Foreign Exchange Operations

The ultimate nuts-and-bolts guide to foreign exchange operations

The foreign exchange landscape is particularly risky since so much of the world is unregulated and takes place over the counter (off exchange). Brilliant traders and money managers who are profitable may find themselves underperforming, or worse, losing, simply because they failed to establish strong operations. In this book, David DeRosa provides industry players with everything they need for strong operational functions from all the types of trades to execution, master trading agreements, documentation, settlement, margin and collateral, and prime brokerage services.

• Contains vital work flow solutions for trading in the volatile foreign exchange marketplace
• Offers information for mastering the operational aspect of foreign exchange trading to help determine best partners such as prime brokers and others
• Written by David DeRosa a leading foreign exchange expert who has consulted to hundreds of financial institutions

Foreign Exchange Operations helps traders mitigate risks and offers a guide to all aspects of trading operations from mastering trading agreements to margin documentation.

Preface xi

Acknowledgments xv

CHAPTER 1 Introduction to Foreign Exchange 1

Defining Money 1

Participants in the Foreign Exchange Market 2

Identifying Currencies and Exchange Rates 4

Quotation Conventions 5

The Foreign Exchange Market 6

Foreign Exchange Regimes 11

Exchange Rate Controls 12

The Structure of the Foreign Exchange Market 12

Banks’ Identification Codes 13

The Authorities 15

Spot Foreign Exchange Deals 17

Profit and Loss on a Simple Trade 18

Value Dates 19

Forward Foreign Exchange and Covered Interest Parity 20

Forward Swaps 21

Non-Deliverable Forwards 22

Summary 22

Appendix 1.1: ISO Currency Codes 23

References 34

CHAPTER 2 Options on Foreign Exchange 35

Option Basics 35

Put–Call Parity 37

The Importance of Option Models 39

Risk Parameters 41

The Minor Greeks 44

More on Delta 45

Portfolios of Options 50

American Exercise Models 51

Volatility 52

Important Option Strategies 55

Option Market Making 56

Non-Deliverable Options 56

Barrier Options 58

Binary Options 65

Barrier Determination Agency 69

Other Exotic Options 70

More on Option-Related Risks 70

Summary 72

Appendix 2.1: Further Comments on Put–Call Parity 72

Appendix 2.2: Black-Scholes-Merton Model 74

Appendix 2.3: Barrier and Binary Options 75

References 78

CHAPTER 3 How Trades are Executed and Confirmed 81

Spot Foreign Exchange Deals 83

Forward Outright Deals 83

Forward Swap Deals 85

Option Trades 87

How Foreign Exchange Trades are Executed 88

Concentration in Market Making 89

Example of an Electronic Trading Platform: FXall 92

Trade Documentation Cycle 97

Internal Operations and Reports for Dealers 141

Summary 159

Appendix 3.1: Transactions at Daily Fixings 160

References 160

CHAPTER 4 Foreign Exchange Settlement 161

Settlement Instructions for an Individual Spot Foreign Exchange Deal 161

Overview of the Settlement Process 170

The Bretton Woods-Smithsonian Period 171

The Herstatt Legacy 172

Settlement Risk 173

Netting 176

How the Modern Settlement Systems Developed 181

Large-Value Transfers 186

Central Bank Involvement 186

Correspondent Banking 187

Payment Systems 187

Designated-Time Net Settlement (DTNS) 189

Real-Time Gross Settlement (RTGS) 189

Examples of Modern Payment Systems 192

CLS Bank International 203

Internal Controls 208

Summary 209

References 209

CHAPTER 5 Master Agreements 211

Motivation 212

The Architecture 214

The FXC Master Agreement Forms 215

The ISDA Master Agreement Forms 215

Single Agreement 217

Non-Reliance: Parties to Rely on Their Own Expertise 219

Netting: Payment or Settlement Netting and Novation Netting 220

Events of Default 221

Termination Events 228

Additional Termination Events 230

Close-Out Netting 231

Safe Harbors 232

Early Termination 233

Payments Upon Termination and Close-Out Amounts 234

Close-Out Amount: 2002 ISDA 236

Set-Off Provisions 241

Special Features for Options: ICOM and FEOMA 241

Special Features for Non-Deliverable Forwards 242

Miscellaneous Issues 242

More on Deeds of Adherence and Schedules 245

Summary 245

Appendix 5.1: IFXCO Terms 246

Appendix 5.2: IFXCO Adherence Agreement 275

References 281

CHAPTER 6 Margin and Collateral 283

Credit Agreements 283

Framework for the ISDA Credit Support Deed and the FXC Collateral Annex 285

Framework for the ISDA Credit Support Annexes 293

Enforcement Rights of the Secured Party 294

Some Additional Features Commonly Found in Credit Support Documents 296

The Value-at-Risk Concept 297

