to send an internal settlement instruction in order to settle a transac-
tion. If, for example, a bank salesperson offers a short-term loan to an enter-
prise with an account at the same bank, the back office merely has to send an
internal settlement instruction to the department managing the bank's accounts,
requesting that the enterprise's account is credited and the internal financial
markets/money market account is debited.
Settlement instructions must always be sent to the settlement institution before
a certain time to ensure that the amount is transferred to the recipient's account
on the required value date and the receiver is able to invest the money in the
money market. If this is the case, it is called good settlement value in jargon.
The final time by which settlement instructions can be sent and still result in
good settlement value is called the cut-off time. The cut-off time for transfers in
euros processed through TARGET, for instance, is 17:30 hours, for transfers
processed through Euro1 it is 16:00 hours.
4.1 Shadow accounts
Financial institutions have an internal shadow account for every nostro account
that they hold. All transfers that must take place on the external account are also
processed on the shadow account. To this end, the back office system sends an
internal settlement instruction to the system in which the shadow account is
managed. For instance, if a bank has to pay a US dollar amount, it will send an
external settlement instruction to the dollar correspondent bank to debit the US
49
dollar nostro account and an internal settlement instruction to its own account-
ing system to debit the shadow account of the USD nostro account. If the bank
in a later stage receives a transfer statement from the correspondent bank
(MT910), it can compare this with the position movement in its shadow admi-
nistration. This check is called Nostro reconciliation and is usually performed
by a separate department in the back office, operations control, or by the
finance department.
4.2 Standard settlement instructions (SSI)
If a front office employee concludes a lot of transactions with one particular
client, it is inefficient to enter all client and settlement data for each separate
transaction. For this reason, it is common practice to make an agreement with
the client as to which accounts are normally to be used for processing the trans-
actions. Instructions that relate to this common practice are normally referred to
as standard settlement instructions, or SSIs. SSIs are part of a client's static data.
Whenever a front office employee concludes a transaction with a client without
further notice, he may assume it is to be processed in accordance with the SSI.
If the client wishes the transfer to be directed through a different account, he
must explicitly indicate this.
Back office employees must always be alert for abnormal settlement instruc-
tions. If they suspect something is wrong, they must check with the front office
of with the counterparties back office whether the settlement instructions are
correct. If the beneficiary is a third party, alertness is even more vital, as this
may indicate the possibility of fraud.
4.3 Settlement risk
The risk of an incoming transfer not being processed, or being processed too
late, is called settlement risk. The risk of an outgoing transfer not being pro-
cessed, or being processed too late, however, is an example of operational risk.
In securities or currency transactions, settlement risk can be avoided by making
the transfers interdependent. This is the case whenever a currency transaction is
settled through the CLS bank (payment versus payment) and whenever a securi-
ties transaction is processed in accordance with the DVP condition (delivery
versus payment).
50
Another way of reducing settlement risk is to make use of payment netting.
Payment netting reduces counter payments following from multiple transac-
tions due on the same date in a single currency to a single net payment.
Example
A bank concludes a receiver's interest rate swap on 13/7/2009 with a
principal of 100 million euros. The fixed interest rate is 3% (30/360) and
the variable interest coupon is based on a six-month EURIBOR. In their
ISDA Agreement, the parties have agreed that the fixed coupon payment
will be netted with a variable coupon payment if they happen to coincide
on the same value date.
On 13/1/2010 the six-month EURIBOR for the coupon period 15/1/2010
- 15/7/2010 is fixed at 2% (actual/ 360, 181 days). The coupon payments
on 15/7/2010 are:
Fixed interest coupon first year:
EUR 100 mio x 0.03 x 360/360 = EUR 3,000,000
Floating interest coupon 15/1/2010 - 15/7/2010:
EUR 100 mio x 0.02 x 181/360 = EUR 1,005,555.55
As a result of the netting agreement, on 15/7/2010, the bank receives the
net amount of EUR 1,994,444.45 from the counterparty.
Erroneous settlements often occur during weekends or bank holidays. In order
to avoid such errors, the back office must consistently maintain a bank holiday
calendar for all relevant currencies. Whenever a new bank holiday is intro-
duced, it must be entered into this database. If the settlement of a previously
concluded transaction happens to occur on such a date, according to the model
code of the ACI, the following rules apply:
� the modified following convention is used;
� the shift applies to both currencies in an FX transaction;
� the price is not modified.
51
5 Event calendar
For some financial instruments, transfers not only take place directly after the
conclusion of a transaction, but may also take place in the course of the con-
tract period. These transfers are scheduled in an event calendar, a list of events
requiring action on the part of the back office during the contract period. The
list is drawn up in the back office system. The actions listed in an events calen-
dar may also pertain to refixing coupon interest rates, periodically assessing
whether the collateral volume needs adapting, distributing or collecting divi-
dend payments or performing early redemptions. The table below shows an
event calendar of an interest rate swap.
Figure 6.2 Event calendar of a receiver’s interest rate swap in US dollars closed on 13 july 2009
Date Event
13/1/2010 Fixing of the 6 months LIBOR for the coupon period:
15/1/2010 - 15/7/2010
15/1/2010 Pay the floating coupon for the
coupon period: 15/7/2009 - 15/1/2010
13/7/2010 Fixing of the 6 months LIBOR for the coupon period
15/7/2010 - 17/1/2011
15/7/2010 Receive the net amount of the fixed coupon for the 1st year and
the floating coupon for the coupon period 15/1/2010 - 15/7/2010
13/1/2011 Fixing of the 6 months LIBOR for the coupon period
17/1/2011 - 15/7/2011
17/1/2011 Pay of the floating coupon for the coupon period
15/7/2010 - 17/1/2011
13/7/2011 Fixing of the 6 months LIBOR for the coupon period
15/7/2010 - 17/1/2012
15/7/2011 Receive the net amount of the fixed coupon for the 2nd year and
the floating coupon for the coupon period
17/1/2011 - 15/7/2011
13/1/2012 Fixing of the 6 months LIBOR for the coupon period
17/1/2012 - 17/7/2012
17/1/2012 Pay the floating coupon for the coupon period:
15/7/2011 - 17/1/2012
17/7/2012 Receive the net amount for the fixed coupon of the 3rd year and
the floating coupon for the coupon period
17/1/2012- 17/7/2012
52
6 Diagrams of processing methods
A number of back office work processes will be described in this paragraph.
The various stages of processing an FX transaction and an OTC securities trans-
action will first be dealt with, and then the process of a structured product will
be discussed.
Processing of FX and money market transactions
Figure 6.3 Processing of an FX/MM transaction with another bank as counterparty
1. The transaction data are imported into the front office system from a deal
system.
2. Compliance with the counterparty limit is checked by means of an interface
with a counterparty limit system.
3. After authorization, the transaction data are imported into the back office
system.
4. The back office system generates a SWIFT confirmation message MT300
(FX) or MT 320 (MM). The confirmation message goes to SWIFT through
an internal portal/mailbox.
5. Once the counterparty has returned the confirmation, it is entered into the
matching system and matched with the back office system's output.
EBS
RD 3000
ICAP
BloombergBrokers
Telephone
BO system
Counterparty
limit system
FO system
Front office Operations
SWIFTSWIFTAlliance
Matching
system
CorrespondBank
EBA
( <50.000)
TARGET
CLS Bank
Archive
Counterparty
SWIFTSWIFT
Portal
SwiftPortal
Internal settl.
interface
Account
system
1
2
3
4 5
6 7
8 9
10
53
6. After the matching system has matched the deals, they are given the status
'matched' in the back office system.
7. The matching system sends the matched confirmations to an archive system
for storage.
8. The back office system sends an internal settlement instruction to the
accounts system.
9. The back office system draws up a settlement instruction to debit a nostro
account belonging to the bank at the ECB or at a non-euro correspondent
bank, with reference to 'financial markets' which is sent to the correspon-
dent bank.
10.Having performed the transfer, the correspondent bank sends a transfer
statement, which is reconciled with the information in the account system.
Processing of an OTC cash securities transaction
Figure 6.4 Processing of an OTC cash securities transaction with an asset manager
1. The BO system sends a confirmation, using a confirmation system for
clients connected to this system and a fax/letter for other clients. This confir-
mation has no further purpose for the bank as far as the rest of the process-
ing procedure is concerned.
2. a. The BO system generates settlement instructions for the custodians. These
are SWIFT messages sent to SWIFT.
Telephone BO systemFO system
Front-office Operations
SWIFTSWIFTAlliance
Corresp.bank
Counterparty
ECB
Confirmation
system
Letter
Fax
Internal settl.
interface
Account
system
Cash man
system
Payment
system
Counterparty
limit system
Euroclear
Bank
Corresp.
bank
ECB1
2a
2b
3
4
5
6
7
2a
54
The custodian also receives instructions from the counterparty and gives the
transaction a 'matched' status if the instructions correspond with each other
and sends a message to that effect through SWIFT. The transaction thus is
either confirmed or not.
b. As far as securities in the custody of the back office itself are concerned
(e.g. local Government bonds), the back office system sends a direct SWIFT
message to Euroclear Bank's EUCLID system. Euroclear Bank returns sta-
tus notifications through the EUCLID system.
3. The BO system sends information about the deal to the cash management
system. This report contains the money transfers resulting from securities
transactions for each custodian. The cash management system calculates the
amounts to be deposited into or withdrawn from the custodians' accounts
(sweeping).
4. The cash management system sends information on the required sweeping
transactions to the payment system (or generates these orders itself).
5. The payment system forwards this information to the system in which the
shadow accounts are managed.
6. The payment system generates an external settlement instruction to the cor-
respondent bank payable to the custodian or vice versa.
7. Correspondent banks and custodians return a transfer statement, confirming
that the transfer has been concluded, which is reconciled with the informa-
tion in the account system.
The processing of structured products
Structured products are financial instruments consisting of various plain vanilla
instruments offered to a client as a single instrument. Structured products can-
not always be processed in one and the same back office system. If this is the
case, the various instruments constituting the structured product are entered
separately in the back office systems in which these instruments are normally
entered, but under the same deal number, a 'structure ID'.
55
Figure 6.5 Processing of a structured deal
Without further action, each separate back office system would create a confir-
mation which would be sent to the counterparty and each separate instrument
would generate its own cash flows. However, as it is neither desirable for a
client to receive multiple confirmations for an instrument presented to him as a
single instrument, nor for him to see several different cash flows on his account,
both the confirmations and the cash flows of these joint instruments are sup-
pressed in the separate back office systems.
A dedicated department in the back office, the Structured Products Group,
sends one manually created confirmation and processes only the net cash flows
of a structured product on the client's account. Before the confirmation is sent,
the structured product group contacts the front office to have the confirmation
and the event calendar checked.
BO system
FX/MM
Structured Product
Group
BO system
Derivatives
BO system
Bonds
Decomposition of the structured deal /
confirmations and settlement suppressed
Client
One confirmation
and net settlement flows
56
57
Chapter 7
Money settlement
Nearly all transactions in financial instruments lead to transfers of money. With
most of these money transfers, more than one bank is involved simultaneously.
This is because the accounts of the two parties that close a transaction are often
not held with the same bank. Therefore, banks often need to transfer money to
another bank or they receive a transfer of money from another bank.
A bank can only transfer money to another bank if it has direct or indirect
access to an account system that the other bank also has direct or indirect access
to. Banks have direct access to the account system of the local central bank.
Banks have indirect access to the account system of central banks in other
countries because they hold accounts at correspondent banks.
In order to effect a transfer in its own currency, a bank must send a settlement
instruction to the local central bank. There are two ways to do this, via an RTGS
system or a clearing institution. For the transfer of foreign currency amounts, a
bank must send a settlement instruction to its correspondent bank.
1 Bank accounts
Accounts are held at banks by individuals, companies and asset managers, but
also by foreign banks. Banks call these client accounts loro accounts. Banks
keep track of the balances and mutations of such loro accounts in their own
account system.
Banks also hold accounts themselves. For the local currency, they hold an
account with the central bank of the country for which they have a banking
licence. All banks with a banking licence in euro countries, for instance, hold a
euro account at the European Central Bank (ECB). These may also be subsi-
diary companies of banks outside the euro area if they are a separate European
legal entity. Banks can use the euro account at the ECB to make transfers in
euros to other banks with a 'euro' banking licence.
58
In order to execute transfers in a foreign currency, a bank must have an account
in that currency. Because a legal entity can only have a banking licence in one
country it can have an account with only one central bank. In order to execute
payments in foreign currencies, banks open accounts with foreign banks that in
turn hold an account with the central bank in the country where the foreign cur-
rency is the local currency. These banks are called correspondent banks or inter-
mediary banks and the accounts are referred to by the bank that holds them as
Nostro accounts. If a bank with a French banking licence wants to hold an
account in US dollars, for instance, it opens a US dollar account at a bank with
an American banking licence. Although banks may use subsidiaries for this pur-
pose, they only choose do so if the subsidiary has access to the local clearing
system.
Most banks use more than one correspondent bank per currency. They do this
because they do not use correspondent banks for the sole purpose of taking care
of payments in foreign currencies. Banks also use correspondent banks to take
care of documentary credits, for instance. Most banks also have a foreign cur-
rency account with one or more custodians that register their overseas securi-
ties ownership. The correspondent bank that executes the payment transactions
is normally called the principal correspondent.
2 Money transfers in the local currency
If a bank needs to transfer money to a counterparty, e.g. resulting from a
granted money market loan, there are two possibilities. The first is that the
counterparty holds an account at this bank. The second is that the counterparty
is a client of another bank.
If the counterparty holds an account at the bank, the bank can credit the coun-
terparty's account within its own account system and debit the financial mar-
kets division's internal account. If the counterparty holds an account at another
bank, the bank must transfer money to that bank. In the case of euro transfers, a
Spanish bank, for instance, must use its account with the European Central
Bank for this purpose. The bank prepares a SWIFT settlement instruction and
sends it to a system that takes care of the first step in the processing of the
transfer. This system may be either a RTGS system or a clearing system.
59
2.1 RTGS systems
An RTGS system is a computer system that processes money transfers on an
individual basis. RTGS stands for real time gross settlement. An instruction that
is entered into an RTGS system is immediately forwarded to a central bank's
account system. The central bank in question checks whether the paying bank's
balance is sufficient. If this is the case, the settlement instruction is irrevocable
and final and the central bank executes the settlement instruction immediately.
It debits the paying bank's account and credits the beneficiary bank's account.
The RTGS system for transfers in euros is called TARGET2. TARGET2 can be
accessed by all banks that have a banking licence in a euro country. Banks use
SWIFT MT202 messages to access the TARGET2 system. The RTGS system
for transfers in US dollars is Fed Wire, for transfers in Pound Sterling CHAPS
and for Japanese yens BOJ-Net.
Transfers that are sent to an RTGS system are processed individually and are
thus more expensive than transfers that are processed via a clearing system.
This why this system is almost exclusively used to transfer urgent and/or large
payments, high value payments. Money transfers that custodians send to Euro-
clear resulting from securities transactions are also always processed by
TARGET2. Figure 7.1 shows a transfer in euros from the French Banque
Paribas to the Italian Banca di Roma using TARGET2.
Figure 7.1 Interbank RTGA transfer from Banque Paribas to Banco di Roma
Banca di
Roma
TARGET
ECB
Banque Paribas -/-
Banca di Roma+
Account statement
Account statement
SWIFT-message MT 202
Payment instruction
MT 202
Banque
Paribas
60
2.2 Clearing systems
A clearing system is a computer system that processes large numbers of settle-
ment instructions simultaneously. The institution that operates a clearing sys-
tem, the clearing institution, acts as a central counterparty for the member
banks. The clearing system first sorts the settlement instructions and than calcu-
lates the most efficient manner of settlement for each member bank. In order to
achieve this, most clearing systems collect all settlement instructions daily and
balance these at the end of the day until the net amount to be credited or de-
bited per member bank is known.
A clearing institution holds an account at the central bank. It sends collection
instructions to the central bank for the debiting of net payers' accounts and the
crediting of its own account. It also sends settlement instructions chargeable to
its own account and payable to the net receivers' accounts. After the central
bank has executed these instructions, the clearing institution's account balance
is zero again.
The most frequently used clearing system for transfers in euros is Euro1. Euro1
is operated by the European Banking Association (EBA).
The settlement instructions that banks send through Euro1 are processed after
the cut-off time of TARGET2, i.e. the value date is the next day. This is why the
settlement instructions that are sent to Euro1 are mostly not urgent. Because the
amounts transferred are often not large, they are also referred to as low value
payments. Banks generally have settlement instructions in euros processed by a
clearing system if the amount is less than EUR 150,000.
In figure 7.2, the Spanish Banco Santander sends a payment instruction to the
ECB using the Euro1 clearing system. The EBA processes this instruction
together with the instructions it has received that same day from all other mem-
ber banks. The Euro1 clearing system calculates the balance to be paid or
received for each member bank based on all these settlement instructions. EBA
subsequently sends settlement instructions to the ECB using TARGET2. Next,
the ECB executes the settlement instructions. The EBA sends information about
each individual transaction to the beneficiary's bank (notification message), the
Anglo Irish Bank (AIB), in this case. AIB is not the final beneficiary in this
example, however. This is Sean Cork.
61
Figure 7.2 Transfer from Banco Santander to Sean Cork through the Euro1 system
3 Money transfers in foreign currencies
If a bank needs to transfer money to a foreign currency account held at another
bank, it must send a settlement instruction to its correspondent bank in the
country where the currency is the local currency. The correspondent bank in
turn sends a settlement instruction to the central bank in order to transfer the
amount to another local bank. In the case of a large amount, the correspondent
bank uses an RTGS system to do this and in the case of a small amount it uses a
clearing system.
The bank to which the correspondent bank has the amount transferred can be
either the final beneficiary or the beneficiary bank. In the latter case, the paying
bank must send an additional settlement instruction to the beneficiary bank in
order to have the final beneficiary's account credited.
AIB Group
Sean Cork
EURO1
EBA
ECB
Banco Santander -/-
EBA + and -/-
AIB Group +
Account statement Account statement
Settlementinstruction
Notification
Banco
Santander
TARGET2
Settlementinstruction MT103
Account statement
62
Figure 7.3 Transfer of a US dollar amount from ING Bank to Porsche through correspondent
banks
Figure 7.3 shows a transfer of US dollars instructed by the Dutch ING Bank
and chargeable to its nostro account at Bank of America (BOA). The benefi-
ciary is Porsche GMBH, that holds a US dollar account at Deutsche Bank. ING
sends an MT202 message to BOA. This is a SWIFT message that is used for a
transfer to an account held in the name of a bank, Deutsche Bank in this case.
BOA in turn sends a settlement instruction to the Federal Reserve Bank via the
Federal Reserve Bank RTGS system Fedwire, ordering it to debit its account
and credit JP Morgan Chase's account. This message also states that Deutsche
Bank is the beneficiary bank. The FED forwards this MT202 to JP Morgan
Chase and they in turn send a transaction statement to Deutsche Bank (MT910).
The transaction statement informs Deutsche Bank that its JP Morgan Chase
nostro account has been credited. Figure 7.4 shows the content of the MT202
message.
Deutsche
Bank
Porsche GMBH
ING Bank
JP Morgan
Chase
BOA
USA / Fedwire
MT 910
MT 103
MT202
Federal
Reserve
MT202 MT202
63
Figure 7.4 MT 202 sent by ING to Bank of America
If Deutsche Bank were to receive no further information, it would not know
who the beneficiary is of the amount that has been credited to its JP Morgan
Chase account. The money would then remain in an intermediary account at
Deutsche Bank. This is why ING sends an MT103 message to Deutsche Bank.
This is a settlement instruction with a non-bank entity as beneficiary, Porsche
GMBH in this case. ING also states the MT103 reference code in the MT202
message that it sends to BOA and JP Morgan in turn mentions this code in its
MT910 message to Deutsche Bank. This enables Deutsche Bank to recognize
the incoming amount. Figure 7.5 shows the content of the MT103 message.
