Derivatives have always presented delicate control risks and corporates, with their limited resources, are particularly exposed. This article explores these risks and suggests practical risk mitigation, specifically four eye FX dealing.

Rogue traders

Some recent accounts of rouge traders in the press set me thinking about the risks for corporate treasury. Granted, many of the famous cases involving rouge traders occurred in financial institutions and trading houses. This makes sense because such institutions tend to trade huge volumes and to hold derivative positions for profit, entailing greater risk.

Corporates, on the other hand, generally use derivatives for hedging purposes alone and have relatively smaller volumes. That said, a derivative hedge is still an outstanding position in the derivatives book. Furthermore, corporates are often resource constrained, and cannot afford the organisational bulk and complexity that financial institutions deploy to mitigate derivative risk – leaving room for foul play.

The danger of derivatives

Most of the famous rogue trader cases involve financial instruments like stock indices, bonds, and some commodity instruments. In fact, many were in futures markets, which are relatively transparent but presumably the rogue positions were hidden in large complex positions.

For the corporate treasurer, the greatest dealing risk comes from pure derivatives with future settlements. Over the counter (OTC) products, often used by corporate treasurers, normally trade against credit lines which makes them more easily hidden than futures, for example, which entail margining and daily mark-to-market with brokers.

If we exclude commodities as a minority sport in corporate treasury, the main OTC derivatives used by corporates are interest rate swaps and FX forwards. Given that interest rate swaps tend to involve longer tenors and therefore more complex and hard to hide credit discussions, the most common vulnerability is probably from FX forwards.

In contrast, cash transactions such as loans, deposits and spot FX settle promptly (instantly or nearly instantly). Any damage caused from foul play can arguably be limited because the results of the transaction remain hidden for less time. There are of course exceptions to this rule. Take for instance structured notes or deposits which tend to be cash deposits with derivatives (usually options) embedded. These can pose nasty risks, but corporates should not be using these in any case.

Front office risk

In the days of phone dealing, corporates simply had to trust their front office. There was little that could be done to stop a dealer who had gone off the rails from sneaking in a large unauthorised trade. And, even in the absence of malignancy, there was also the risk of human error – buying instead of selling or mistakenly adding an extra zero.

Whilst open plan offices have helped in creating a self-regulating environment, there is still plenty of opportunity – particularly in small teams with colleagues frequently travelling or in meetings – for a problem to occur. Moreover, small treasuries often don’t record phone lines and by the time a paper confirmation has arrived, it may be the case that the market has turned against you.

Visibility and segregation of duties are essential to mitigate the risk of rogue trading.

FX trading

For the majority of corporate treasuries, the control situation is now much better than in the days of phone dealing. Most corporates deal FX online through multi bank portals like FxAll, Currenex, 360T and Bloomberg. This gives a powerful audit trail that can be monitored by middle office in real time. A large number also use electronic confirmation, which provides near real-time awareness of FX deals – usually with segregation of duties where the front office deals and back office confirms.

In some parts of the world however, eFX is less well accepted. Treasurers seem to believe that they can obtain better prices from their buddies at the banks’ treasury sales desks. And some fear that eFX will damage bank relations. The reality is very different.

It is very clear that eFX dramatically aids price discovery. The ability to get multiple prices at once while viewing market rates is unbeatable. While it is not recommended to ask too many sources for each deal, treasurers can cover far more counterparties with eFX than by using multiple phone lines. And the risks are far lower because the eFX portals update in real-time, which is not possible with over the phone dealing.

On the bank relationship side, eFX allows treasurers to show more deals to more banks than would be possible by phone dealing. Thus it offers banks more opportunity to win business and can thus improve the relationships. In addition, during relationship reviews, eFX provides detailed bid data that helps banks understand how to win more business. eFX also reduces costs for banks, so everyone gains.

Four eye dealing

A major source of dealing risk comes from one individual being able to deal alone. The Holy Grail in this respect is to have four eye dealing – segregation of duties within the dealing process itself. Note that the deal approval feature in most TMSs is no help because it happens after the deal is executed and cannot guarantee that the deal was correctly captured, or indeed captured at all, in the system.

One treasurer that I worked with resorted to doing FX deals by having a dealer and manager on the phone at the same time, and insisting that banks only book the deal when the manager has confirmed. This is extremely cumbersome and complex (which means operationally risky) for the banks, not to mention a waste of time for the corporate. The solution we found was to segregate roles within the eFX platform.

The different roles and user rights are:

• FX risk team.

  This team collects and analyses exposure forecasts from subsidiaries, and calculates the net exposure per currency to be hedged. Within the dealing platform, they have rights to enter the deal currency, amount, and maturity. They do not have the right to deal.

• Front office.

  This team comprises the dealers themselves. Within the dealing platforms, the dealers’ rights do not allow them to input currency, amount and maturity. They are only allowed to execute the deals that have previously been entered by the FX risk team.

• Middle office.

  This team monitors financial and operational risk to ensure compliance with policy.

Within the dealing platform, they have read-only rights to the whole system, so they can see what is happening in real-time. They are notified with real-time emails of all significant events within the platform.

Obviously, confirmation, settlement and reconciliation are segregated to back office in the normal way.

In constructing this process, we have been able to create a system of enforced segregation between determining what is to be dealt and dealing itself – the FX risk team enters what is to be dealt but cannot deal while the front office executes deals but cannot enter what is to be dealt.

Not all corporates will have large enough organisations to allow different teams. That is not important. All that matters is to have different individuals take each of the roles above, to ensure proper segregation of duties.

Visibility and segregation of duties are essential to mitigate the risk of rogue trading. eFX platforms provide this for the most common derivatives traded by corporate treasuries. With the proper set-up of user access rights, a good eFX platform can even enforce four eye dealing – a segregation that was not practical with phone dealing.