VaR for Spot, Forward, and Vanilla Options 298

Portfolio Value-at-Risk 305

Sample Customer Credit Snapshot 310

Limitations of VaR 310

Limitations of Collateralized Agreements 313

Summary 313

Appendix 6.1: The 1999 Collateral Annex to FEOMA, IFEMA, or ICOM Master Agreement 314

References 337

CHAPTER 7 Foreign Exchange Prime Brokerage 339

Overview of FX Prime Brokerage 339

Pros and Cons of FX Prime Brokerage 341

Execution and Confirmation in an FX Prime Brokerage Environment 343

The Legal Architecture of FX Prime Brokerage 345

The FX Prime Broker and the Executing Dealer 346

The Master FX Give-up Agreement 346

Other Elements of the Master FX Give-up Agreement 354

The FX Prime Broker and the Designated Party 359

The Executing Dealer and the Designated Party 366

Reverse Give-Up Relationships 366

Summary 368

Appendix 7.1: Master FX Give-Up Agreement 369

Appendix 7.2: Compensation Agreement 384

References 388

About the Author 389

Index 391

David F. DeRosa is President of DeRosa Research and Trading, Inc., a firm that conducts research into derivatives pricing, macroeconomics, monetary policy, and foreign exchange. He is an adjunct associate professor of finance at the Fu Foundation School of Engineering and Applied Science at Columbia University where he teaches courses in pricing models in financial engineering. David sits on the boards of several prominent hedge fund groups. He is the author of many books including Options on Foreign Exchange (Wiley), Central Banking and Monetary Policy in Emerging-Markets Nations, and In Defense of Free Capital Markets. David received his PhD in finance and economics from the Graduate School of Business of The University of Chicago, and his BA in economics from the College of The University of Chicago. Before founding DeRosa Research, he worked on Wall Street as a foreign exchange trader, hedge fund trader, and portfolio manager.

The volumes traded on the international foreign exchange market are huge, exceeding $4 trillion daily, far surpassing those of all other portions of the international capital market. Yet there is surprisingly little written to help professionals who want to learn about foreign exchange and to gain proficiency in the mechanics of trading in this important market. Even less has been written to explain the mechanics of foreign exchange operations, how money flows, and how the settlement process works.

Traders, operations personnel, hedge fund managers, investment bankers, financial managers, attorneys, and financial regulators will all find this volume indispensable for understanding what happens behind the scenes between the execution of a trade and its settlement.

David DeRosa, a veteran of financial markets, explains how the foreign exchange market conducts trading and operations. He addresses the practical considerations of how market participants contract with one another to do trading and operations, conduct margin and credit, and undertake foreign exchange prime brokerage services.

DeRosa’s work is immensely practical. Understanding the operations process helps control costs, minimize errors, and to some extent preclude fraud. DeRosa’s explanation of operational conventions and their development also reveals the story of how the foreign exchange market grew and developed over the last four decades: a largely ignored but important corner of financial history.

Foreign Exchange Operations walks the reader through all practical aspects of foreign exchange operations, from trade execution to documentation to trade confirmation. It focuses on the processes by which foreign exchange trades are settled using real time gross settlement systems. The later chapters focus on the legal and financial superstructure of the market, including master agreements, margin and collateral practices, and foreign exchange prime brokerage. DeRosa provides concrete examples to illustrate market practice, including more than 100 exhibits that contain real-world examples of trades, confirmations, settlement instructions, and other key documents.

Some of the main topics include:

• The structure of the foreign exchange market
• Quotation and trading conventions
• Currencies, exchange rates, and exchange rate controls
• Foreign exchange deals, including spot, forward, and non-deliverable forwards
• Foreign currency options, both vanilla and exotic options
• How foreign exchange trades are executed and confirmed
• Trade settlements, including payment systems, DTNS, RTGS, and CLS Bank
• Master agreements—the primary contracts that bind counterparties
• Uses of credit, margin, and collateral in foreign exchange trading
• Foreign exchange prime brokerage