SWIFT format Relevance of the information
Message header
Reference code 202998988
SWIFT code sender INGBNL2A ING sends the payment instruction
SWIFT code receiver BOFAUS3N BOA has to execute this instruction
Message text
Reference code MT
103
394882 Reference to the corresponding MT
103 message
Name and BIC code of
correspondent bank of
beneficiary’s bank
JP Morgan Chase
CHASUS33
BOA should know to which
correspondent bank the money
should be transferred
Name and BIC-code
of the beneficiary’s
bank
Deutsche Bank
Frankfurt
DEUTDEFF
BOA should know which bank is
the ultimate beneficiary’s bank
Value date, currency
code and amount
110325USD3,000,000 On 25 march 2011 an amount of
USD 3,000,000 has to be transferred
64
Figure 7.5 MT103 Message sent by ING to Deutsche Bank
SWIFT format Relevance of the information
Message header
Reference code 394882
SWIFT-code sender INGBNL2A ING sends the settlement instruc-
tion
SWIFT-code receiver DEUTDEFF Deutsche Bank has to execute the
settlement instruction
Message text
Reference code
MT 202
202998988 Reference to the corresponding
MT 202 message
Value date, currency
code and amount
110325USD3,000,000 On 25 march 2011 an amount of
USD 3,000,000 has to be transferred
Debit/credit Cred Deutsche Bank has to credit the
account of one of its clients
Name and BIC-code of
correspondent bank of
beneficiary’s bank
JP Morgan Chase
CHASUS33
Deutsche Bank should know which
of its own accounts will be credited
Name and BIC-code
correspondent bank of
payer’s bank
BOA New York
BOFAUS3N
In case its own account will not be
credited, Deutsche Bank should be
able to inform JP Morgan which
bank should have transferred the
money
Beneficiary’s name
and IBAN code
PorscheGMBH,
DEUTDEFF0123456
789
Deutsche Bank should know which
of its clients accounts it should
credit
Agreement on who
should bear the costs
BEN Porsche GMBH has to pay the
transfer fees
65
The header of every SWIFT message contains a reference code and the name
and SWIFT code of both the sender and receiver. The SWIFT code of a mem-
ber bank always consists of an eight-character letter/digit combination. The first
four characters are the financial institution's bank identification code (BIC). The
next two characters are the country code (in accordance with the ISO standard).
The last two characters represent the organization’s place of business. For
instance, the Swift code for Deutsche Bank in Frankfurt is DEUTDEFF, where
FF stands for Frankfurt.
An MT103 message text contains, among other information, the final benefi-
ciary's account number. For euro payments, this is an IBAN number. An IBAN
number consists of a two-letter country code, a two-digit control number that is
derived from the other parts, the BIC code of the beneficiary's bank and finally
the beneficiary's 10-digit account number. An MT103 message also says who
has to pay the costs of the transfer. The codes OUR, BEN and SHA are used for
this purpose. OUR means the party giving the instruction pays all costs, BEN
means the beneficiary pays all costs and SHA means that the costs are shared.
4 Bank holidays
Interbank payment instructions can only be executed when the computer sys-
tem of the interbank settlement institution, the central bank, is operational, i.e.
not on weekends or bank holidays. Bank holidays are days - other than week-
ends - on which the central bank is closed in a certain country, meaning that the
interbank payment system is not operational. The bank holidays in the euro area
are called TARGET days. Figure 7.6 gives an overview of the bank holidays in
the euro area, the United States and Great Britain.
66
Figure 7.6 Bank holidays in Europe, the US and the UK
In the case of a currency transaction, the central bank payment systems of the
two currencies being traded need to be operational on the same day. In the case
of currency transactions in Islamic or Jewish countries, the fact that their week-
end is on Friday and Saturday needs to be taken into consideration. In special
cases, the Islamic currency can be delivered on Sunday and the other currency
can be delivered on Monday, for instance. This must be taken into conside-
ration in the swap points, there is one less interest day for the Islamic currency
in this case.
TARGET days US Bank holidays UK Bank holidays
New Years Day New years Day New Year’s Day
Good Friday Martin Luther King Day
app. 15 January
Good Friday
Easter Monday Washington Day
app. 20 February
Easter Monday
Labour Day Memorial Day
app. 29 May
Early May
First Monday of May
Christmas Day Independence Day
4 July
Spring Bank Holiday
Last Monday of May
Boxing Day Labor Day
app. 4 September
Summer Bank Holiday
Last Monday of August
Columbus Day
app. 9 October
Christmas Day
Veterans Day
11 November
Boxing Day
Thanksgiving Day
app. 23 November
Christmas Day
67
Chapter 8
Securities settlement
Securities ownership by investors and securities traders is registered by custodi-
ans. The securities ownership of these custodians is in turn registered by cen-
tral securities depositories. These organizations are both also responsible for the
settlement of securities transactions. They carry out the transfer of securities
from the seller's to the buyer's securities account and often also the opposite
transfer of the associated money amount.
A clearing institution acts as the central counterparty for securities transactions
that are concluded through an exchange. It closes many contracts with all mem-
bers of the exchange every day. In order to allow the processing of the transac-
tions to proceed as smoothly as possible, the clearing institution balances all
transactions it has concluded with each individual exchange member at the end
of each trading day. The settlement of all exchange executed transactions takes
place via a securities account that the clearing institution holds at a central secu-
rities depository and a cash account that the clearing institution holds at the cen-
tral bank. More and more, clearing houses also act as central counterparty for
over-the-counter transactions.
1 Central securities depositories
A central securities depository (CSD) is an organization that registers the secu-
rities ownership of a limited number of parties and carries out settlement
instructions between the securities accounts of these parties. Euroclear Nether-
lands, for instance, is the local central securities depository for most Dutch
securities. Euroclear Netherlands is connected to a computer system in which
instructions for all Euronext exchanges can be deposited: ESES. ESES stands
for Euroclear Settlement of Euronext Zone Securities.
68
1.1 Account holders and responsibilities of a CSD
The entities holding accounts at CSDs are custodians and clearing institutions
(dealt with later in this chapter), issuers and other (usually foreign) CSDs. The
custodians and other CSDs are a CSD's real clients. They hold a securities
account at the CSD for each fund for which they, in turn, carry out the securi-
ties registration for the end investors. Clearing institutions hold securities
accounts at a CSD for each of the funds they provide the clearing for. With the
exception of issuing institutions and the clearing institution, every account
holder also has a cash account at the CSD.
CSDs register the securities ownership of both exchange traded securities and
securities that are traded exclusively over-the-counter, such as commercial
paper, certificates of deposit and medium-term notes.
Although the securities registration takes place by means of balances on securi-
ties accounts, the issuing institutions still need to produce one physical docu-
ment for each security they issue: a global note. The global note contains
information on the characteristics of the security concerned and the maximum
number of securities the issuer is allowed to issue.
1.2 The role of a CSD with the settlement of securities transactions
CSDs carry out the transfer of the securities resulting from securities transac-
tions. They also often carry out the transfer of the associated money amounts.
In the case of an exchange transaction, the CSD receives the settlement instruc-
tion from the clearing institution. In the case of an OTC transaction, the trading
partners each send a settlement instruction via the CSD computer system,
directly or through their custodian.
Initial public offerings and seasoned issues
New securities are created when initial public offerings take place. When asked
by the bank that services the issue, the CSD stores a global note for these secu-
rities and requests an international securities identification number, the, ISIN
code. It subsequently creates an account in name of the issuer in order to regis-
ter the not yet issued securities.
After the issue, the CSD creates a securities account for the new securities for
each of the banks that have subscribed for the issue and have been allotted the
new securities. The CSD subsequently transfers the securities from the issuer’s
account to these new securities accounts. At the same time, the CSD debits the
69
cash accounts belonging to the subscribing parties and credits the cash account
of the bank supervising the issue. The supervising bank, in turn, transfers the
issue proceeds to the issuer's account within its own account system.
In the case of a follow-up issue, also called seasoned issue, the global note is
increased and the new securities are again transferred to the issuer's account.
After the issue, these securities are again transferred to the securities accounts
of the parties that have subscribed for the issue. Securities that have been reim-
bursed by an issuer are also registered on the issuers account.
Exchange transactions in already issued securities
In the case of transactions in existent securities that are concluded through an
exchange, the CSD receives settlement instructions from the clearing institu-
tion after every trading day. These instructions are sent directly from the clear-
ing system to the CSD system. The instructions involve the CSD debiting the
clearing institution's securities account for a specific number of securities and
crediting another account holder's securities account, or vice versa.
The settlement of transactions in securities executed on the exchange normally
takes place three business days after the transactions have been concluded (t+3).
During the three interim days, all parties involved can check the transaction
details and settlement instructions in order to ensure that the settlement will be
executed properly.
Over-the-counter transactions
In the case of over-the-counter transactions between two professional parties,
the two contract parties both independently enter a settlement instruction into
the CSD computer system on the transaction date. Based on these instructions,
the CSD transfers a number of securities directly from the one account holder to
the other account holder on the settlement date and usually transfers an amount
of money in the opposite direction. The settlement of over-the-counter transac-
tions in securities normally takes place two business days after the transactions
have been concluded (t+2).
70
1.3 Execution conditions
Parties that conclude an OTC securities transaction can give two kinds of
instructions on how the settlement should take place: delivery versus payment
(DVP) and free of payment (FOP).
In the case of DVP, a CSD may only transfer the security from a securities
account if there are sufficient funds in the counterparty's cash account. If the
balance of both parties is sufficient, the transfer of the securities and the money
take place simultaneously. Therefore, parties that conclude transactions DVP do
not run any settlement risk. Transactions that are concluded through an
exchange are always processed DVP.
In the case of FOP, the transfers of securities and the money take place indepen-
dently. The CSD takes care of the transfer of the securities and the central bank
independently takes care of the transfer of the money. Because the CSD and the
central bank do not contact each other to check whether the opposite transfer
actually takes place, there is a chance that the securities are transferred while
the money is not, or vice versa. There is, therefore, settlement risk. This
explains why these terms of delivery are not often used.
Regardless of the execution conditions, the selling account holders must ensure
sufficient balances in their securities accounts for all securities transactions. If
this is not the case, they must temporarily borrow securities using a securities
lending transaction.
In the case of over-the-counter transactions that take place DVP, the account
holders that have bought securities must also ensure sufficient funds in their
CSD cash accounts. Because the CSD holds an account at the central bank, an
account holder can transfer money to its CSD cash account through the central
bank. Some account holders have a credit line at the CSD. This means that DVP
settlement can also take place if the buying account holder has insufficient
funds in its cash account, provided it remains within its credit limit.
In the case of exchange transactions, an account holder that has bought securi-
ties must ensure it has sufficient funds at the central bank. This is important
because the clearing institution, which is authorized to debit this account for the
money that needs to be paid on account of the exchange transactions, otherwise
doesn’t transfer the securities.
71
1.4 Feedback on the status of settlement instructions
The CSD shares information on the status of transfers related to OTC transac-
tions with both contract parties. It uses SWIFT messages for this purpose. If
both contract parties have deposited a settlement instruction at the CSD and the
data corresponds, the CSD indicates this using the code matched (MATC). If
one of the parties has not yet sent a settlement instruction or if there are diffe-
rences between the settlement instructions, the CSD indicates this using the
code unmatched (UNM). The CSD sends the party that has not yet sent a settle-
ment instruction a message with the status advised (ADV). Other examples of
codes that a CSD uses to indicate the status of a settlement instruction are given
in figure 8.1.
Figure 8.1 Examples of SWIFT codes that indicate the status of a transaction
1.5 The role of CSDs with the registration of foreign securities
Some CSDs carry out the securities registration for both domestic and foreign
securities. These CSDs are called international central securities depositories
(ICSD). Two examples of European ICSDs are Euroclear Bank and Clear-
stream. In order to be able to carry out the registration of foreign securities, an
ICSD does not need to store the global note associated with these foreign secu-
rities themselves. Instead, the CSD can open an account for these securities
with the CSD that does store the global note. This is customary in the case of
foreign securities.
Code Meaning
USEC The balance in the own securities account is insufficient
CSEC The balance in the counterparty's securities account is insufficient
PROV/WAIT The balance in the own cash account is insufficient
OK The settlement instruction has been executed
72
Figure 8.2 Accounts of an ICSD
Figure 8.2 shows parts of the securities accounts belonging to the Depository
Fund Company (the CSD in the United States) and to Euroclear Bank. The left
side of the Euroclear Bank’s balance shows the accounts is has at two other
CSDs. Because Euroclear does not store the global notes for American shares, it
has opened a securities account at the US CSD for funds such as Coca Cola,
Merck, etc. The Euroclear Bank also holds an account at Euroclear Netherlands
for Dutch shares. Euroclear Bank can now offer its own clients, for instance
SNS Securities or RBC Dexia, securities accounts in US and Dutch securities.
2 Clearing institutions
Securities clearing institutions are organizations that provide various services to
their members with respect to the processing of securities and derivatives trans-
actions. Clearing consists of three activities. The first activity is that the clear-
ing institution functions as a central counterparty. The second activity is that the
clearing institution cancels out opposite transactions with one and the same
counterparty. This is called netting. The third activity is that the clearing institu-
tion sends settlement instructions to the central securities depository and the
central bank. In that respect, they are authorized to have clearing members'
accounts debited.
CSD United States
Citibank
-Cocal Cola
-Merck-Ford
-Mc Donalds
EuroclearBank
-Coca Cola
-Merck
-Ford
-MCDonalds
BNY Mellon
-Coca Cola
-Merck
-Ford-MCDonalds
Euroclear Bank
Euroclear
Netherlands
-Heineken
-Royal Dutch-DSL
CSD VS
-Coca Cola
-Merck-Ford
-McDonalds
SNS Securities
-Coca Cola
-McDonalds
-Ford-McDonalds
RBC Dexia
-Coca Cola
-Merck-Ford
-McDonalds
Global Notes
VS Securities
73
LCH. Clearnet and EMCF are examples of European clearing institutions.
LCH.CLearnet carries out the clearing for the London Stock Exchange (LSE),
clears listed derivatives transactions for EDX London and clears swaps and
repos that are concluded over-the-counter through Swapclear and Repoclear.
European Multilateral Clearing Facility (EMCF) delivers clearing services for,
amongst others, Chi-X Europe and NASDAQ.
2.1 Clearing members
The parties that are affiliated with a clearing institution are called clearing
members. Clearing members are custodians. A custodian that wants to become
a clearing member must have a minimum amount of equity, the required
arrangements with a bank, employees that know enough about the instruments
that need to be cleared and access to computer systems that are fit for the pur-
pose.
Individual clearing members (ICM) may only process transactions of their own
organization. General clearing members (GCM) may also process transactions
for other exchange members such as small trading houses, securities firms, and
banks that are not clearing members themselves.
2.2 The clearing process for cash transactions
If an exchange's trading system has executed two orders against each other, a
clearing institution functions as central counterparty (CCP). Two contracts are
simultaneously concluded in this case. The selling exchange member sells the
securities or derivatives to the clearing institution and the buying exchange
member buys the securities or derivatives from the clearing institution. The
clearing institution subsequently concludes new contracts that set out the deli-
very obligations resulting from both transactions. Clearing members are the
counterparty in these contracts. They take over the settlement obligations from
the exchange members.
The clearing institution concludes many contracts related to the processing of
exchange transactions with each of the clearing members every day. In most
cases, opposite delivery obligations apply. After every trading day, the clearing
74
institution computer system balances the number of securities to be delivered
and received and the associated purchase and sale amounts for every clearing
member and every fund.
Example
On March 6th, Banque Paribas has completed 5,000 exchange transac-
tions. Among the transactions were the following transactions in the
French Danone share for three of its private clients:
Based on these transactions in the Danone share, Banque Paribas must
deliver 600 Danone shares to the clearing institution, the clearing institu-
tion must, in turn, transfer an amount of 25,950 euros to Banque Paribas.
The clearing institution carries out a calculation like the one in the above exam-
ple for every fund. This results in an overview of how many of each fund traded
in, each clearing member must deliver or receive from the clearing institution.
The clearing institution subsequently balances all money amounts per clearing
member resulting from the purchase or sale of each individual fund.
Example
The clearing institution has calculated the following net purchase and
sale data for Banque Paribas. Based on this information, the clearing
institution calculates how much Banque Paribas must pay or receive on
balance.
purchase/sale Number Price Total value pay/receive
sale 100 43.00 EUR 4,300 receive
sale 1000 43.20 EUR 43,200 receive
purchase 500 43.10 EUR 21,550 pay
balance sale 600 EUR 25,950 balance receive
75
Netted transactions per fund for Banque Paribas
Banque Paribas must pay the clearing institution an amount of 104,050
euros on balance.
After the completion of a clearing round, the clearing institution sends informa-
tion on the net payable and receivable amounts and the securities to be received
or delivered on balance, as well as a transaction overview for all individual
transactions on the trading day concerned to the clearing members. The clear-
ing members compare this information to the transaction information they have
received from their brokers and traders and any other exchange member for
whom they provide the clearing of exchange transactions.
The clearing institution also sends settlement instructions to the CSD and the
central bank. The settlement instruction to the CSD is an order to execute all
securities transfers generated by the clearing process. The settlement instruc-
tion to the central bank is an order to execute all money transfers generated by
the clearing process.
2.3 Risk management
Clearing institutions run the risk of a clearing member not fulfilling its obliga-
tions. However, the clearing institution must deliver to one clearing member
regardless of whether the other clearing member delivers. The clearing institu-
tion must also purchase from the one clearing member regardless of whether the
other clearing member purchases from it.
If a clearing member does not meet a securities delivery obligation, the most
extreme consequence is that the clearing institution must buy shares from a
third party in order to meet its own delivery obligation. A clearing house can
use a buy-in procedure for this purpose.
Danone sale 600 EUR 25,950 receive
AXA sale 10,000 EUR 90,000 receive
Credit Agricole purchase 20,000 EUR 300,000 pay
France Telecom sale 5,000 EUR 80,000 receive
EUR 104,050 pay
76
Buy-in procedure
If a clearing member does not have sufficient securities in its account on the
settlement date, the clearing institution immediately fines the clearing member
and temporarily suspends its own delivery obligation in that fund. If the clear-
ing member has still not met its obligations after seven days, the clearing insti-
tution can start a buy-in procedure. The European clearing institution
LCH.Clearnet, for instance, does this on the eighth business day. A buy-in pro-
cedure entails the clearing institution organizing a purchase auction, which is
announced publicly and to which anyone can subscribe. The clearing institu-
tion then selects the best sale offer, however bad it may be.
Example
A clearing member of LCH.Clearnet has concluded an exchange transac-
tion in which it has sold 100,000 Lloyds Group shares on February 15, at
a price of 70 British Pounds. On February 15, it becomes apparent that
the clearing member cannot fulfil its delivery obligation.
On February 25, the securities have still yet to be transferred to the clear-
ing member's CSD securities account and so LCH.Clearnet starts a buy-
in procedure. The lowest sale offer in the auction is 75 British pounds.
LCH.Clearnet accepts this offer and buys 100,000 Lloyds Group shares
for an amount of 7,500,000 British pounds.
As LCH.Clearnet will receive 7,000,000 British pounds from the origi-
nal opposite transaction, it loses an amount of 500,000 British pounds.
If a buying clearing member fails to meet its obligations, the clearing institu-
tion can start a sell-out procedure. This means that the clearing institution sells
the securities it has bought after at least seven days. The sell-out procedure is
identical to the buy-in procedure. The clearing institution must sell the securi-
ties to a third party in order to be able to meet its own purchase obligation. If
the price has fallen in the mean time, the clearing institution suffers a loss
resulting from this procedure.
The clearing institution recovers any losses resulting from buy-in or sell-out
procedures as much as possible from the clearing member in default. Every
clearing member must deposit an amount of money when concluding a transac-
tion in shares or bonds to offset any possible losses resulting from the counter-
party risk. This is called an initial margin. The initial margin is based on the
volatility of the underlying asset and the market liquidity in the underlying
asset.
77
As an extra security precaution, clearing institutions can force all clearing mem-
bers to deposit money in a guarantee depot, the clearing fund. If the initial mar-
gin of the defaulting member is not sufficient to cover the loss, the clearing
institution will withdraw money from this depot. The other clearing members
then each are held responsible for part of the loss.
2.4 The tasks of clearing institutions with derivatives
Clearing institutions that work for derivatives markets are responsible for the
processing of option premiums, the settlement of futures at maturity and the
(interim) execution of options. The clearing institution also functions as central
counterparty for derivatives transactions and requires collateral on a daily basis
to protect itself against counterparty risk.
Activities related to options and futures contracts
Clearing institutions that process options and futures calculate the net sums to
be paid and received per clearing member after every trading day. The cash
flows that a clearing institution includes in this process have to do with option
premiums, money transfers resulting from collateral obligations (margins) and
the settlement of options and futures. The net amounts are transferred the next
day.
If options are executed, the clearing institution plays an important role in the
process of appointing the writer of an option who has to fulfil his obligation.
This process is called assignment. If an options holder wants to make use of his
execution right, he must order his broker to do so. The broker passes this order
on to its custodian, who in turn uses an exercise note to pass it on to the clea-
ring institution.
As central counterparty, the clearing institution is the entity responsible for ful-
filling the obligation first. Because the clearing institution is only an intermedi-
ary from an economic point of view, it appoints a clearing member that must
fulfil the option obligation. The appointed clearing member in turn appoints one
or more brokers by way of another random selection procedure. And the broker
in turn appoints one or more clients. Both the broker of the executing option
buyer and the broker of the appointed option seller subsequently issue an order
to the stock market for the underlying transaction, so that it can be executed.
78
Derivatives transactions margins
Like with securities transactions, the clearing institution runs a counterparty
risk in the case of futures and purchased options. This is why it demands an
amount of money as collateral in the case of these transactions. This money
amount is called a margin. There are two kinds of margin in the case of futures,
the initial margin and the variation margin. Clearing members must impose the
margin obligations on their own account holders, too.
The initial margin is an amount of money that the clearing institution demands
when concluding a futures (or option) contract. At the maturity date, the clear-
ing institution returns the initial margin to the clearing member's cash account
at the central bank. This also applies if the clearing member closes its position
prior to maturity. As with cash transactions, the initial margin is based on the
volatility of the underlying asset and the market liquidity in the underlying
asset.
Variation margin or margin call is the daily offsetting of the profits and losses of
a futures contract. The closing price of a futures contract is determined at the
end of each exchange day. If this closing price is higher than the closing price
of the previous day, the clearing member that bought a future has made a profit.
The clearing institution deposits an amount equal to this day profit into the
clearing member's account at the central bank. If the closing price is lower than
the previous day, the clearing institution instructs the central bank to debit the
clearing institution's account at the central bank. Only the final day result is off-
set at the future contract's maturity. Together with the daily results that have
been offset throughout the maturity period, this forms the total result of the
futures transaction.
Example
A trader on the Chicago Board of Trade buys 10 Dow Jones Futures con-
tracts on Monday at a price of 11.502. The underlying value of a Dow Jones
Futures contract is 10 times the Dow Jones Index Average. On the trade
date, the initial margin for these contracts is set at 13,000 US dollars per
contract. The closing prices of the Dow Jones Futures contract throughout
the week are as follows:
Mon: 11.512, Tue:11.546, Wed: 11.532, Thu: 11.580, Fri: 11.623.
The amounts debited and credited on behalf of the initial margin and varia-
tion margin are as follows:
79
If the trader sells the Dow Jones Futures on Friday at the closing price of
11.623, he makes a profit that consists of the net total of all payments
and receipts on account of the variation margin:
100 + 340 - 140 + 480 + 430 = 1,210 US dollars.
This amount has been offset during the week via the central bank account
of the bank at which the futures trader works. After the close out transac-
tion, the clearing institution transfers the initial margin amount back to
this account.
Swapclear and Repoclear
The European clearing institution, LCH.Clearnet, also clears money transfers
resulting from interest rate swaps and money market transactions that have been
concluded over-the-counter. It has developed two systems for this purpose,
Swapclear and Repoclear. Clearing members that make use of these systems
must re-enter their over-the-counter transaction into these systems. Every origi-
nal bilateral over-the-counter contract is then replaced by two separate con-
tracts, with LCH.Clearnet being the counterparty. The cash flows resulting from
interest rate derivatives are calculated in Swapclear and offset on a net basis.
The same takes place in Repoclear for all money market transactions like repos
and deposits without collateral. LCH.Clearnet finally sends settlement instruc-
tions chargeable to its own account and collection orders chargeable to the
members' accounts at the central bank in order to have the net amounts trans-
ferred.
day initial margin variation margin
Monday -130,000 (11.512 - 11.502) * 10 = + 100
Tuesday (11.546 - 11.512) * 10 = + 340
Wednesday (11.532 - 11.546) * 10 = - 140
Thursday (11.580 - 11. 532) * 10 = + 480
Friday 130,000 (11.623 - 11.580) * 10 = + 430
80
3 Custodians
A custodian is a company that registers securities and settles securities transac-
tions on behalf of investment managers, investment funds, institutional inves-
tors, private investors and the financial markets divisions of banks. Custodians
are often a separate division of a bank. In addition to a securities account,
clients also hold cash accounts with custodians. Custodians in turn hold cash
and securities accounts at Central Securities Depositories. Custodians can func-
tion as a clearing member, in which case they are sometimes called clearing
custodians.
The clients' securities accounts are not formally held at the custodians them-
selves but at a separate company. Although it is true that this company is usu-
ally connected to the bank to which the custodian belongs, it is always a
separate legal entity. This arrangement has been chosen in order to ensure that
clients' securities ownership is separate from the bank's personal claims and
properties. Custodians are authorized to make changes to the securities accounts
held at the separate company.
3.1 Local and global custodians
A Dutch investor can hold a securities account at a Dutch custodian for all
Dutch securities. This is because every Dutch custodian holds a securities
account for all of these securities at Euroclear Netherlands. If an investor wants
to have an American security registered, they can usually do this at a Dutch
custodian, too. This is because Dutch custodians themselves hold securities
accounts at several foreign CSDs or at an ISCD like Euroclear Bank.
A custodian that offers securities accounts for securities that are registered at
foreign CSDs is called a global custodian. A custodian that only registers local
securities is called a local custodian. The advantage of a global custodian is that
an investor that invests in multiple countries does not need to use a separate
custodian for each security.
81
Figure 8.3 Accounts of a global custodian
Figure 8.3 shows how BNY Mellon holds accounts for Dutch securities at
Euroclear Netherlands and accounts for American securities at DTC, the Ameri-
can CSD. As such, BNY Mellon is a global custodian that is able to offer secu-
rities accounts for domestic and foreign securities.
3.2 Role of custodians in the settlement of securities transactions
Custodians are responsible for the settlement of securities transactions. A client
that sells securities (DVP delivery condition) orders its custodian to debit its
securities account on the transaction date and to credit the counterparty's securi-
ties account. The custodian first checks whether these securities are actually
present in the client's account. If the counterparty has a securities account at
another custodian, the custodian then immediately sends the CSD an instruc-
tion to have the securities transferred from its own account to the seller's custo-
dian's securities account. If all goes well, the counterparty's custodian
simultaneously sends an instruction to the CSD to have the money transferred.
If the data in the two instructions match, the CSD sends both custodians a mes-
sage with 'MATC' status. Both custodians forward this confirmation message to
their clients. The seller and buyer now know that the processing of their trans-
action has gone well so far.
The selling party's custodian must ensure that securities are in its CSD securi-
ties account on the settlement date. If all goes well, the counterparty's custo-
dian, in turn, will have transferred money to its CSD cash account. After the
CSD has checked both balances, it simultaneously effects the securities and
money transfers. Next, the CSD sends an message to both custodians stating the
Citibank
-Coca Cola -
-Merck-Ford
-Mc Donalds
BNY Mellon
-Coca Cola
-Merck
-Ford
-MCDonalds
Euroclear Netherlands BNY Mellon
Robeco
-Royal Dutch-Aegon
-TomTom
-Coca Cola -
-Merck-McDonalds
Global Notes
VS Securities
Euroclear
-Royal Dutch
-Aegon
-TomTom
-Staatsobligaties
Global Notes
NL Securities
CSD VS-Coca Cola
-Merck
-Ford
-McDonalds
Euroclear NL
-Royal Dutch-Aegon
-TomTom
-DSL 05/37
CSD VS-Coca Cola
-Merck
-Ford
-McDonalds
Rabo Securities
-Royal Dutch
-Aegon
-TomTom
-Staatsobligaties-CocalCola
-McDonalds
BNY Mellon
-Royal Dutch
-Aegon
-TomTom
-DSL 05/37
CSD United States (DTC)
82
settlement is OK. The selling party's custodian subsequently debits the selling
party's securities account and credits its cash account. Finally, the custodian
sends a transfer statement to the seller.
The buying party must ensure that the cash account it holds at its custodian has
a positive balance on the settlement date. The custodian must subsequently
transfer this money to its cash account at the CSD. After the custodian has
received the CSD settlement 'OK' message, it debits the monetary amount from
the client's account and credits the securities to its securities account. Finally,
the custodian sends a transfer statement to its client. If the delivery condition
had been FOP, the buying party's custodian would have needed to transfer the
money directly through its central bank’s account to the seller's cash account at
its custodian. The CSD would then transfer the securities to the buying party
regardless of any payment.
If both parties were to hold accounts at the same custodian, it would suffice for
this custodian to carry out internal transfers of the money and securities
between the seller and buyer's accounts within its own computer system.
Example
An asset manager sells 10,000 Heineken shares to an ING Bank trader
(broker) at a price of 30 euros. The asset manager's custodian is BNY
Mellon and the ING Bank's custodian is BNP Paribas.
Shortly after the transaction has been concluded, the asset manager
instructs BNY Mellon to transfer the shares to the ING Bank account at
BNP Paribas (DVP). BNY Mellon subsequently sends Euroclear Nether-
lands an instruction requesting it to debit its account for the Heineken
shares on the settlement date and credit ING Bank’s Heineken account at
BNP Paribas (DVP). The ING Bank also sends instructions to its custo-
dian, BNP Paribas. BNP Paribas subsequently sends an instruction to
Euroclear Netherlands (DVP) to transfer 300,000 euros to BNY Mellon
on the settlement date. Euroclear Netherlands immediately sends a mes-
sage to both custodians containing the instruction status, which is MATC
in this case.
On the settlement date, ING transfers an amount of 300,000 euros to the
cash account at BNP Paribas, which in turn has the ECB transfer it to its
Euroclear Netherlands (1) cash account. If the securities account of BNY
mellon has a sufficient balance, Euroclear Netherlands simultaneously
83
(DVP!) transfers the securities from BNY Mellon's account to BNP
Paribas' account and transfers the money from BNP Paribas to BNY
Mellon (2a and 2b).
Once the settlement is given the OK status, BNY Mellon (3a) and BNP
Paribas (3b) adjust their clients' cash accounts and Heineken securities
accounts balances in their own administrations.
3.3 The role of custodians with tri-parti repos
With tri-party repurchase agreements, a custodian takes over the collateral ma-
nagement activities of both contract parties. The custodian performs the admi-
nistration and calculates and executes all necessary margin payments. The cus-
todian is also responsible for the settlement of coupon payments. In case of a
coupon payment, the custodian will debit the money accounts of parties that on
balance have received collateral and transfers the coupon amounts to the par-
ties that on balance have pledged collateral.
Euroclear Netherlands BNY Mellon
ING Bank
-Royal Dutch
-Aegon
-TomTom
-Heineken + 10,000 (3b)-euro account + 300,000 (1)
-/- 300,000 (3b)
BNP Paribas
Asset Manager
-Royal Dutch
-Aegon-Heineken -/- 10,000 (3a)
-euro acc. + 300,000 (3a)
Global NotesNL Securities
Euroclear NL
-Royal Dutch
-Aegon-TomTom
-DSL
-Heieneken
Euroclear NL
-Royal Dutch
-Aegon
-TomTom
-DSL-Heineken
Fortis Securities-Royal Dutch
-Aegon
-TomTom
DSL
BNY Mellon
-Royal Dutch
-Aegon
-TomTom
-Heineken -/- 10,000 (2a)-euro acc. + 300,000 (2b)
BNP Paribas
-Royal Dutch
-Aegon-TomTom
-Heineken +10,000 (2a)
-euro acc. + 300,000 (1)
-/- 300,000 (2b)
Asset
Manager
ING Bank
transaction
instructioninstruction
instruction
instruction
84
4 Overview of the process of an exchange traded transaction
Figure 8.4 gives a global overview of the information flows related to the
closing and processing of an exchange transaction.
Figure 8.4 Closing and processing of exchange transactions
1. A client gives an order to the broker.
2. The broker, who is a member of the exchange, puts the order through to the
exchange.
3. The exchange sends information about each separate trade to the clearing
institution.
4. The clearing institution sends information about each separate trade and
about the total net settlement flows to the clearing members.
5. The clearing institution sends settlement instructions to the CSD (a) and to
the central bank (b).
6. After the settlement has taken place, the CSD sends account statements to
the clearing member.
7. The custodian sends an account statement to its client.
Exchange Clearing House
Closing of Securities transactions Processing of Securities transactions
Central Securities Depository
Central Bank
Bank /
Broker
Clearing
Member
Client
1
2
3
4
5a
5b
6
7
85
Chapter 9
Nostro reconciliation
The back office department of a bank's financial markets division usually has a
special department that is responsible for the most important checks with regard
to processing transactions in financial instruments. This department is usually
called operations control. The most important task of operations control is to
perform various reconciliations. In addition to this, operations control investi-
gates the causes of incorrectly performed settlements and imposes interest
claims on the internal or external parties responsible for the mistakes.
1 Reconciliation
Reconciliation is checking data for accuracy and completeness by comparing
two different sources. In the context of transactions in financial instruments,
reconciliation usually means checking whether the settlement of money has
been performed adequately, in other words, whether the right amounts have
been transferred to or from other parties. This is referred to as Nostro reconcili-
ation. As the reconciliation of settlements of money is one of the most impor-
tant controls for transactions in financial instruments, it is the responsibility of a
separate department. With many banks, this responsibility is given to the opera-
tions control department that is part of the back office. Some banks even place
the Nostro reconciliation activities outside the back office, within the finance
department, for instance.
The Nostro reconciliation involves comparing the movements on the accounts
in a bank's own shadow administration with the transfer statements of the orga-
nization with which the settlement has taken place, a cor-respondent bank or
custodian. Once the bank has received an account overview from the correspon-
dent bank or the custodian in charge of the external account, the data are com-
pared with those in the bank's own shadow administration. The reconciliation of
money settlements is performed by means of a separate reconciliation system,
86
such as IntelliMatch. The reconciliation system reports on settlements 'by
exception'. This means that a separate overview is drawn up of settlements that
somehow differ from the settlements in the shadow administration.
In addition to reconciling the money settlement, the operations control depart-
ment may also perform a number of other reconciliation activities, such as
1. reconciliation between the front office and back office systems;
2. reconciliation between the securities back office system and the custodians'
systems (custodian reconciliation);
3. internal deal reconciliation: check whether all internal transactions cancel
each other out so that they are eliminated in the official reports.
2 Investigations
Reconciliation systems generate a list of transfer differences on the basis of a
comparison of the shadow administration with the transfers reported by the
external parties. The list contains four categories of differences.
1. The shadow Nostro account in the shadow administration has been
credited and the Nostro account has not been credited.
2. The shadow Nostro account in the shadow administration has been
debited and the Nostro account has not been debited.
3. The Nostro account has been debited, but this does not appear in the shadow
administration.
4. A Nostro account has been credited, but this does not appear in the shadow
administration.
If the reconciliation brings to light a difference, a separate department is called
in to identify the cause. This department is called investigations. The investiga-
tions department will try to find out which party is responsible for the mistake.
Each of the above categories requires a different approach. The investigations
department always first investigates the mistakes that could lead to interest
claims from other banks.
1. The investigations department will contact the counterparty in order to find
out whether it has actually transferred the amount. If the counterparty admits
to having made the mistake and is not able to rectify this on the same value
date, an interest claim will be drawn up. To this end, the investigations
department will send the necessary information to the compensation depart-
ment. If the counterparty indicates that it was not required to make a trans-
87
fer, the shadow transfer in the internal system is probably incorrect.
Investigations must now find out which shadow transfer should have been
made instead.
2. The investigations department will investigate whether a settlement instruc-
tion indeed has been sent to the correspondent bank. If this is the case, the
investigations department will contact the correspondent bank in order to
find out why the transfer has not yet been carried out. If the mistake lies
with the correspondent bank, any possible interest claim filed by the coun-
terparty will, in turn, be submitted to the correspondent bank.
If the correspondent bank has not been sent a settlement instruction, there
are two possible causes:
a. The settlement instruction was never sent. After checking with the back
office, Investigations will then immediately have a settlement instruction
drawn up manually.
b. A settlement instruction has been sent to the wrong account. In this case,
the investigations department will ensure that a correct settlement instruc-
tion is sent after all. Following this, it will contact the bank to which the set-
tlement instruction has mistakenly been sent, requesting for the transfer to
be reversed as quickly as possible.
In both cases, the investigations department must find out who is responsi-
ble, the front or back office.
3. In this scenario, the internal transfer may yet have to be made and the inves-
tigations department will have to find out whether it is on the way. Another
possibility is that the reconciliation system has identified another open item
in the shadow administration, in which another Nostro account has been de-
bited in the same currency This means a settlement instruction has been sent
to the wrong bank. This scenario is basically the same as that described
under 2b.
4. Investigations will contact the bank that has sent the settlement instruction.
This bank must see to it that the settlement instruction is cancelled. For the
sake of reputation, erroneously received sums are returned as quickly as pos-
sible. If the counterparty maintains that it was definitely required to make a
transfer, the shadow transfer was incorrect. Investigations must now find out
which shadow transfer should have been made.
88
3 Compensation
If an error in the settlement is discovered too late, it cannot be rectified on the
same value date. The result is that there is too little money on the beneficiary's
account for one or more days and interest costs will be incurred. The benefi-
ciary may submit an interest claim to recover these interest costs. The amount
of the claim is calculated on the basis of a certain interest rate percentage of the
transfer sum and the number of days by which the transfer is delayed. The inter-
est rate used is money market benchmark e.g. EONIA, SONIA or fed funds.
Claims on other banks are always submitted, claims on clients are sometimes
not, depending on the circumstances. The department responsible for drawing
up interest rate claims is sometimes referred to as Compensation.
Example
Dexia Bank sells 10 million Swiss francs to Fortis Bank with value date
March 15. The Fortis Bank FX trader indicates that he wishes the Swiss
francs to be delivered to his UBS account. The standard settlement
instructions for Fortis Bank, however, state that Credit Suisse is the cor-
respondent bank. The Dexia trader fails to pass on the irregular settle-
ment instructions to the back office, so that on March 15 the Swiss francs
amount is transferred to Credit Suisse in accordance with the standard
instructions.
On March 16, Fortis Bank Investigations contacts Dexia Bank Investiga-
tions about this mistake. Dexia Bank Investigations immediately has a
settlement instruction sent to its Swiss francs correspondent bank in
favour of UBS with Fortis Bank as final beneficiary. Next, Dexia Bank
Investigations contacts Credit Suisse to request for the Swiss francs sum
to be debited from the Fortis Bank account in favour of its own account
at Credit Suisse.
As a result of this error, Fortis Bank may claim that for the duration of
one day its account with UBS showed an unduly overdraft. As a result,
Fortis will probably submit a claim.
Dexia Investigations will hold the FX trader responsible for the wrong
settlement and will submit Fortis Bank's possible interest rate claim to
the front office which will reduce the trader’s profit.
89
Chapter 10
Treasury systems
When capturing and completing transactions in financial instruments, banks
make use of treasury systems that must offer all of the functions needed to close
and process transactions. These systems must be capable of capturing trade
details, creating confirmations and sending settlement instructions. Also, they
must be able to exchange information with other systems at the bank, such as
the accounting system and the ledger, and with external systems such as
SWIFTNet and systems of data vendors such as Thomson Reuters and
Bloomberg.
1 Front office and back office systems
A front office system is a system whereby transaction information is entered
after a trader or salesman has entered into a transaction. Before a trader can
complete a transaction, he needs information about current market prices and he
must be able to check that no limits will be breached as a result of the transac-
tion. The trader must enter information to this end in the front office system
before concluding the deal. Once a transaction has been completed, the trader
wants to keep track of his results and the extent of market risk of his position.
The most important functions of front office systems are position keeping, valu-
ation, calculating results and measuring market risk.
Front office systems have interfaces with information systems of data vendors
like Eikon, the combined information/trading system of Thomson Reuters, with
a counterparty limit system, with electronic trading systems and with the back
office system. If a financial institution makes use of multiple front office sys-
tems, these systems all interface with a central market risk system. In a front
office system, the market risk of one or a limited number of activities is mea-
sured. In the central market risk system, the market risks are then combined.
Correlations between the risk of the relevant trader and the market risk of the
other trading positions of the bank are then taken into account.
90
A back office system is a computer system that generates information related to
transaction processing. Back office systems serve the following functions:
� process confirmations;
� create payment instructions;
� create notification messages with regards to the fixing of interests rates,
interest payments and dividend payment;
� create information needed for journal entries.
When transactions are carried out through an exchange system or a system such
as Marketwire, they are automatically confirmed by these external systems. The
back office system then does not need to create an additional confirmation.
Most back office systems have the option to identify the status of each transac-
tion and generate queues of transactions in a particular phase of the settlement
process, such as all transactions for which confirmation has been sent, but
which have yet to be confirmed by the counterparty. All back office systems
have an interface with the front office system, SWIFTNet or with another pay-
ment system and the accounting system (ledger).
Most major banks use more than one front and back office system. For cap-
turing simple instruments they use other systems than those used for complex
derivatives. Some systems, however, are able to process all types of instru-
ments.
2 Information exchange between systems
The exchange of information between computer systems within an organiza-
tion takes place through interfaces. Banks also exchange information between
one another, e.g. when sending confirmations or settlement instructions. A party
that has concluded a transaction in a financial instrument that involves a pay-
ment obligation to the other party, for example, must instruct the institution
where his account is held to debit the account in favour of the counterparty. If a
party is connected to the computer system of the institution where his account is
held, such a settlement instruction can be entered directly into that system. Non-
banks, for instance, usually have a direct link to the payment system of their
bank or the computer system of their custodian.
Banks are not usually linked directly to the computer systems of other financial
institutions. Settlement instructions that financial institutions send to one
another are therefore not directly exchanged via interfaces between their com-
puter systems, but are often sent over a computer network that has been specifi-
cally developed for this purpose, SWIFTNet.
91
Back office systems are also sometimes linked to external reconciliation sys-
tems, such as TriResolve from TriOptima or clearing systems such as Swap-
clear and Repoclear from LCH.Clearnet.
3 Static data and standing files
Banks enter fixed information into their systems where possible in order to
ensure that this information does not need to be re-entered with each new trans-
action. Such fixed data is known as static data. Static client data includes
names, addresses, account numbers and standard settlement instructions (SSI).
For each new financial instrument, static data is also entered such as the inte-
rest calculation method, currency type and ISIN code (international securities
identification code). The use of static data reduces the risk of input errors. Static
data is recorded by a separate unit within the back office department.
Besides static data, a number of other matters must also be recorded such as
which entries must take place in accounting for a particular transaction or a list
of bank holidays. All fixed data is stored in standing data files, which are also
known a standard data tables. Both, front office and back office systems are
capable of holding static data. However, sometimes a separate data system is
used for this purpose.
Figure 10.1 Examples of static data
File Information stored
Client file ���� Name and adress
���� SWIFT-code / BIC-code/ Account number (IBAN)
���� Authorized personnel
���� Location of head office
Deals file Data of closed deals
Currency file ISO codes of all relevant currencies
Holiday file Bank holidays of all relevant currencies
Business code file Internal and external branch code
Ratings file Rating categories of the different rating agencies and
own rating categories
Trade or deal type file List of codes to classify a transaction
Accounting rules file List of required journal entries
92
4 Capturing deals in the ledger
In order to capture the data of a transaction from a back office system in an
accounting system (ledger), the transaction data must be converted into journal
entries. Banks have established accounting entry rules for this purpose. These
rules state which journal entries must be made during the term of a contract.
Accounting entry rules are captured in a separate system or in a separate mo-
dule in the back office system. This separate system or part of the back office
system is known as a rules engine or accounting entry generator (AEG). The
AEG is powered by (a different part of) the back office system and creates jour-
nal entries for all events based on transaction data.
Figure 10.2 shows an example of an overview of journal entries that must be
made related to a fixed-income instrument in a foreign currency.
Figure 10.2 Journal entries of a fixed-income security denominated in a foreign currency
Journal entries are sent to the ledger through an interface. Broker fees and ope-
rating costs are also included in this ledger. The financial markets ledger is, in
turn, linked with the bank's general ledger. Information is also sent from the
financial markets ledger to a system in which reports are processed for the cen-
tral bank. Figure 10.3 gives an simplified overview of the total flow of informa-
tion related to a transaction in a financial instrument.
Event Entry
Trade date buy Deal capture buy
Trade date sale / Redemption date Deal capture sale
Each day Interest accrual
Each day Revaluation of FX-rate
Coupon date Interest settlement
93
Figure 10.3 Information flow through different treasury systems
5 Computer systems requirements
Financial institutions today depend entirely on computer systems for their busi-
ness operations. A financial enterprise must be certain that these systems meet a
number of conditions. Firstly, computer systems must be adequately secured.
Secondly, they must be able to reliably provide all the relevant data. Third, they
must process all data correctly. Finally, the data provided by the computer sys-
tems must always be available (in time).
Access control and confidentiality
Data should be confidential and only be accessible to authorized personnel, who
are allowed to perform certain activities or to access certain information in a
computer system. In order to ensure this, employees have to use an assigned
log-in code and a password to access the parts of the system they need to per-
form their specific tasks. This procedure is called authorization. Organizations
must make sure their employees do not know the passwords of their col-
leagues, so that they cannot use authorizations other than their own. If they are
able to do so, the necessary separation of functions may be compromised. Also,
AEGFO system BO systemFinancial Markets
ledgerGeneral ledger
Central Bank
reporting system
Central Bank
Cost System
Management
Information systems
94
authorization mix-ups can make it more difficult to establish who is responsi-
ble for possible unlawful actions. It is important that the authorizations of
employees are frequently monitored by a periodic scan of user rights.
Example
In 2008, the access control is said to be compromised at Société Ge-
nerale when Jérome Kerviel seemed to be able to use an authorization
assigned to him at one of his previous functions. Therefore, he was able
to conclude major futures transactions at the banks risk and expense. A
periodic scan of user rights could have prevented this.
Another measure taken by banks to ensure data confidentiality is to communi-
cate with other financial institutions almost exclusively through the SWIFT net-
work. This reduces the chance of messages being altered by unauthorized
personnel or people outside the bank.
Integrity
Integrity means the certainty that the computer systems process all relevant data
correctly. A valuation system is an example of a system that is vulnerable to
integrity. The range of structured products available, for instance, is incredible
and they are sometimes very hard to value. Financial institutions even make
provisions against erroneous calculations of the value of some instruments.
The integrity of data of large financial institutions is also jeopardized by the fact
that they usually consist of multiple business units with offices all over the
world and the input provided by the various business units should be centra-
lized at one point.
Banks, for instance, often have more than one dealing room, requiring the posi-
tion information of the traders to be brought together from the local systems in
a central system via interfaces. If these interfaces are badly programmed, the
information from the local systems fed into the central system may be incom-
plete or inaccurate. This means a bank may not have a clear view of its total
position and its risk may be wrongly assessed.
Accuracy
Computer systems often gather information from other systems and transpose
it. A bank must be certain that the data provided by each supply system are
accurate.
Static data are a well-known example of data collected from other computer
systems. If the static data have been entered incorrectly, all systems using those
data will be affected. Errors in static client data, for instance, may result in an
95
incorrect confirmation being sent or an incorrect settlement of a transaction.
These, in turn, may lead to damage claims and loss of credibility. Clients dis-
like administrative errors and will often deal with major or consecutive errors
by temporarily terminating the relationship and moving to another bank.
Availability
Systems must be continuously operational and therefore secured against
viruses, power cuts and suchlike. Many financial institutions have backup sys-
tems to ensure that business will continue as usual if the actual systems mal-
function. Many also have back up dealing rooms. In many countries, the
regulators demand banks to have a business continuity plan (BCP) in place. A
BCP is a logistical plan that outlines the measures an organization must take to
recover in case of severe disruptions. Among other things, a BCP states which
employees play a key role in restarting business activities and what these
employees must do in the event of a disaster. A BCP also includes a disaster
recovery plan (DRP), which outlines the IT measures necessary for recovery.
This plan describes the most important applications and how they can be
restarted as quickly as possible. A BCP also includes measures aimed at pro-
tecting static data and stored transaction data from destruction and/or misuse.
Computer systems must also have sufficient spare capacity to be able to cope
with increasing volumes and new product variations. When a new system is
being bought or developed, the users should therefore have a major say. After
all, they are the ones who can best assess future requirements. Conversely, IT
staff should have a major say in the development of new product variations, as
they will have to ensure that the systems can cope with the new product.
96
97
Chapter 11
Money market instruments andinterest calculations
The money market is the market in which interest related financial transactions
with a short term take place. Traders normally only consider transactions with a
term shorter than one year as money market transactions. The most important
function of the money market is to enable parties with temporary liquidity sur-
pluses (lenders) to give short-term loans to parties with a shortage of money
(borrowers). The lenders receive compensation, the money market interest. The
traditional financial instruments on the money market are deposits, money mar-
ket paper and repurchase agreements. The majority of money market instru-
ments are concluded over-the-counter.
1 Deposit
A deposit is the placement of money by a party with another party for an agreed
period of time and at an agreed interest rate. The party that lends the money has
the advantage of a higher interest rate than the remuneration on his current
account. The minimum maturity period for a deposit is one day (call deposit or
overnight deposit). Common maturity periods are one, two and three weeks and
one, two, three, six and twelve months. The majority of deposit transactions on
the money market are usually interbank deposits. The settlement flows of a
deposit consist of a transfer of the principal at the beginning of the period
(t+2 where ‘t’ stands for transaction date) and an opposite transfer of the princi-
pal plus the interest amount at maturity. A money market loan has the same
characteristics as a deposit, it is a short-term loan to a company or lower
government authority with a fixed maturity period and a fixed interest rate.
98
2 Calculation of interest amounts
Interest amounts are normally paid out in arrears and are calculated using the
following equation:
Interest amount = Principal x interest rate x daycount fraction.
Because interest rates are always presented per annum, a correction factor is
applied to bring the interest rate in line with the maturity period. This correc-
tion factor is called the daycount fraction.
The equation to calculate the daycount fraction is:
.
2.1 The duration of the coupon period
The start date of a coupon period is normally a fixed number of days later than
the (re)fixing date of the interest rate. The first coupon period of a loan starts at
the settlement date of this loan. That is, when the nominal amount is trans-
ferred from the lender to the borrower. With money market deposits, this is nor-
mally two working days after the closing of the loan agreement (t+2). With
exchange traded bonds, normally after three working days (t+3). With an inte-
rest rate derivative the first coupon period normally starts on t+2. If the interest
rate is refixed periodically during the term of a contract, the coupon period
starts two working days after the fixing date.
The end date of a coupon period is called the coupon date. On this date the cou-
pon is paid. The coupon dates of regular periods (1, 2, 3 months etcetera) nor-
mally fall on the same day in the month as the start date. There are, however,
exceptions to this rule.
If the coupon date falls in a weekend or on a bank holiday, the coupon can not
be paid on this date. This is because the central bank’s payment system is not
operational on these days. The coupon date will then be adjusted to the previ-
ous or the next business day according to the convention agreed upon in the
market or in the specific contract.
The most used conventions are ‘following’ and ‘modified following’. With the
convention following, the coupon date will be postponed to the next business
day. This is also the case with the convention modified following with one
exception, however. If the adjusted coupon date would fall in the next month,
Daycount fractionnumber of days in coupon period (tenor)
year basis-------------------------------------------------------------------------------------------------=
99
the coupon date is set on the previous business day. In the money market, nor-
mally, the modified following convention is used. This is also the case in ISDA
agreements.
Figure 11.1 shows the maturity dates of the regular periods for trading day
13 April 2009.
Figure 11.1 End dates of regular periods
If the spot date falls on a month ultimo date, i.e the last trading day of a month,
all regular dates will in principle be set on a month ultimo date too. Additio-
nally, the modified following convention is applied. In this case, the convention
is referred to as end-of-month convention (EOM). Figure 11.2 shows the matu-
rity dates for several regular periods for trading day 28 April 2009.
Figure 11.2 EOM value dates
period date day remark
spot 15/4/2009 Wed
1 month 15/5/2009 Fri
2 months 15/6/2009 Mon
3 months 15/7/2009 Wed
4 months 17/8/2009 Mon 15/8 is Sat
5 months 15/9/2009 Tue
6 months 15/10/2009 Thu
period date day remark
spot 30/4/2009 Thu
1 month 29/5/2009 Fri 31/5 is sun
2 months 30/6/2009 Tue
3 months 31/7/2009 Fri note: 31st
4 months 31/8/2009 Mon note: 31st
5 months 30/9/2009 Wed
6 months 30/10/2009 Fri 31/10 is sat
100
If the coupon date of a long term contract is adjusted, the question is whether
the coupon term should be adjusted too. Again, two different conventions may
be used: adjusted and unadjusted. Adjusted means that the number of the inte-
rest days is adjusted to the new coupon date. Unadjusted means that the num-
ber of interest days stays unchanged.
The number of days in a coupon period is calculated by including the start date
and excluding the end date.
Example
A deposit starts on 4 April and ends on 23 May.
The number of interest days is 49: 27 in April and 22 in May.
2.2 Daycount conventions
There are different methods to calculate daycount fractions. These are called
daycount conventions. Which daycount convention applies depends on the type
of interest instrument traded and on the country where this instrument is traded.
There are two types of daycount conventions. They differ in the way that the
number of days in a coupon period is calculated, the tenor. With the first type,
the number of days in each month is set at 30. With the second type, the actual
number of calendar days is calculated.
Daycount conventions 30/360
With daycount convention 30/360, the number of interest days is calculated by
setting each whole month that falls within the coupon period at 30 days, in prin-
ciple. The intervening ends of months dates are also set at 30. The year basis is
always set at 360.
Figure 11.3 shows some examples of calculations of the number of days accor-
ding to the 30/360 convention.
101
Figure 11.3 Examples of the calculation of the number of days with daycount convention 30/360
1. There are two ways of calculating the number of interest days:
a.
from 14-3 to 14-9 are six whole calendar months: 6 x 30 = 180 days.
b.
Number of interest days in March: 30 - 13 = 17;
Number of interest days April to August: 5 x 30 = 150;
Number of interest days in September: 13;
Total: 180 interest days.
2. Again there are two ways to calculate the number of interest days:
a.
from 14-2- tot 14-4 are two whole calendar months: 2 x 30 = 60 days.
b.
Number of interest days in February: 30 - 13 = 17;
Number of interest days in March: 30;
Number of interest days in April: 13;
Total: 60 interest days.
3. Number of interest days in January: 30 - 27 = 3;
Number of interest days in February: 9;
Total: 12 interest days.
4. Number of interest days in February 30 - 13 = 17;
Number of interest days in March: 4;
Total: 21 interest days.
5. Number of interest days in February: 30 - 13 = 17;
Number of interest days in March: 4;
Total: 21 interest days.
Start date End date # Days 30/360
1. 14-3-2009 14-9-2009 180
2. 14-2-2009 14-4-2009 60
3. 28-1-2009 10-2-2009 12
4. 14-2-2009 5-3-2009 21
5. 14-2-2008 5-3-2008 21
102
There are a few alternative applications of the 30/360 daycount convention.
These alternatives all have their own exceptions to the rule that the month
ultimo is set at 30. The most frequently used 30/360 daycount convention is
bond basis. With the bond basis convention, exceptions are made in the follow-
ing cases:
1. if a coupon period starts or ends on 28 or 29 february;
2. if a coupon period ends on the 31st and at the same time doesn’t start on the
30st or 31st.
In these cases, the ultimo dates are not set at 30. Figure 11.4 shows examples of
these exceptions.
Figure 11.4 Exceptions with daycount convention 30/360
1. Start date 31-8 is not an exception and will be set at 30;
End date 28-2 is an exception and stays 28;
Number of interest days: 5 x 30 + 28 = 178.
2. Start date 28-2 is an exception and stays 28;
End date 4-3 stays 4;
According to the general rule the intervening February month ultimo date
will be set at 30;
Number of interest days: 3 in February and 3 in March add up to 6.
3. a
Start date 28-2 is an exception and stays 28;
End date 31-3 is also an exception and stays 31; this is because the coupon
period doesn’t start at the 30st or 31st;
Number of interest days: 3 in february and 30 in March add up to 33.
b.
From 28-2 tot 28-3 is 30 days (one whole month);
Start date End date Start date
acc. to
bond basis
End date
acc. to
bond basis
# Days
1. 31-8-2009 28-2-2010 30-8-2009 28-2-2010 178
2. 28-2-2009 4-3-2009 28-2-2009 4-3-2009 6
3. 28-2-2009 31-3-2009 28-2-2009 31-3-2009 33
4. 13-3-2009 31-3-2009 13-3-2009 31-3-2009 18
103
From 28-3 tot 31-3 is 3 days;
Total number of interest days is 33.
4. Start date 13-3 is an exception and stays 13;
End date 31-3 is also an exception and stays 31; this is because the coupon
period doesn’t start at the 30 or 31;
Number of interest days is18.
Apart from 30/360 bond basis there are two other alternative 30/360 daycount
conventions: 30E/360 Eurobond and 30E/360 ISDA. With these alternatives
only the ultimo date of February (28 or 29) is an exception. With 30E/360 euro-
bond, a start or end date of a coupon period that falls on the ultimo date of Fe-
bruary is not set at 30. With 30E/360 ISDA this is only the case with the last
coupon. If these exceptions apply, the start or end dates stay unchanged at the
28th or 29th.
Daycount conventions actual
With daycount conventions ‘actual’ the exact number of calendar days is calcu-
lated for a coupon period. The year basis, however, can differ.
With daycount convention actual/360, for instance, the year is set at 360 days.
This daycount convention is used on the money markets in the euro area, in the
US, in Switzerland and on the Japanese money market. With the daycount con-
vention actual/365, the year is set at 365 days. This is the case in the UK money
market and, for instance, in Australia, New Zealand, Singapore and Hong
Kong.
Example
A bank invests in a deposit with a principal of 20 million euros and an
interest rate of 3.2%. The start date is 4 April and the end date is 23 May.
In order to calculate the interest amount, first, the number of interest
days must be calculated. In April, 30 - 3 = 27 days are included (the first
three days of April do not count, April 4th does). In May 22 days are
included (May 23rd does not count). The total number of interest days,
therefore, is 27 + 22 = 49 days.
The interest amount for this deposit is:
EUR 20,000,000 x 3.2% x 49/360 = EUR 87,111.11
With the daycount convention actual/actual the number of days in the coupon
period and the number of days in a year are both set at their actual number. In
regular years the year is set at 365 and in leap years at 366. This daycount con-
vention is used with most government bonds.
104
A deposit runs from 15 February 2008 (leap year) to 20. March. Figure 11.5
shows the daycount fractions according to the different daycount conventions.
Figure 11.5 Comparison of daycount fractions with different daycount conventions
Special cases of the actual/actual convention
If part of a coupon falls in a leap year, with daycount convention actual/actual,
the daycount fraction is calculated by splitting up the coupon period in one part
that falls within the leap year and another part that falls within the regular year.
The following equation is used in these cases:
.
Where:
dl= number of days in the leap year
dr = number of days in the regular year
Example
A German Government bond with a nominal value of EUR 1,000 has a
coupon of 4.5% with daycount convention actual/actual. The coupon
date is 1 October. On 1 April 2008 an investor buys this bond. The day-
count fraction for the expired period is:
.
The accrued interest of this bond is
EUR 1,000 x 0.50068 x 0.045 = EUR 22.53.
Daycount
convention
# Days in cou-
pon period
Year basis Daycount
fraction
actual/ 360 (29-14)+19=34 360 34/360
actual/actual (29-14)+19=34 366 34/366
actual/365 (29-14)+19=34 365 34/365
30/360 (30-14)+19 = 35 360 35/360
Daycount fractiondl
366---------
dr
365---------+=
Daycount fraction92
365---------
91
366---------+ 0 25205, 0 24863,+ 0 50068,= = =
105
3 Repurchase agreement
Repurchase agreements (repos) are contracts for selling securities, containing
an agreement that the securities will be bought back after a certain time period.
Repos can be regarded as money loans for which the borrower gives securities
as collateral. As opposed to a normal loan with securities as collateral, how-
ever, with a repo the money lender has legal ownership of the securities during
its term. The party that lends the money and receives the securities as collateral
calls this transaction a reverse repo.
The maturity period of a repo is usually less than two weeks and is sometimes
as short as a single day. Some repos are at notice, which means that the money
lender can revoke the contract, with or without a certain prior period of notice.
Repurchase agreements are widely used by central banks with the execution of
their monetary policy. The refinancing transactions of the European Central
Bank are repurchase agreements, for instance.
The amount of money that is transferred at the beginning of a repo is called ini-
tial consideration. The initial consideration is related to the value of the colla-
teral. It is the dirty price in the case of bonds, i.e. including accrued interest.
The size of the amount at maturity is called maturity consideration. The matu-
rity consideration equals the initial consideration plus a coupon that is based on
the repo rate.
Example
The market value of a portfolio of bonds is EUR 50 million. The matu-
rity period of the repo is seven days and the repo rate is 4.00%.
The maturity consideration of this repo is
EUR 50,000,000 x (1 + (7/360 x 0.04)) = EUR 50,038,888.89.
Sell/buy back
A financial instrument that resembles a repurchase agreement is a sell/buy back.
A sell/buy back also concerns a loan that is taken out with securities as colla-
teral. Incidentally, the money lender calls a sell/buy back transaction a buy/sell
back transaction.
106
In the case of a repo, an interest rate is determined as a payment for lending the
principal and, in the case of a sell/buy back, a separate price is determined for
the sale of the stocks at the beginning and for the purchase of the stocks at the
end of the transaction. The difference between these two rates is the renumera-
tion for borrowing the money.
The main difference between a repo and a sell/buy back transaction, however,
becomes apparent when there is a coupon payment over the collateral during
the transaction period. In the case of a repo, the party that holds the collateral
transfers the amount received by him directly to the party that has supplied the
securities as collateral. In the case of a sell/buy back transaction, the coupon
payment is included in the price for the second securities transaction.
4 Money market paper
Money market paper is a fixed-income security with a term shorter than two
years that is issued through a lending programme. The nominal value or face
value of money market paper is always a multiple of one million. It is thus only
suitable for large investors.
Commercial paper
Commercial paper is a type of money market paper that can be issued by all
kinds of market parties. However, the issuing institutions are usually compa-
nies or local of regional government authorities.
Commercial paper is issued on a zero-coupon basis. This means that the inves-
tor buys the security at a price that is equal to the present value of the commer-
cial paper’s face value. At maturity, the investor receives the face value of the
commercial paper. The investor's yield is determined by the difference between
the buying price and the face value.
The price of a commercial paper is, therefore, calculated by using the equation
of the present value. The interest rate used in this equation is also referred to as
yield.
.price (present value)Face value
1 interest rate (yield) daycount fraction×+( )------------------------------------------------------------------------------------------------------------=
107
Example
An investor wants to buy a commercial paper with a term of 91 days and
a nominal value of EUR 100 million. The yield is 0.05. The price the
investor has to pay is:
Treasury bills
A Treasury bill is a money market paper issued by the American or British cen-
tral government. At maturity, a Treasury bill is paid back at face value. The
price of a Treasury bill at purchase is determined using the pure discount rate
(PDR). This involves calculating an interest amount on the face value and sub-
tracting it from the face value:
Price = Face value -/- Face value x PDR x daycount fraction.
Example
A UK Treasury bill with a 91 days maturity period has a face value of
GBP 50 million. The pure discount rate is 4.25%.
The price of this Treasury bill is:
GBP 50,000,000 -/- GBP 50,000,000 x 0.0425 x 91/365 =
GBP 49,470,205.50.
Bank bills/bankers' acceptances
A bank bill or banker's acceptance is a money market paper that is issued by a
non-bank but guaranteed by a bank. The price of the bank bill is determined
using the pure discount rate. At maturity, a bank bill is paid back at face value.
Certificate of deposit
A certificate of deposit (CD) is a money market paper issued exclusively by
banks. As opposed to the other forms of money market paper, CDs are some-
times issued at face value and, at the maturity date, the face value amount plus
the interest payment is paid back. So, as with a deposit, a coupon is attached. If
a CD is traded before maturity, the price is equal to the present value of the sum
of the principal plus the interest payment. Other CDs, however, are issued at the
present value and are repaid for the nominal amount and they resemble com-
mercial paper.
price EUR 100 mio
1 0.05 91 360⁄×+---------------------------------------------
EUR100 mio
1.102639------------------------------- EUR 98,751,887.= = =
108
Figure 11.6 gives an overview of the different types of money market papers.
Figure 11.6 Overview of money market papers
5 Money market benchmarks
Every day a EURIBOR rate is determined on the money market by approxi-
mately 50 large banks, the panel banks, for specific periods up to one year as
well as a rate for the day interest rate, the EONIA. The banks pass on these
rates to the European Banking Federation (EBF). This is a European coordina-
ting organization of national interest groups of banks.
EURIBOR stands for euro interbank offered rate and EONIA stands for euro
overnight index average. The EURIBOR rates and the EONIA rate are rates that
banks charge each other for uncollateralized interbank deposits. Banks base
themselves, in principle, on the current interest rates of the European Central
Bank (ECB) and on the expectation about movements in the interest rates of the
ECB during the coming year when determining the level of these rates. The
EURIBOR rates and the EONIA rate well-known benchmarks for the money
market.
Because of the fact that during the credit crisis the interbank deposit market
dried up, however, two other benchmarks gained importance on the money mar-
ket: Eurepo, that is related to repuchase agreements and the overnight swap
index (OSI) that is related to overnight index swaps. Both indices are deter-
mined in the same way as EURIBOR.
Instrument Issue Price Yield/PDR Maturity
Consideration
Issuer
Commercial
paper
Present value
(yield)
Yield Face value Miscellaneous
Commercial
paper US
Present value
(PDR)
Pure discount
rate
Face value Miscellaneous
Treasury Bill Present value
(PDR)
Pure discount
rate
Face value US/UK Federal
Government
Bank bill Present value
(PDR)
Pure discount
rate
Face value Corporates
Certificate of
deposit
Face value Yield
(present value)
Face value +
Coupon
Banks
109
Chapter 12
Capital marketinstruments andcorporate actions
Securities with a long-term or infinite maturity period are traded on the capital
market. The capital market consists of two sub-markets, the equity capital mar-
ket and the fixed-income capital market. The traditional instrument on the
equity capital market is a share and on the fixed-income capital market they are
fixed-income securities.
1 Shares
A share is a proof of co-ownership in a company. Companies are the only orga-
nizations that issue shares. As a co-owner, a shareholder shares in the company
risk. In the worst case scenario, the company goes bankrupt and the share-
holder loses his capital. This is why shares are called risk-bearing capital.
In principle, a share has an undetermined term. It exists until the company is
dissolved, taken over by another company or goes bankrupt. Many shares are
listed on an exchange. These shares can also be traded through a multilateral
trading facility (MTF), over-the-counter or through systematic internalization.
Unlisted shareholdership is sporadically traded. This is referred to as private
equity.
Ownership of listed shares is registered using a balance on a securities account.
End investors hold securities accounts with custodians for this purpose, and
custodians in turn hold securities accounts with central securities depositories.
Return on shares
The return on shares consists of two parts, the direct return in the form of a di-
vidend and the indirect return in the form of share price changes. Dividend is a
distribution to share holders taken from the net profit. If the company does not
make a profit, it will not distribute dividends. But, on the other hand, that does
not mean that a company that does make a profit always distributes dividends.
110
The management of the company proposes the dividend amount during the
annual shareholders meeting. The shareholders vote on whether they agree with
the proposal. If they do not give their approval, the management must modify
the proposal.
Securities lending
Securities lending is a financial instrument whereby a party agrees to tempo-
rarely lend securities to another party. The borrower gives the lender a renume-
ration and may provide collateral. This collateral may consist of a certain num-
ber of securities, a bank guarantee or a certain amount of money. In the latter
case, a securities lending transaction is identical to a repurchase agreement.
A common reason for a party to borrow securities in a securities lending trans-
action is in order to meet a delivery obligation resulting from taking a short
position in securities. For instance, if a shares trader wants to profit from fall-
ing prices, he will take a short position by selling shares now with the intention
of buying them back in the market at a lower price later on. The sale transac-
tion gives him a delivery obligation. In order to meet this obligation, he can
borrow the shares using a securities lending transaction. If the trader buys the
shares in the market after some time has passed, be it with or without a profit,
he can return them to the lender.
The lender of the securities is often an institutional investor. In the case of cash
collateral, the institutional investor has temporary access to an amount of
money. The institutional investor gives the lender of the securities an interest
payment in return. However, the interest rate that is used for this purpose is
lower than the market interest rate. The profit for the institutional investor is
that he can place the cash collateral on the money market at a higher rate of
interest. In the case of other forms of collateral or no collateral, the lender
receives a fee.
2 Fixed-income securities
Fixed-income securities are tradable debt notes issued by an organization in
which it declares that it will repay a borrowed amount with interest to the per-
son who owns the fixed-income security, the holder
Fixed-income securities can be issued in various ways: through an exchange or
directly to the investor (over-the-counter). In general, fixed-income securities
that are listed on an exchange can be easily traded through the exchange or
other public trading platforms or over-the-counter. The most well-known fixed-
income securities that are traded through an exchange are bonds. Fixed-income
111
securities that are directly placed with investors are usually part of a lending
programme. This means that an organization can issue fixed-income securities
up to a certain maximum amount with relatively low administrative burden.
Most issues through the programme are over-the-counter. A lending pro-
gramme is also called a debt issuance programme (DIP) or note issuance faci-
lity (NIF). A commercial paper programme is one example of a lending pro-
gramme. Issuing through a lending programme is also referred to as drawing.
The drawing on a programme can be either on initiative of the issuer or on the
initiative of the investor.
The interest payment on a fixed-income security can take place periodically,
using coupons, or once, at maturity. A fixed-income security contract specifies
how much money the issuing organization must pay back to the owner of the
fixed-income security. This is called the nominal value. The nominal value of a
bond is usually EUR 1,000 and the nominal value of a medium term note
(MTN) is a multiple of EUR 1 million.
Most fixed-income securities in euros have an annual coupon. Most fixed-
income securities in US dollars have a semi-annual coupon. The coupon rate is
usually determined once at the time the fixed-income security is issued. Some
fixed-income securities, however, have a floating coupon. These are floating
rate notes, whereby the coupon rate is redetermined (fixed) every three or six
months based on a reference interest rate such as EURIBOR or LIBOR. Some
fixed-income securities do not pay out interim coupons. These are zero-coupon
bonds. Zero-coupon bonds are issued at a price that is calculated as the present
value of the nominal value and are repaid at the nominal value at the end of the
term. The remuneration for the investor is included in the difference between
the purchase price and the nominal value.
As with listed shares, fixed-income securities are registered in securities
accounts with custodians or central securities depositories. However, this
applies to all fixed-income securities, listed fixed-income securities like bonds
and unlisted fixed-income securities like commercial paper or medium term
notes.
112
2.1 The yield of a fixed-income security
The yield of a fixed-income security is the return that investors demand, based
on the assumption that they will keep the bond until the end of the term. This is
why it is also called yield to maturity. Investors consider the following factors
when determining the yield on a fixed-income security:
� the general interest rate level on the capital market;
� the quality of the issuing entity;
� the liquidity of the bond.
The general interest rate level on the capital market
The capital market interest rate is determined by the free interplay between sup-
ply and demand. The interest rate level on the capital market is largely deter-
mined by the expected inflation. When investors expect a higher rate of
inflation, they demand higher compensation ('inflation compensation'). This is
because inflation lowers the value of the amortization in real terms. A higher
inflation (expectation) is therefore coupled with an increase in the capital mar-
ket interest rate. Conversely, a lower inflation (expectation) leads to a decrease
in the capital market interest rate.
In addition to the inflation expectation, supply and demand factors also play a
role. The capital market interest rate may fall due to an increase in the demand
for fixed-income securities. This may be the case, for instance, when investors
liquidate their share investments en masse, so that more money becomes avail-
able for fixed-income securities.
A well-known benchmark on the capital market is the return on government
loans. However, because of the fact that government bonds are not issued on a
frequent regular basis, this benchmark is not often used nowadays. Instead, the
interest rate swap (IRS) rate level is now often used as a benchmark. These are
interbank rates, just like the Euribor rates. The benchmark that applies to IRS
rates is the ISDAFIX Swap Rate, which is fixed daily based on quotes given by
several dealers selected by ISDA, ICAP and Thomson Reuters. The ISDAFIX
service provides average mid-market swap rates for seven major currencies at
selected maturities on a daily basis. ISDAFIX rates are based on a mid-day and,
in some markets, end-of-day polling of mid-market rates.
113
The quality of the issuing entity
The quality or creditworthiness of the issuing organization indicates the likeli-
hood of it being able to pay back the loan. The better the quality, the more cer-
tain the investor is that he will get his money back. An investor that buys a
bond issued by a central government is usually almost certain that he will get
his money back. The certainty of repayment is lower when it comes to bonds
issued by companies. In order to compensate for this, investors demand higher
coupon interest rates for securities that are less creditworthy. The difference in
interest rate between the coupon that a certain institution must pay and that
which the government must pay is called the risk premium or spread.
In order to determine the creditworthiness of issuing institutions, many inves-
tors consult these parties' ratings. A rating is an assessment of an organization’s
creditworthiness, expressed as a letter or a combination of letters and digits.
Rating agencies make a rough distinction between two categories: investment
grade and high yielders. If a bond is qualified as Investment grade, it means that
it is a reasonably safe investment. The categories of ratings used by Moody's
and Standard & Poor's are shown in figure 12.1.
Figure 12.1 Overview of credit ratings
Investment Grade Moody’s S&P
Highest quality Aaa AAA
High quality Aa AA
Upper medium grade A A
Adequate payment capacity Baaa3 BBB-
High Yielders Moody’s S&P
Predominantly speculative Ba BB+
Speculative / low grade B B
Poor quality / vulnerable to default Caa CCC
Highest speculation Ca CC
Lowest quality / no interest being paid C C
In bankruptcy D
114
In addition to the quality of the issuing organization, the domicile also plays a
role with regard to the creditworthiness of a client. Governments sometimes
impose restrictions on the payment of interest and amortization of foreign debts.
This is called political risk. The political risk is included in the rating of indi-
vidual parties. If there is a political risk, an investor demands a higher coupon
interest rate.
The liquidity of the bond
Liquidity with respect to financial instruments means tradability. If bonds are
not regularly traded, they are less appealing to investors and they will demand a
higher yield. This is because investors need to wait and see if there is a counter-
party that is interested and how much he is willing to pay should they want to
sell these bonds. The liquidity of a bond is closely related to the number of
bonds issued. Generally speaking, the liquidity increases as more bonds of a
certain type are issued.
2.2 Clean and dirty price
In the case of a transaction in a fixed-income security, the interest accrued up to
the settlement date is sold with the security. The price of a bond thus consists of
the exchange price, plus the coupon interest accrued up to the settlement date.
The price without the accrued interest is called the clean price. The price
including the accrued interest is called the dirty price. The interest amount is
calculated by applying the interest rate, adjusted according to the daycount frac-
tion, to the nominal value of the fixed-income security.
The daycount convention for fixed-income securities varies. For most Govern-
ment bonds, the actual/actual convention is used. For eurobonds 30/360 is com-
mon practice.
Example
A portfolio manager buys a French government bond (OAT) on an
exchange at a price of 98.60 and an annual coupon interest rate of 5%
(actual/actual), which is paid on July 15th.
If the settlement date for this transaction is July 10th, 360 interest days
will have passed since the last coupon payment. The daycount fraction in
this case is thus 360/365 and the dirty price of the obligation is calcu-
lated as follows
98.60 + 100.00 x 360/365 x 0.05 = 98.60 + 4.932 = 103.532.
115
If the settlement date for this transaction would have been July 20th, five
interest days would have passed since the last coupon payment. The day-
count fraction in this case is thus 5/365 and the dirty price of the obliga-
tion is calculated as follows
98.60 + 100.00 x 5/365 x 0.05 = 98.60 + 0.068 = 98.668.
3 Special types of fixed-interest securities
A wide range of fixed-income securities are issued in the financial markets,
each with its own features.
Floating rate notes
A floating rate note (FRN) is a fixed-income security with an interest coupon
that is reset periodically, usually after three or six months. The reference rate of
an FRN is usually a money market benchmark such as LIBOR or EURIBOR.
Asset-backed securities and covered bonds
Asset-backed securities are issued as a result of a securitization transaction.
With securitization, the initiating party transfers a portion of its assets to a third
party. This is often a legally independent entity created specifically for this pur-
pose, known as a special purpose vehicle (SPV). The SPV obtains its funds by
issuing debt securities in the form of bonds, medium-term notes or commercial
papers.
Securitization is not the actual sale of assets. If the bank, for example, were to
securitize a loan portfolio, all contracts between the bank and the borrowers
would have to be replaced by contracts between the SPV and the borrowers. In
order to prevent this, credits are only transferred in an economic sense and not
in a legal sense. This means that the bank has to arrange for all cash flows
arising from the transferred portfolio to be forwarded to the SPV. The SPV can
in turn use these cash flows to pay interest and installments for the fixed-inte-
rest securities it has issued.
The cash flows of the acquired receivables thereby serve as a kind of collateral
for payment obligations resulting from securities issued by the SPV. These
interest-bearing securities are therefore called asset-backed securities (ABS) or
collateralized debt obligations (CDOs). Apart from the duty to channel all cash
flows of the securitized portfolio to the SPV, the bank has no obligations
towards the SPV.
116
A variation on asset-backed securities are covered bonds. These are bonds
issued by a bank whereby a specific credit portfolio serves as collateral in the
event of the bank’s bankruptcy.
Callable/putable bonds
Callable notes are fixed-income securities that can be redeemed prematurely by
the issuer. The issuer only makes use of this option if the current interest rate is
lower than the coupon rate. This is not a favourable option for investors as they
have to invest their funds at a lower rate. Loan terms and conditions, therefore,
often state that callable bonds are redeemed at a price at or above 100 in the
event of premature redemption.
A putable note or bond is a fixed-income security that the holder is entitled to
sell prematurely to the issuer under predetermined conditions.
Perpetuals
Perpetuals are fixed-interest securities that do not need to be redeemed. Interest
on most perpetuals is periodically reviewed, e.g. every 10 years, which means
that the coupon is adjusted to prevalent market rates every 10 years. Investors
are thereby given the assurance that interest yields will not vary from prevalent
market rates for too long. Most perpetual bonds are callable and they can be
redeemed prematurely at intervals as defined in the loan agreement.
Subordinated loans or junior loans
Subordinated loans or junior loans are loans whereby interest payments and
repayments are subordinated to other fixed-interest securities of the issuer. In
the event of payment difficulties, the issuer must first settle obligations in
respect of other loans before it is required to comply with loan interest pay-
ments and/or to repay a junior loan. Investors thereby run a greater risk of not
getting their money back than with a regular fixed-income security. In return for
this risk, they receive a higher interest rate.
117
Inflation-linked Bonds
Inflation-linked bonds or index-linked bonds are fixed-interest securities
whereby the nominal value is periodically adjusted for inflation. Interest is also
calculated against the higher amount. In case of inflation, the investor receives a
higher amount at settlement than the initial investment.
Example
A pension fund invests in a one-year index-linked bond with a nominal
value of EUR 1,000.00 and a coupon yield of 1%, with the guarantee that
the principal amount is indexed to inflation.
With an inflation rate of 2.4%, the pension fund will be repaid the princi-
pal amount of EUR 1,024.00, plus 1% interest after one year (1% of
EUR 1,024.00 = EUR 10.24). The total amount payable after one year is
EUR 1,034.24.
Junk bonds
Junk bonds or high-yielders are fixed-interest securities issued by companies
with low credit ratings. Investors buy these fixed-interest securities because
they offer a high return. A fixed-income security can also be downgraded to
junk bond status during its lifetime. This happens when the creditworthiness of
the issuer falls sharply during the lifetime of the fixed-income security. The
fixed-income security is than referred to as a fallen angel. High-yield bonds or
junk bonds have a lower credit rating than Baa3 or BBB-.
Convertible bonds
Convertible bonds are bonds that can be exchanged by the holder during their
lifetime for a pre-determined number of shares in the issuer. The holder of a
convertible bond actually holds a combination of a bond and a call option on
the issuer’s shares. The option premium is included in the interest rate, and this
rate is, therefore, lower than the interest rate on a regular bond with the same
maturity.
Zero coupon bonds
Zero coupon bonds are fixed-interest securities that do not yield any interim
coupons during their lifetime. Zero coupon bonds are redeemed at their face
value. The issuing rate is calculated as the present value of the face value. Zero
coupon bonds are popular among investors because they run no reinvestment
risk, which is also why they are often used as a hedge for guarantee products.
118
4 The role of the bank with a securities issue
Companies that have large financial requirements can choose to issue shares or
fixed-income securities themselves as an alternative to bank credit. The issues
and syndicates department of the financial markets division supervises these
issues.
A bank that services an issue is called the arranger. The arranger assists the
issuer, for instance, in determining the issue price and represents the issuing
institution towards the regulatory bodies and investors. An arranger always acts
as issuing and paying agent.
The responsibility of an issuing and paying agent is to draw up a global note,
deposit it with the central securities depository and apply for an ISIN code. The
issuing agent is also responsible for compiling a prospectus, in the case of listed
securities, or a bond indenture, in the case of unlisted fixed-income securities.
Both documents contain the terms and conditions of security issued. A prospec-
tus also reveals comprehensive information about the issuing institution. These
documents must be approved by and deposited with the regulatory supervisor,
such as the Financial Services Authority (FSA) in Great Britain. Finally, the
issuing agent is responsible for distributing the terms and conditions of the issue
among investors. Finally, the issuing and paying agent is responsible for draw-
ing up the settlement instructions for the payments and the securities transfers
related to the issue and the coupons or dividends.
If a security is traded on an exchange, the arranger also acts as listing agent. In
this role, the arranger applies to the exchange for a listing on behalf of the issu-
ing institution. The listing agent is also responsible for the following tasks:
� reporting to and/or gaining approval for the listing from the supervisor;
� registering stocks with the clearing institution;
� placing a public announcement;
� publicizing the result of the issue in the media.
In order to increase the placing power, the arranger often forms an issue syndi-
cate. This is a group of banks that jointly execute an issue. The arranging bank
is called the syndicate leader. Apart from the syndicate leader, there are a num-
ber of parties involved as dealer. They are allowed to buy the securities directly
from the issuer and sell them to their own clients.
119
In case of a lending programme, the arranging bank draws up a base prospec-
tus. This document contains information about the borrowing institution and the
general terms and conditions that apply for all issues of fixed-income securities
issued through the programme. The base prospectus serves as a master agree-
ment for the fixed-income securities issued under the programme and can
somehow be compared with e.g. an ISDA Agreement. A base prospectus must
include the following information:
� scope of the programme;
� risks of the programme;
� type of fixed-income securities that may be issued as part of the programme;
� conditions under which the fixed-income securities may be issued;
� information on the issuing institution (annual report);
� who the dealers are;
� information on taxation.
The drawing on a programme can be either on the initiative of the issuer or on
the initiative of the investor. In the first case, the issuer contacts one or more
dea-lers and orders them to find investors. In the second case, an investor asks a
dealer to find out whether the issuer is interested in issuing new securities.
In both cases, two contracts are closed simultaneously. In the first contract, the
issuer sells the securities to the dealer. In the second contract, the dealer, in turn,
sells the securities to the investor. These contracts contain the terms and condi-
tions of the issue in question: the amount, the coupon rate, the frequency of
interest payments, the maturity date, conditions of early redemption and so on.
Bond indentures can somehow be compared with the confirmations of a con-
tract that is closed under a ISDA agreement. If a listed bond is issued through a
lending programme, however, still a comprehensive prospectus has to be drawn
up.
If the dealer is not also the arranger of the programme, both the dealer and the
issuer send information about the deal to the arranger who applies for a ISIN
code and takes care of the settlement, in its role of issuing and paying agent
respectively.
120
5 Corporate actions
Corporate actions are events in the life of securities that take place on the initia-
tive of the issuing institution and have a direct impact on the holders of the
securities. Examples of corporate actions in relation to bonds are coupon pay-
ments and redemptions. The most common corporate action relating to stocks is
the dividend payment. Corporate actions may have far-reaching consequences
for shareholders, e.g. rights issues and takeovers. The actions required as a
result of corporate actions are mainly carried out by central securities deposito-
ries, custodians and asset managers.
5.1 Reasons for corporate actions
Issuers may have a number of reasons for initiating corporate actions, inclu-
ding in relation to shares:
� providing remuneration to the holder (dividends);
� raising additional capital from own shareholders (rights issue);
� enhancing the marketability of shares (stock split or reverse split);
� changing the structure of a company (acquisition);
� giving information to shareholders (notice of a shareholders' meeting);
and in relation to bonds:
� providing remuneration to the holder (coupon interest);
� (early) redemption of debt;
� converting debt into equity (conversion of a convertible bond).
5.2 Corporate action categories
Corporate actions can be classified into three categories: mandatory corporate
actions, voluntary corporate actions and issuer notices. The extent of the impact
on the holders depends on the category of a corporate action. Because the con-
sequences of corporate actions in relation to equity can be great, they must in
principle be approved by the general or a special general meeting of sharehol-
ders.
Mandatory corporate actions
A mandatory corporate action is a corporate action performed for all security
holders, without exception. Examples of mandatory corporate actions are divi-
dends, coupon payments and stock splits.
121
Voluntary corporate action
A voluntary corporate action is a corporate action whereby individual security
holders may choose if they want to encounter direct consequences. An example
of a voluntary corporate action is a takeover.
Issuer notices
Issuer notices are messages from the company to security holders. Examples of
issuer notices are announcements of a shareholders’ meeting, the distribution of
the minutes of a shareholders' meeting, the notification of new coupon interest
rates and the notification of a change in an ISIN code. Issuer notices do not
need the approval of the shareholders.
Some corporate actions consist of several related corporate actions, multi-stage
corporate actions. One such example is a rights issue. A rights issue consists of
two successive corporate actions, an issue of claims and the conversion of
claims into shares.
5.3 Implementation of corporate actions
With corporate actions the following parties are involved:
� issuer;
� central securities depository;
� custodian;
� asset manager or manager of a mutual fund;
� end investor.
These parties each have specific responsibilities with regard to the flow of
information concerning the corporate action. An issuer is obliged to publish
information regarding a proposed corporate action. This can be done via finan-
cial newspapers, the screens of data vendors such as Thomson Reuters or Tele-
kurs and the websites of issuers or stock exchanges.
All parties affected by a corporate action are required to retrieve this informa-
tion themselves. Custodians and investment managers, however, often under-
take this task on behalf of their clients. Parties with a vested interest often check
the accuracy of the information regarding a corporate action they have obtained
from a particular source with another source. This is referred to as cleansing.
Implementation of a dividend payment
When an issuer has declared a dividend, the corporate action takes place via a
number of stages that are shown in figure 12.1.
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Figure 12.1 Distribution of cash or securities related to a dividend payment
The following steps are shown:
1. The issuer's bank, in its capacity as paying agent, transfers the total divi-
dend amount from the issuer's account to the central securities depository’s
account with the central bank.
2. The CSD is responsible for distributing the total dividend amount received
from the issuer among its account holders, i.e. the custodians. In this con-
text, the CSD performs the following actions:
a. gathering information on the dividend payment;
b. determining the dividend to be received by each custodian;
c. sending a message to the custodians entitled to dividends;
d. paying out the dividends through cash accounts held by the custodians at
the CSD.
3. Custodians are responsible for distributing the dividend amount that they
have received among their clients In this context, they are responsible for
the following actions:
a. gathering information on the dividend payment;
b. determining the dividend to be received by each client (asset manager,
investment institution or end investor);
c. sending messages to the clients that are entitled to the dividend;
d. sending messages to the CSD regarding the total dividend amount to be
received;
e. checking the total dividend amount received from the CSD;
f. transferring the dividend to the cash accounts of the securities holders.
4. Asset managers and managers of mutual funds can pay the dividends to the
final investors depending on the mandate or the terms of the mutual fund.
Issuer
Mutual Fund
Investor
CustodianCSDAsset
ManagerInvestor
1. 2.
3.
Investor
4.
4.
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Stock dividend
A stock dividend is a dividend payment in shares. If a company declares a stock
dividend, the issuer's bank instructs the CSD to create securities. These securi-
ties are called stock dividends and have a short duration. The stock dividends
are then recorded on the accounts of the custodians, who in turn book them on
their clients' accounts. On the payment date of the dividend, the balances on the
stock dividend accounts are debited and the shares accounts are credited at a
specified ratio.
Choice dividend
A choice dividend is a dividend whereby the holder can opt for a dividend in
cash or equity. Payment of choice dividends is a mandatory corporate action
with an option element. Holders have the option to receive a specified amount
in cash for each share held, or a stock dividend can be credited to a separate
account.
Once an issuer has announced a choice dividend, the custodian must communi-
cate this to his clients. This message must state within which period the client's
option must be exercised, when the ratio of the required dividend rights for
newly issued shares will be established (if this has not yet taken place) and what
the payment date is for the dividend. Once the issuer has determined the ratio
between the dividend rights needed per new share to be issued, the custodian
must inform his clients accordingly. The clients must then specify their prefe-
rences.
Rights issue
A rights issue is an issue whereby current shareholders receive claims. These
are newly issued securities with a short duration, which the holders can
exchange in a certain ratio against shares, or which can be traded on the stock
exchange. The rate at which current investors can purchase newly issued shares
by submitting claims is usually lower than the prevalent market rate. Because of
the selection option, a rights issue is considered to be a voluntary corporate
action.
Custodians must indicate to their clients how many claims are needed to pur-
chase new shares and within which time frame they must respond. Once the
clients have made their selections, the custodian must communicate to the CSD
the total amount of claims that their clients want to be converted to shares. For
each client that converts claims into shares, the custodian must debit the claims
account and credit the equity account at a specified ratio.
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Stock split
With a stock split, existing shares are converted into multiple new shares. A
stock split is a mandatory corporate action. The reverse also occurs when se-
veral existing shares are exchanged for a smaller number of new shares. This is
called a reverse stock split. With a (reverse) stock split, custodians must adjust
the number of shares on their clients' accounts.
Example
The Financial Times of 15 August 2007:
'Supermarket group Ahold implements a reverse stock split on 22 August
2007, following approval in June by the shareholders. Every five exis-
ting shares with a nominal value of 0.24 euro cents will be merged into
four new shares with a nominal value of 0.30 euro cents.’
Takeover
In a takeover, a company buys the shares of another company. In many cases,
this takes place in mutual consultation. The acquisition is then approved at a
shareholders' meeting and the rate is established. However, individual share-
holders must decide whether they are willing to sell their shares to the acquirer.
Should they decide to do so, they must report their shares for the takeover.
Custodians must send a message to their clients, stating the acquisition rate and
the period within which clients must respond. Custodians must then confirm the
total number of reported shares to the CSD. On the acquisition date, custodians
must debit the securities accounts of clients who are cooperating in the take-
over and credit their cash accounts.
Coupon payment
A coupon payment is a periodic payment of interest at a fixed interest value.
With coupon payments, it is not difficult to gather information as the dates on
which the coupons are paid are fixed and the coupon interest rate is contractu-
ally determined. Coupons are always paid in full to the bearer of the fixed-inte-
rest security on the coupon date.
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5.4 Pending transactions
Problems can be encountered if certain transactions have been concluded, but
have not been processed in the securities administration. These transactions are
called pending transactions. Pending transactions have a bearing on two ba-
lances: the economic balance and the technical balance. The economic balance
is the balance on which an investor runs a price risk and for which corporate
actions are relevant. The technical balance is the balance that is actually on the
account. The economic balance changes immediately with every transaction,
but the technical balance is only adjusted on the settlement date.
The moment at which the custodian decides who will be affected by a corpo-
rate action is called the record date. The cum date mostly serves as the record
date for dividend payments. The cum date is the last day on which a share is
traded including dividends. The economic balance is determined after the
exchange has closed on the record date. In order to determine the economic ba-
lance, the custodian adjusts the technical balance for pending transactions.
Example
If an investor buys shares on or before the cum date, the purchasing price
takes into account dividends yet to be received. The buyer is therefore
entitled to that dividend. However, if settlement should fall after the
record date, the shares are not updated on his account on the record date.
The technical balance is therefore not updated and if the custodian were
to look only at the technical balance, the buyer would not receive the
dividend, despite having paid for it. The seller would, on the other hand,
receive the dividend twice.
With bonds, custodians do not take into account pending transactions, as bonds
are always sold with accumulated interest up to the settlement date. If the settle-
ment date is prior to the coupon date, the buyer receives the full interest cou-
pon.
126
127
Chapter 13
FX instruments and settlement ofFX transactions
The foreign exchange market (FX market) is the market on which different cur-
rencies are traded against one another. The rate at which this happens is called
the exchange rate or FX rate. Various instruments are used on the FX market,
including FX spot transactions, FX forwards, and FX swaps. All of these instru-
ments are mostly traded over-the-counter.
FX transactions are settled by two opposite money transfers in the currencies
traded. In order to limit the settlement risk associated with these transactions,
several international banks have jointly developed a system called the continu-
ous linked settlement system (CLS system). The CLS system makes the oppo-
site transfers in a FX transaction interdependent.
1 FX spot
With most FX transactions, the currencies are traded at the current market
exchange rate and settlement takes place on a standard delivery date, usually
two business days after the transaction date. These transactions are called FX
spot transactions. The current market exchange rate is also sometimes called the
FX spot rate.
Example
The UBS euro-dollar trader buys 10 million euros on May 12th 2009
from the Deutsche Bank euro-dollar trader at the FX spot rate of 1.3425.
As a result, on May 14th 2009, UBS must transfer an amount of
13,425,000 US dollars to Deutsche Bank. Deutsche Bank, in turn, must
transfer an amount of 10,000,000 euros to UBS.
128
For certain currency pairs, the settlement of spot transactions takes place after
only one business day. This is the case, for instance, for currency transactions
between US and Canadian dollars. Sometimes the value date for one currency is
different from that of another currency. This may be the case, for instance, when
a currency from an Islamic nation is traded for a currency in a Western country
and the delivery date is near the weekend.
Exchange rates
The exchange rate between two currencies is given using an FX quotation. An
exchange rate expresses the value ratio between two currencies as a number. In
the case of most exchange rates, one unit of a currency is expressed as a num-
ber of unit of another currency. The currency mentioned first in an FX quota-
tion is the trade currency or base currency (the traded good) and the second
currency is the price currency or quoted currency (the currency in which the
price of the traded good is expressed).
In FX quotations, currencies are expressed by their ISO-codes. ISO stands for
International Standardization Organization. Figure 13.1 shows a table with the
ISO-codes of some of the most important currencies.
Figure 13.1 ISO currency codes.
There are international conventions regarding which currency is the base cur-
rency and which is the price currency in an FX quotation. The euro is always
quoted as the base currency against other currencies: EUR/USD, EUR/GBP,
EUR/JPY, EUR/CHF etc.
Currency ISO code
Euro EUR
US dollar USD
Pound sterling GBP
Japanese yen JPY
Canadian dollar CAD
Australian dollar AUD
Hong Kong dollar HKD
Singapore dollar SGD
Korean won KRW
Swiss franc CHF
Chinese yuan CNY
Russian Ruble RUR
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The British pound and the other currencies of the Common Wealth are base cur-
rency in all exchange rate quotations except in the cases that the euro is the
counter currency. The US dollar is the base currency in most exchange rate quo-
tations with exception of euros, British pounds etcetera:
USD/JPY; USD/CHF; USD/CNY, however,
EUR/USD; GBP/USD; AUD/USD.
Exchange rate quotations for which these rules are properly applied, are
referred to as direct quoted rates. If these rules are not applied, for instance in
case of GBP/EUR, the quotation is called an indirect quoted rate.
If the EUR/USD exchange rate is 1.5000, this means that one euro is worth just
as much as 1.5000 US dollars. The euro is the trade currency and the dollar is
the quoted currency. If a company wants to buy 1,000,000 euros, it pays
1,000,000 x 1.5000 = 1,500,000 US dollars.
It is a little more complex if a company wants to buy 1,000,000 US dollars for
euros. The US dollar now looks like the traded good, but the exchange rate does
not reflect this. In order to know how many euros the company must pay, the
reciprocal of the exchange rate is used: 1,000,000 x 1/1.5000 =
EUR 666,666.67.
2 FX forward
An FX forward, also known as an FX outright, is an FX instrument whereby
two parties enter into a reciprocal obligation to exchange a certain amount of a
currency at a certain time in the future for a predetermined amount in another
currency. The rate used is called the forward rate. The forward rate is largely
based on the spot exchange rate.
Because settlement only takes place after some time in the case of an FX for-
ward, the FX spot rate is corrected. The correction used is based on the diffe-
rence in the interest rates for the two currencies involved and is represented
using swap points. One swap point for EUR/USD, for instance, is equal to
0.0001. Swap points are the translation of a difference in interest rates between
two currencies into the difference between the FX spot rate and the FX forward
rate.
130
Example
An ING Bank euro-dollar trader concludes an FX forward with the Deut-
sche Bank euro-dollar trader on May 12th, 2009 and buys 10,000,000
euros for US dollars with the delivery date being May 14th, 2010 (one
year after the spot date). The EUR/USD cash rate is 1.3475 and the swap
points amount to -/- 0.0130. The EUR/USD FX forward rate is thus
1.3345.
On May 14th, 2010 ING Bank must transfer an amount of 13,345,000
US dollars to Deutsche Bank and Deutsche Bank must transfer an
amount of 10,000,000 euros to ING Bank.
Theoretical calculation of an FX forward rate
The FX forward rate can theoretically be calculated by calculating the future
value of one unit of the trade currency and of the corresponding amount of units
of the quoted currency, both on the forward delivery date. The future value in
the quoted currency should then be divided by the future value in the trade cur-
rency.
In figure 13.2 the FX forward rate is calculated for an FX forward contract
EUR/USD with a term of 91 days. The FX spot rate EUR/USD is 1.2500, the
three months euro interest rate is 2% and the three months US dollar interest
rate is 1%.
Figure 13.2: Three months FX forward rate EUR/USD
USD 1.2500
EUR 1.0000
USD 1.25316
EUR 1.005056
FX spot rate
1.2500/1.0000 = 1.2500
FX forward rate
1.25316/1.05056 = 1.246856
1.0% / 91 days
2.0% / 91 days
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The future value of 1.2500 USD (quoted currency) after three months is:
.
The future value of one euro (base currency) after three months is:
.
The theoretical FX forward rate is calculated by dividing the future value in the
quoted currency by the future value in the trade currency:
.
The general theoretical formula to calculate an FX forward rate is:
.
In this formula rq is the interest rate of the quoted currency and rb is the interest
rate of the base currency, both for the corresponding term of the FX forward
contract.
In the above example, the FX forward rate is EUR/USD 1.2469 (rounded)
where the FX spot rate is EUR/USD 1.2500. The difference between the
FX forward rate and the FX spot rate is 0.0031, or 31 forward points. Here, the
FX forward rate is lower then the FX spot rate. The euro now trades on a ‘dis-
count’ against the US dollar. If the euro interest rate would have been lower
than the US dollar interest rate, the FX forward rate would have been higher
than the FX spot rate. The euro would then be traded at a ‘premium’.
Value today and value tomorrow FX outrights
In some cases market parties want the settlement of an FX transaction to take
place at a point in time prior to the spot date, on the trading day itself (value
today), for instance, or on the first subsequent business day (value tomorrow).
Settlement value tomorrow is always possible, settlement value today is only
possible if the systems used for the settlement of currency transactions, the pay-
ment systems of the central banks for the currencies involved, are still in opera-
tion. As with FX forward contracts, the FX spot rate is adjusted for the interest
rate differential between the traded currencies.
Future value of USD 1.2500 1.2500 1 91 360⁄ 0.01×+( )× USD 1.25316= =
Future value of EUR 1 1 1 91 360⁄ 0.02×+( )× EUR1.005056= =
Forward FX rate1.25316
1.005056---------------------- 1.246856= =
Forward FX rateSpot rate 1 days year basis⁄ rq×+( )×
1 days year basis⁄ rb×+-------------------------------------------------------------------------------------------=
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3 FX swap
An FX swap is an OTC currency derivative with a short maturity period,
whereby two parties enter into a reciprocal obligation to exchange a certain
amount of two currencies on the spot date at the FX spot rate and to reverse this
exchange at the FX forward rate, in the future. The exchange at the beginning
of the maturity period is called the short leg, the exchange at the end of the
maturity period is called the long leg.
Example
A bank sells a client one million euros for 1,250,000 US dollars with
delivery after two business days (EUR/USD FX spot rate is 1.2500) and
at the same time agrees to buy the euros back after one year at an FX for-
ward rate of 1.2469, therefore receiving 1,246,900 US dollars. This con-
tract is called a ‘EUR/USD FX swap’ with a term of one year.
4 Settlement of FX transactions
An FX transaction is processed using two separate interbank transfers in the
currencies concerned. If, for instance, a Dutch bank buys dollars from a Japa-
nese bank for euros, the Dutch bank sends a settlement instruction for the euro
amount to the ECB on the settlement day chargeable to its euro account and
payable to the Japanese bank's euro correspondent bank with the Japanese bank
as final beneficiary. The Japanese bank in turn sends a settlement instruction to
its US correspondent bank, chargeable to its US dollar account and payable to
the Dutch bank's US correspondent bank, with the Dutch bank as final benefi-
ciary.
Because the transfers in the two currencies do not take place within one and the
same system, there is a risk that one party's transfer takes place without the
other party's transfer taking place. This is called settlement risk. Because of the
huge volume of FX transactions, banks have decided to limit this risk by foun-
ding a settlement institution for FX transactions: the CLS Bank.
4.1 The role of the CLS Bank
The CLS Bank is a settlement institution that carries out transfers in the most
important currencies resulting from the FX transactions of about 70 of the
world's largest banks. In order to effect an FX transaction through the CLS
bank, both transaction parties need to be registered with the CLS bank and both
currencies need to be included in the CLS bank's currency assortment: euro, US
133
dollar, Japanese yen, Canadian dollar, Australian dollar, New Zealand dollar,
Hong Kong dollar, Singapore dollar, Korean won, Danish crown, Swedish
crown, Norwegian crown, Swiss franc, South African rand, Mexican peso,
Israelian shekel.
All participating banks hold an account at the CLS bank in each of the afore-
mentioned currencies, in order to facilitate the processing of the FX transac-
tions. The CLS bank in turn holds accounts at the central banks concerned. For
instance, the CLS holds a US dollar account at the Federal Reserve Bank
(FED), a Japanese yen account at The Bank of Japan and a euro account at the
ECB. Banks can transfer amounts to the accounts they hold at the CLS bank
using these accounts. These transfers are called 'pay-ins'.
Example
Barclays needs to deposit an amount in its CLS Bank US dollar account.
In order to do this, it must instruct its correspondent bank JP Morgan
Chase to transfer the US dollar amount to the CLS Bank's US dollar
account at the FED in favour of Barclay’s CLS Bank US dollar account.
4.2 The settlement procedure of the CLS Bank
The CLS Bank processes transfers in three phases. First, the receipt of instruc-
tions and pay-ins through the central banks, second, the internal settlement
within the CLS Bank and finally the external settlement through the central
banks. The interbank payment systems (TARGET2, Fedwire etc.) of all curren-
cies involved are operational throughout these three phases.
Phase 1: the delivery of instructions and pay-ins
All member banks send SWIFT messages of the FX transactions they have con-
cluded to the CLS Bank (MT300 series). Based on all the transactions deli-
vered, CLS Bank creates a pay-in schedule every day. This is an overview of
the payment obligations in all currencies of the banks involved on account of
the FX transactions they have concluded and that need to be settled on that day.
The cut-off time for the notification of transactions that have to be processed on
that same value date is 06:30 CET (Central European Time).
Phase 2: internal settlement within the CLS Bank
The settlement of transactions subsequently takes place between 07:00 CET and
09:00 CET. For the Far East, this at the end of the afternoon and for the United
States it is in the middle of the night. The CLS system processes the FX trans-
actions on an order-to-order basis. This means that the CLS Bank processes
each transaction separately, on a first in first out basis. The payment-versus-
134
payment principle (PVP) applies to each individual transaction. This means that
the two cash flows resulting from a FX transaction take place simultaneously
and that the CLS bank only debits a member's account if it is certain that
another account belonging to the same member is simultaneously credited in
another currency.
The CLS Bank may also processes an FX transaction under certain circum-
stances if a bank does not have sufficient funds in a currency to be delivered. In
such cases, the bank must have sufficient collateral in the form of balances in
other currencies. However, the CLS Bank does not take the entire balance in
other currencies into account, but subtracts a safety margin: the haircut. This is
how the CLS Bank allows for possible changes in exchange rates during the
day. In the case of a 15% haircut, the collateral value of a balance in another
currency is equal to 85% of that balance.
Example
Société Générale carries out an FX spot transaction with Deutsche Bank.
It sells 100 million British pounds for 130 million US dollars.
Settlement takes place at the CLS Bank.
However, the balance on Société Générale's British pound account at the
CLS Bank is only GBP 75 million. The CLS Bank would therefore not
carry out the transaction based on the GBP balance alone.
However, Société Générale has a credit balance of 100 million euros on
its euro account. At a EUR/GBP exchange rate of 0.75, that is equiva-
lent to GBP 75 million. The CLS Bank applies a 10% haircut. This
means that the collateral value of the euro credit balance is equal to 90%
x GBP 75 million = GBP 67.5 million.
Because Société Générale has sufficient collateral, the CLS Bank will
execute the GBP/USD FX transaction.
If a bank has sufficient collateral, the CLS Bank therefore also executes transac-
tions that result in a debit position on an account in a certain currency. The
advantage of this is that a bank does not need to transfer money immediately to
the CLS Bank to make up the debit balance. That would not be efficient,
because it is very possible that a debit balance on this account would be supple-
mented through the settlement of another transaction that is processed later in
the day.
This is why banks do not need to carry out pay-ins for each separate currency
equal to the net amount to be transferred based on all the FX transactions they
have deposited. Instead, they ensure that the account in their own currency has a
surplus, in order to be able to provide the necessary collateral for possible
135
interim debit positions in other currencies. Settlements through the CLS bank
therefore have considerably less impact on the liquidities of the members' banks
than the traditional method of settlement.
The CLS Bank does however impose a limit on the size of the debit balance of
an account. If this limit is reached, the member bank must cover the deficit of
the currency account concerned before the CLS Bank continues to process the
transactions chargeable to this account. This applies regardless whether the
bank concerned has sufficient collateral.
A deficit can be covered in three ways: through an interim pay in to the CLS
Bank, through an inside/outside swap (I/O swap) or through a today/tomorrow
swap.
An I/O swap is an intraday FX swap whereby one leg is completed within and
the other leg is completed outside the CLS system. In order to remove a debit
balance in euros, a member can conclude an I/O swap with another member in
which the member buys euros within the CLS system for US dollars and sells
the euros outside the CLS system for US dollars at the same rate. The second
leg of the swap is settled outside the CLS bank, through the central banks'
RTGS systems. A disadvantage of an I/O swap is that part of the settlement risk
is being reintroduced to the parties. After all, the second leg of the swap takes
place outside the CLS bank.
A today/tomorrow swap is an FX swap that is settled entirely within the CLS
bank. The settlement of the first leg takes place on the day the today/tomorrow
swap is concluded. The settlement of the second leg takes place a day later. The
advantage of a today/tomorrow swap over an I/O swap is that no settlement risk
returns. The drawback of the today/tomorrow swap is that the liquidity position
of both members in the two currencies is influenced for an entire day.
Phase 3: external settlement through the central banks
During the final phase of the settlement process, the CLS Bank pays out the
balances that are on the member banks' accounts after the internal settlement of
all transactions has been completed. In order to do this, the CLS Bank instructs
the central banks to debit its account there and credit the account of the mem-
ber banks. These transfers are called pay-outs.
The CLS bank only transfers amounts to a member after the member has co-
vered any debit balances on its accounts. This is why the member banks still
have the opportunity to make interim pay-ins during phase 3, too.
136
At the end of phase 3, all the accounts within the CLS bank have a zero ba-
lance. This also applies to all accounts that the CLS bank holds at the central
banks. Phase 3 ends at 10:00 CET for the Asia and Pacific region and at 12:00
CET for the Europe region.
137
Chapter 14
Derivatives
Derivatives are instruments whereby the value is derived from the value of tra-
ditional instruments or the value of certain financial indicators. In every finan-
cial sub-market, derivatives are traded. In the money market, for instance,
money market futures are traded. In the capital market fixed-income, amongst
others, interest rate swaps are traded. And in the FX market, FX options are
traded. Derivatives can be used to hedge interest or FX positions or to take open
positions.
1 General features of derivatives
The instruments or indicators that the value of derivatives is derived from are
called the underlying value. The underlying value is also sometimes called the
reference value. The following can be agreed within a financial derivatives con-
tract:
� to buy/deliver a certain financial security (possibly after an opposite initial
trade) on a future date;
� to offset the difference between an interest rate or price that has been agreed
upon in the contract and the actual interest rate or price at a certain time in the
future, the fixing date;
� to swap the yields of two different financial instruments during a future
time period;
� to conclude a certain transaction at a predetermined price or fixed-interest rate
on a future date.
The following must be recorded when concluding a derivatives contract. First,
the size of the contract, which is expressed in a number of shares in the case of
shares derivatives, a nominal amount in the case of interest rate derivatives and
an amount of a certain currency in the case of currency derivatives. Second, the
reference value, the reference value is the closing price on an exchange in the
case of shares derivatives, an interest rate benchmark like EURIBOR in the case
138
of interest rate derivatives and an agreed exchange rate on a certain screen at a
certain point in time in the case of FX derivatives. Third, who the buyer and
seller are. With the exception of options, no physical selling or buying actually
takes place when the derivatives contract is concluded. After all, derivatives
refer to the entering into of future obligations. Even so, the terms buying and
selling are used. A derivative buyer is generally the party that profits from an
increase in the price/rate of the underlying value and a seller is the party that
profits from a decrease.
A contract price or rate should also be included in a derivatives contract. This is
the price or rate that is compared to the reference value on the fixing dates or
the price at which a future transaction shall be concluded as a result of the
derivatives contract.
Fixing dates and settlement dates must also be included in the contract. Fixing
dates are the dates on which the contract price is compared to the reference
value or the market price of the underlying value at that moment. Settlement
dates are the dates on which the parties involved settle the calculated obliga-
tions.
2 Option
An option is a derivative for which one of the parties obtains the right to
� buy or deliver a certain asset;
� offset a difference between an interest rate or price that is fixed in the
contract and the actual interest rate or price at a certain moment in the future;
� exchange the yields of two different financial instruments or
� enter into a certain transaction at a predetermined price or interest rate.
The party who obtains this right is the buyer of the option. The buyer can
demand that the other party, the seller, fulfils its side of the agreement. The
seller, also referred to as writer, enters into a one-sided obligation without the
right to demand that the buyer fulfils the opposite obligation. The selling of
options is also called writing options.
The predetermined rate or interest rate level at which the buyer can exercise his
right is called the strike price. A right to buy the underlying value or receive an
amount of money when the market price/rate of the underlying value is higher
than the strike price is called a call option. A right to sell the underlying value
or receive an amount of money when the market price/rate is lower than the
strike price is called a put option. The date on which an option contract ends is
called the expiry date.
139
Options can be based on a wide range of underlying values, varying from shares
to CO2 emission rights. Options such as share options, interest rate instrument
options and currency options are traded in just about every sub-market of the
financial markets. Long-term share options are sometimes called warrants.
Many financial instruments have options hidden in them. Such options are
called embedded options.
Some options, like share options, are traded on an exchange. Other options are
traded over-the-counter, for instance the currency options that companies use
for covering their currency risk. Just about all interest rate options are OTC
options, too.
The settlement of options
It is not possible to say in advance whether settlement will take place during the
maturity period of an option or at maturity. For the purpose of option settle-
ment, the price of the underlying instrument is compared to the exercise price.
If the buyer wants to exercise the option, there are two possibilities. Either the
difference between the market price and the exercise price is paid (cash settle-
ment) or physical delivery takes place. This means that a transaction in the
underlying value is created.
Example
An investor holds a call option General Electric with a strike of 14.00 US
dollars and a contract amount of 10,000 shares. At the expiry date of the
call option, the price of a the General Electric share is 15.00 US dollars.
The investor now exercises his option by buying 10,000 General Elec-
tric shares at a price of 14.00 US dollars.
An investor holds 1,000 put options on the FTSE 100 with a strike of
5,400. The FTSE option trades at GBP 10 per contract. At the expiry
date of the put option, the FTSE is fixed at 5,200.
The investor will exercise his option and will receive a cash settlement
amount of 10,000 British pounds.
The buyer of an exchange traded option can exercise his right at any time du-
ring the option maturity period. This means that the settlement can take place at
any point in time during the option maturity period. Options to which this
applies are called American-style options. Settlement of OTC currency options
can only take place at the maturity date. This is called European style. Ber-
mudan options are an intermediate form of options. They can only be exercised
on a limited number of predetermined dates during the maturity period.
140
Part of the settlement of an option that always applies is the payment of a pre-
mium to the seller by the buyer. This premium is usually paid one business day
after the signing of the contract.
3 FRA
A forward rate agreement (FRA) is an OTC interest rate derivative that is traded
on the money market in which two parties enter into a reciprocal obligation to
offset the difference between an interest rate agreed in the contract and the level
of a reference interest rate - usually EURIBOR of LIBOR - once at a certain
time in the future.
The buyer of an FRA is the party that receives an amount of money from the
other party if the reference interest rate on the fixing date is higher than the con-
tract interest rate. The seller receives an amount of money from the buyer if the
reference interest rate is lower than the contract interest rate at maturity.
There are two kinds of maturity periods for FRAs: the contract maturity period
and the underlying maturity period. The contract maturity period runs from the
contract date to the fixing date. The underlying maturity period runs from the
settlement date to maturity. The contract maturity period of a '6s vs. 9s' FRA,
for instance, is six months and the underlying maturity period is three months.
Example
The relevant dates of a '6s vs. 9s' FRA contract that is closed on the 1st
of March are:
� Contract date: March 1st;
� Fixing date: September 1st;
� Settlement date: September 3rd;
� Maturity date: December 3rd.
The settlement of an FRA
The amounts involved in the settlement of an FRA are calculated on the FRA
contract fixing date. Settlement takes place on the corresponding spot date,
which in most cases means two workings days later (t+2). The calculation of
the FRA settlement amount takes place in three steps:
141
1. The reference interest rate is compared with the contract interest rate.
2. The difference in interest rates is calculated as an amount over the
underlying maturity period and over the principal.
3. Because the settlement date is two days after the fixing date, in stead
of at the maturity date of the underlying period of the FRA, the
settlement amount is discounted against the money market reference
rate that corresponds with the underlying period.
Example
Two parties have concluded a '4 vs. 7' FRA. Maturity is in four months
and the reference interest rate is the three-month EURIBOR. The con-
tract interest rate is 3.75%. The contract principal is EUR 5,000,000.
On the fixing date, the three-month EURIBOR is fixed at 3.95%.
This FRA is settled as follows:
1. The difference between the contract interest rate and the reference
interest rate = 0.20%.
2. The interest amount over the underlying maturity period and over the
principal amount of EUR 5,000,000 is calculated:
EUR 5,000,000 x 91/360 x 0.20% = EUR 2,527.78.
3. This amount is discounted using the three-month EURIBOR rate of
3.95%. The present value formula is used to achieve this:
Settlement amount/(1 + days /360 x interest rate).
In this case, the settlement amount is:
2,527.78/(1 + 91/360 x 0.0395) = EUR 2,502.79.
The seller has to pay EUR 2,502.79 to the buyer on the settlement date.
4 Financial future
A financial future is an exchange traded financial instrument whereby two par-
ties enter into a reciprocal obligation to buy or deliver a certain financial secu-
rity at a certain point in time in the future at a predetermined price (physical
delivery) or to offset the difference between the price or interest rate that is
agreed upon in the futures contract and the actual price or interest rate at that
point in time (cash settlement).
In Europe, financial futures are mainly traded on Euronext.liffe and Eurex, the
derivatives daughter markets of NYSE Euronext and Deutsche Burse, respec-
tively.
142
Bought futures contracts can be sold to the exchange and sold futures contracts
can be bought back from the exchange at any time during their lifetime. This is
referred to as closing the futures contract or offsetting it. If a party closes a
futures contract, the original contract becomes void. The last date on which
trading may take place is called the expiry date. Just before the expiry date of a
future with physical settlement, the market parties usually close their futures in
order to avoid physical delivery.
Because financial futures are exclusively traded on stock exchanges, they have
standardized conditions. In the case of most futures, only a limited number of
series are traded. Contract sizes are also standardized. Parties that want to con-
clude a futures contract need only indicate how many contracts they would like
to conclude.
As with options, futures have a wide range of underlying values, varying from
bonds to exotic fruits. As with securities, the registration of futures is done by
custodians and central securities depositories.
4.1 Shares future and index future
A shares future is an exchange listed forward contract whereby shares are deli-
vered at maturity at a predetermined price. The contract size of a shares future
on Euronext, for instance, is 100 shares.
In addition to futures that have a specific share as the underlying value, there
are also index futures. Index futures are futures that have a price index as the
underlying value. An example of such is the Dutch FTI future. An FTI future is
an exchange listed forward contract whereby the difference is offset at maturity
between the actual Dutch AEX Index at maturity and the AEX Index agreed
upon in the futures contract. The underlying value of an FTI future is 200 times
the level of the Dutch AEX Index.
Example
The AEX Index closes at 375. A trader expects a rise of the AEX Index
and buys an FTI contract at 375. When the trader later closes this con-
tract at 382, he makes a profit of: (382 - 375) x 200 euros = 1,400 euros.
143
4.2 Bond future
A bond future is a stock market listed forward contract whereby Government
bonds must be delivered at a predetermined price at maturity. The underlying
value of a European bond future, for instance, is a notional bond with a nomi-
nal value of 100,000 euros and a coupon interest rate that was determined at the
moment the future was introduced, for example 6% in the case of Bund Futures.
The most common bond futures in Europe are the Bund future, Bobl future and
Schatz future. The underlying value for these futures is a notional German
Government bond with ten, five and two-year maturity periods, respectively,
and a 6% coupon. In addition to these bond futures, there is also the German
Buxl future which has a notional bond as its underlying value with a 30-year
maturity period and a 4% coupon. The prices of these bond futures are used as
most important benchmark for the euro capital market interest rate.
4.3 Money market future
A money market future (MM future) is a future with a short-term forward rate
as underlying value. An MM future is comparable to an FRA. Like FRAs, MM
futures have cash settlement. The price of a money market value is expressed as
100 -/- the forward yield over the underlying period of the MM future. The
price will go up if the relevant forward rate decreases and will go down if the
relevant forward rate increases. A party that wants to take profit from higher
interest rates therefore has to sell MM futures. This is the opposite as with
FRAs.
MM futures are standardized. The underlying period is often three months and
the contract amounts are shown in figure 14.1.
Figure 14.1 Overview of money market futures
contract contract volume value of one point Reference rate
Short Sterling GBP 500,000 GBP 12.50 GBP LIBOR
Eurodollar US 1,000,000 USD 25.00 USD LIBOR
Euribor EUR 1,000,000 EUR 25.00 EURIBOR
EuroYen JPY 100,000,000 JPY 1.250 JPY LIBOR
144
The value of one point is the change in the contract value if the underlying
interest rate changes with one basis point (0.01%) using the 30/360 daycount
convention. The value of one point of an Short Sterling contract, for instance,
can be calculated as follows:
Value of one point = 500,000 Sterling x 0.0001 x 90/360 = 12.50 Sterling.
The changes in the value of futures contracts are settled with the exchange on a
daily basis. This process is called margining.
Example
On Monday, a money market trader buys 25 month Eurodollar contracts
at a price of 97.47. During the first week the closing prices of this future
are
Mon: 97.54, Tue: 97.42, Wed: 97.48, Thu: 97.50, Fri: 97.58.
The daily margin payments are as follows:
If the MM trader is able to sell the MM futures on Monday at the open-
ing of the exchange at a price of 97.58, his result will be USD 6,875.
Since the exchange has already paid this amount to the trader during the
term of the contract, no additional settlement will take place.
During the lifetime of a money market future, the price is determined by the
free play of demand and supply. The fixing rate on the expiry date, however, is
set by the exchange. For money futures that are traded on NYSE Liffe, for
instance, this rate is called ‘exchange delivery settlement price’ (EDSP). The
EDSP is fixed at 11.00 a.m. and is calculated as 100 -/- the British Bankers’
Association Interest Settlement Rate (BBAISR), which is a mean of the quotes
of 16 banks for the three months money market interest rate.
Day Price movement
(points)
Margin call Paid by
Monday +7 +7 * 25* USD 25 = USD 4,375 Exchange
Tuesday -12 -12 * 25 * USD 25 = -USD 7,500 MM trader
Wednesday +6 +6 * 25 * USD 25 = USD 3,750 Exchange
Thursday +2 +2 * 25 * USD 25 = USD 1,250 Exchange
Friday +8 +8 * 25 * USD 25 = USD 5,000 Exchange
145
5 Interest rate swap
An interest rate swap (IRS) is an OTC interest rate derivative whereby two par-
ties enter into a reciprocal obligation to exchange interest coupon payments in
the same currency during an agreed period of time without exchanging princi-
pals. Interest rate swaps are used to change the interest rate conditions of a
financial instrument, usually from fixed to variable or vice versa.
For the party in an interest rate swap paying the fixed-interest rate coupon, the
interest rate swap is a payer's swap. For the party in the interest rate swap
receiving the fixed interest rate coupon, the same interest rate swap is a
receiver's swap. Sometimes it is also referred to as the buying or selling of a
swap. The general rule regarding buying and selling on the financial markets
applies here too: a buyer benefits from an increase in a market variable and a
seller benefits from a decrease. The buyer of a swap is therefore the one that
pays the fixed interest. This party benefits from an increase in the interest rate.
The interest rate swap maturity periods vary from one to fifty years. The princi-
pals differ greatly. The principal for most transactions is somewhere between
1 and 100 million euros. The reference for the variable interest rate obligation
of a swap in euros is usually the three or six-month EURIBOR or LIBOR rate.
Sometimes the price of a swap is referred to as the fixed-interest rate level of
the interest rate swap. This fixed IRS rate is determined by supply and demand
on the IRS market and usually follows the market interest rate for Government
bonds with a spread. The fixed-interest rate usually applies for the entire dura-
tion of the interest rate swap. In some cases, both interest rates are floating.
This is the case, for instance, for an interest rate swap in which a three-month
EURIBOR is swapped for a one-year EURIBOR. A swap involving the swap of
two variable interest rates is called a basis swap.
IRS settlement
Both the fixed and floating interest coupons in an IRS are paid in arrears. The
floating coupon is usually paid every quarter or semi-annually. The floating
interest rate for the next coupon period is determined two business days before
the expiration of the current floating coupon period. The fixed interest rate is
146
usually paid at the end of each year. The amount of the fixed coupon is often
offset with the floating coupon that is due on the day that the fixed coupon is
paid. This is called payment netting.
Example
The cash flows for a payer's IRS with a principal of 10,000,000 euros
and a duration of three years, in which a three-year fixed-interest rate of
3.5% is swapped with a six-month EURIBOR rate are as follows. The
first EURIBOR fixing is 2.1% and the first floating coupon period is 183
days.
Period Settlement amount
Receive
Settlement amount
Pay
t = 0 - -
6 m EUR 10,000,000 x 183/360 x 0.021 =
EUR 106,166.-
1 yr EUR 350,000 -/-
EUR 10,000,000 x days/360 x
6m EURIBOR2nd fixing
1.5 yr EUR 10,000,000 x days 360 x
6m EURIBOR3rd fixing
2 yr EUR 350,000 -/-
EUR 10,000,000 x days/360 x
6m EURIBOR4th fixing
2.5 yr EUR 10,000,000 x days/360 x
6m EURIBOR5th fixing
3 yr EUR 350,000 -/-
EUR 10,000,000 x days/360 x
6m EURIBOR6th fixing
147
6 Overnight index swap
An overnight index swap (OIS) is an OTC interest rate derivative whereby two
parties enter into a reciprocal obligation to swap interest rate flows for a short
period of time in the same currency, without exchanging principals and
whereby one of the interest rate coupons is based on an overnight rate. Over-
night index swaps are used to change the interest rate conditions of a money
market instrument.
The maximum duration of an OIS is two years. The principals are always large
(e.g. at least GBP 10 million). The reference value for the daily interest rate is,
for example, the EONIA or SONIA (Euro and Sterling OverNight Index Ave-
rage respectively).
OIS settlement
The fixed interest is determined at the start of the contract period. The daily
interest rates are determined at 18.00 hours daily. Settlement takes place based
on payment netting. Therefore, there is only one cash flow at maturity. The
table below shows when the settlement of overnight index swaps takes place on
the different money markets.
The coupon for the fixed leg is calculated by using the following formula:
principal x days/year basis x interest rate.
The floating coupon is calculated on a compounded base using to the following
formula:
Interest amount floating leg = Principal x ((1+1/360 x r1) x (1+1/360 x r2) x
(1+3*/360 x r3) x ......x ( 1+1/360 x rn) - 1).
In this formula, ‘n’ stands for the last fixing date.
* on Fridays, the EONIA is fixed for the whole weekend.
Currency Settlement date
GBP, CHF maturity date (M)
Japan + EUR M + 1
US M + 2
148
Example
A trader closes an OIS swap denominated in euros with a term of one
week and a principal of EUR 100 million. He is paying the fixed rate of
0.95%. During the week, the EONIA fixings are as follows:
The interest amount of the floating leg is calculated as follows:
EUR 100 mio x ((1+1/360 x 0.95) x (1+1/360 x 0.98) x (1+1/360 x 1.01)
x (1+1/360 x 1.02) x (1+3*/360 x 1.04)-1) = EUR 19,668.07.
The fixed coupon is = EUR 100 mio x 7/360 x 0.0095 = EUR 18,472.22
On the settlement date, the trader will receive the following netted
amount:
EUR 19,668.07 - EUR 18,472.22 = EUR 1,195.85.
* The Friday fixing is used for all days during the weekend.
day fixing
Monday 0.95
Tuesday 0.98
Wednesday 1.01
Thursday 1.02
Friday 1.04
149
7 Non-deliverable forward
A non-deliverable forward or NDF is an OTC instrument that is traded on the
currency market whereby the difference between the contract exchange rate and
the spot exchange rate on the fixing date is offset on the settlement date. A non-
deliverable forward (NDF) is used to hedge currency risks in currencies with-
out a market in ordinary FX forward contracts. This is the case, for instance, for
a number of Asian currencies such the Chinese yuan, the Indian rupee, the
Indonesian rupiah, the Korean won, the Philippines' peso and the Taiwanese
dollar.
You could say that an NDF is an FX forward contract with cash settlement
instead of physical delivery. In theory, the rate for an NDF is determined in the
same way as the FX forward rate for an ordinary FX forward contract. In prac-
tice, however, the rate for an NDF differs from the FX forward rate due to sup-
ply and demand factors.
NDF settlement
The two currencies are not actually exchanged in the agreed exchange ratio on
the expiry date of an NDF contract. Instead, the difference between the contract
rate and the FX spot rate on the fixing date is paid out in the ‘hard’ currency. In
the case of an USD/TWD contract, for instance, the settlement takes place in
US dollars.
Example
A Spanish importer concludes a three-month NDF in EUR/CNY and
hedges against an increase in the Chinese yuan. The contract size is CNY
100 million and the contract rate is 9.45. On the contract fixing date, the
EUR/CNY FX spot exchange rate is 9.25.
The settlement amount is calculated as the difference between a notional
purchase of CNY at the contract rate and a notional sale of CNY at the
FX spot exchange rate on the fixing date:
'Purchase' CNY 100 million at 9.45: EUR 10,582,010.58
'Sale' CNY 100 million at 9.25: EUR 10,810,810.81
The balance the importer receives is an amount of EUR 228,800.23.
150
8 Contract for difference
A contract for difference (CFD), also called an equity swap, is a swap with an
undetermined maturity period whereby the total return of a share is swapped
against a money market benchmark. Contracts for difference are often con-
cluded instead of shares futures for the purpose of protecting share portfolios
from falling prices. The advantage of a CFD relative to a share future is that a
contract for difference has an undetermined maturity period and, therefore, does
not need to be concluded repeatedly.
CFDs can be traded on an exchange or over-the-counter. Large American banks
like Goldman Sachs and Merrill Lynch function mainly in the role of market
maker in the over-the-counter market. It is common practice for the party that
concludes a CFD on an exchange or with a market maker to have the unilateral
right to terminate the CFD contract.
CFD settlement
No settlement takes place when a CFD is entered into. During the term of the
contract, the CFD buyer periodically pays a risk-free interest rate, including a
mark-up, and receives any dividends on the underlying share that may be dis-
tributed. Also normally, during the term of the contract, changes in the value of
the CFD contract due to changes in the price of the underlying share are settled
on a daily basis.
Figure 14.2 shows the settlement flows of an CFD with a contract amount of
EUR 10,000,000 / 500,000 shares.
Partly, buying a CFD produces the same cash flows as investing in the share.
There are both interest costs incurred and dividends received. With an CFD,
however, changes in the value of the position are settled on a daily basis while a
share investor would only realize his total trade result at the moment he sells his
shares.
151
9 Cap and floor
A cap is an OTC interest rate instrument whereby a party has the right to offset
the difference between an agreed interest rate level (the strike interest rate of the
cap) and a reference interest rate, usually the three or six-month EURIBOR or
LIBOR rate, at several future moments, if this reference rate is higher than the
exercise price. One could call the cap a call option on the EURIBOR/LIBOR.
In effect, a cap consists of several consecutive options with the same exercise
price: caplets, also called interest rate guarantees. The buyer of a cap receives a
payment if the level of the EURIBOR is higher than the strike on an expiry date
of one of the options.
The level of the payment is calculated by expressing the difference between the
reference interest rate and the strike as a percentage. This percentage is then
applied to the agreed principal and offset over the underlying period of the
option concerned.
If the reference interest rate on an expiry date is lower than the strike, the option
concerned generates no value, it ‘expires worthless’. The options with a later
expiry date are not affected in such a case and remain intact.
Because a cap is an option, the buyer must pay a premium. There are two ways
to pay the cap premium: up-front (one payment when concluding the cap) or
amortized (spread over the duration of the cap).
Example
A company has closed a cap with a strike of 4.00% and a term of five
years to hedge against increases in interest rates. The contract amount is
10 million US dollars en the reference rate is three months USD-LIBOR.
On 13 May, the reference rate is fixed for the underlying period 15 May
2010 - 15 August 2010 (92 days). The three months USD-LIBOR fixing
is 4.14%.
Because the caplet is in-the-money, on 15 August, the company will
receive an amount of
10,000,000 x 0.0014 x 92/360 = 3,577.78 US dollars.
152
Floor
A floor is an OTC interest rate instrument whereby a party has the right to off-
set the difference between an agreed interest rate level (the strike interest rate)
and the reference interest rate, usually a three or six-month EURIBOR of
LIBOR, at several future moments, if this reference rate is lower than the exer-
cise price. One could call a floor a put option on the EURIBOR/LIBOR.
A floor also consists of several consecutive options with one and the same exer-
cise price. Floors can be used by investors that have long-term variable interest
rate investments and want to protect themselves from decreases in interest rates.
10 Swaption
A swaption is an OTC interest rate instrument whereby a party has the right to
enter into an interest rate swap at maturity at a predetermined interest rate. A
payer's swaption gives the option buyer the right to pay the long interest rate in
the underlying interest rate swap. If the swap interest rate in the market at the
swaption’s maturity is higher than the exercise price, the buyer exercises the
option and thus engages the swap. He then pays a long interest rate that is lower
than the current market interest rate. The buyer can also opt for cash settle-
ment, in which case he requests the seller of the swaption to pay out the market
value of the swap on the settlement date. A receiver's swaption gives the buyer
the right to conclude an interest rate swap in which he will receive the long
interest rate.
Example
On September 2010, a company expects that it will have a long-term
financing need starting on 15 September 2011 and lasting for 10 years.
To hedge against increases in interest rates, the company closes a payer’s
swaption with a contract amount of 5 million British pounds. The strike
of this swaption is 4.75%. The period of the underlying swap is 15 Sep-
tember 2011 - 15 September 2021.
On 13 September 2011, the company closes a loan agreement with the
bank for an amount of 5 million British pounds and a term of 10 years.
The actual IRS rate than is 5.12%. Therefore, the company exercises the
swaption and closes a ten year payer’s IRS with a fixed rate of 4.75%
against six months GBP-LIBOR with a nominal of 5 million British
pounds.
If the interest rate condition of the loan is six months GBP-LIBOR flat,
the company has now fixed its rate for the period 15 September 2011 -
15 September 2021 at a level of 4.75%.
153
Index
A
access control 93
accounting entry generator (EAG) 92
actual/360 103
add-on for potential future exposure (PFE) 28
American style option 139
arranger 118
Asset & Liability Committee (ALM) 4
asset-backed security (ABS) 115
assignment 77
authorization 39
B
back office 7
back test 23
back office system 90
bank bill 107
bank holiday 65
banker's acceptance 107
base currency 128
base prospectus 119
basis point value limit 20
Bermudan option 139
bond basis 102
bond future 143
bond indenture 119
broker 14
brokerage control 38
business continuity plan 95
buyer of the option 138
buy-in procedure 76
C
calculation agent 43
call option 138
cap 151
caplet 151
cash management 2
cash settlement 139
central counterparty 14
central securities depository (CSD) 67
certificate of deposit 107
choice dividend 123
clean price 114
cleansing 122
clearing custodian 80
clearing fund 77
clearing member 73
clearing system 60
client advisor 5
close-out netting 31
callable note 116
collateral 29
commercial paper 106
compensation 88
compliance officer 12
confirmation 44
contract for difference 150
contractual netting 31
convertible bond 117
corporate actions 120
correspondent bank 58
cost of carry 36
cost of fund 3
covered bond 116
credit committee 27
credit limit 27
credit spread sensitivity limit 20
cum date 125
curve policy 34
custodian reconciliation 86
customer due diligence 25
cut-off time 48
D
daycount convention 100
daycount fraction 98
dealer 118
dealing room 6
dedicated control 12
delivery risk 28
delivery versus payment (DVP) 70
deposit 97
debt issuance programme (DIP) 111
154
dirty price 114
disaster recovery plan 95
dual control 12
duty of care 5
E
EBS 15
embedded option 139
end-of-month (EOM) 99
EONIA 108
Eurepo 108
EURIBOR 108
equity swap 150
ESES 67
Euro1 60
European style option 139
event calendar 51
event risk limit 20
exchange 13
exchange rate 127
expiry date 139
exposure at default (EAD) 28
F
fallen angel 117
FATF 26
finance department 10
financial future 141
fixed-income security 110
fixing date 138
floating rate note (FRN) 115
floor 152
following 98
foreign exchange market 127
forward rate agreement 140
free of payment (FOP) 70
front office 7
front office system 89
FTI future 142
fund manager 2
funds entrusted 3
FX forward 129
FX risk management 3
FX spot 127
FX swap 132
G
general clearing member 73
global custodian 81
global note 68
good settlement value 48
Greek limit 20
H
haircut 31
high yielders 113
hypothetical P&L 23
international central securities depository (ICSD) 71
internal control 11
independent price verification (IPV) 34
index futures 142
index-linked bond 117
individual clearing member 73
inflation-linked bond 117
initial consideration 105
initial margin 76
inside/outside swap 135
integrity 94
interbank funding 3
interest rate guarantee 151
interest rate risk management 4
interest rate swap 145
intermediary bank 58
Internal Audit Service 12
investigations 86
investment banking 1
investment grade 113
investment risk 27
ISDAFIX 112
international securities identification code (ISIN) 68
issue syndicate 118
issuer notice 121
J
junior loan 116
junk bond 117
K
key staff exposure 11
155
L
lending programme 1191
lending risk 27
limit control sheet (LCS) 18
liquidity 114
local custodian 81
long leg of an FX swap 132
loro account 57
low value payment 60
M
mandatory cash reserve 2
mandatory corporate action 121
margin 78
margin call 78
market risk 19
maturity consideration 105
merchant banking 1
model reserves 35
modified following 98
money market 97
money market future 143
money market loan 97
money market paper 106
money market risk 27
multilateral netting 32
multilateral trading facility (MTF) 14
N
netting 14
netting by novation 31
new product approval process 17
note issuance facility (NIF) 111
nominal limit 20
nominal value of a bond 111
non deliverable forward 149
nostro account 58
nostro reconciliation 85
O
off-market price testing 33
operational audit 12
operational risk 16
operations control 85
option 138
overnight swap index (OSI) 108
overnight index swap 147
over-the-counter market (OTC market) 14
P
payer's swap 145
pay-in schedule 133
paying agent 118
payment-versus-payment principle 134
pending transactions 125
perpetual 116
physical delivery 139
plain vanillas 7
political risk 114
position 4
positions limit 20
post-trade transparency 13
pre-settlement risk 28
pre-trade compliance 40
private equity 109
proprietary trading 4
put option 139
putable note 116
Q
quoted currency 128
R
rating 113
reasonability check 44
receiver's swap 145
reconciliation 85
reference value 137
replacement risk 28
repo 105
repo at notice 105
repurchase agreement 105
Reuters dealing 3000 15
reverse repo 105
rights issue 123
risk premium 113
RTGS system 59
156
S
sales 5
seasoned issue 69
securities lending 110
self-control 12
sell-out procedure 76
settlement 48
settlement date 48
settlement instruction 48
settlement risk 28
share 109
short leg 132
slope risk limit 20
SNA 46
special purpose vehicle 115
spread 113
standard data table 91
standard settlement instructions (SSI) 49
standing data files 91
static data 91
stock dividend 123
stock split 124
straight-through processing (STP) 39
strike price 138
structure ID 54
structured products group 55
subordinated loan 116
swap points130
swaption 152
systematic internalization 15
T
tenor 100
threshold 29
today/tomorrow swap 135
trader 4
trading limit 19
trading system 13
transparency before the trade 14
Treasury bill 107
U
underlying value 137
V
value at risk limit 21
value date 48
value today 131
value tomorrow 131
variation margin 78
verification 43
voluntary corporate action 121
Y
yield of a bond 112
yield of commercial paper 106
Z
zero coupon bond 117
