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The Foreign Exchange Committee

2009 Annual Report

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Foreign Exchange Committee 2009 Annual Report

Contents

Chairs Letter ........................................................... 1

Actions and Initiatives

Works in Progress or 2010 ...................................5

Legal Initiatives ....................................................... 7

Publications

Documents

Foreign Exchange Prime BrokerageReverse Give-Up Relationships:Overview of Key Issues and Analysisof Legal Framework..........................................11

Committee Letter Announcing thePublication oOverview of theOTC Foreign Exchange Market: 2009............ 21

Overview of the OTC ForeignExchange Market: 2009...................................23

Committee Letter Commentingon Proposed Rule to Establish a Leverage

Limitation or Retail Forex .............................29

SpeechExcerpts rom Lie afer Stress Testing:

Adapting FX to the New FinancialServices Environment ................................... 33

Survey of North American ForeignExchange VolumeAnnouncement ..................................................... 39

Explanatory Notes ................................................ 45

Reporting Dealers ................................................47

Market Share TablesOctober 2009 .................................................49April 2009....................................................... 51

Data TablesOctober 2009 .................................................53April 2009....................................................... 63

Reference Material

Document o Organization .................................75

Meetings, 2009 and 2010 ..................................... 79

Member List, 2009 ................................................81

Member List, 2010 ................................................83

Acknowledgments ................................................85

Index to 1997-2009 Annual Reports .................. 87

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3/95Chairs Letter 1

Chairs Letter

At the start o 2009, financial market conditions were ragile but recovering. Te Foreign Exchange Committeesprimary concerns continued to be unding and liquidity. In the first quarter, the Committee ocused on capitaland credit preservation as members closely monitored the effects o both on the global currency market. Te

Federal Reserve Bank o New York was proactive in communicating both the intent and the substance o thevarious policy initiatives it had undertaken. rade volumes and risk appetite appeared low. Against this back-drop, the Committee chose to direct its efforts to three areas:

n Post-crisis market structure: Evaluating tools that exist within the oreign exchange market to help reducesystemic risk and considering changes to the market structure to urther bolster the markets resilience andefficiency;

n Risk measurement and management: Addressing the risk that arises rom the limitations o conventionalstatistical rameworks as well as broader credit, settlement, liquidity, and reputational risks; and

n Foreign Exchange Committee products and communication: Reexamining the composition and role o theCommittee itsel within the broader oreign exchange industry.

Te global equity markets stabilized at the end o the first quarter o 2009, and the remainder o the yearwas characterized by equity rebounds, episodic signs o slow recovery, and an increasing ocus on new proposedregulation. Globally, countries were at different stages o recovery; domestically, policy responses varied andreflected national concerns. Te responses to quantitative easing, economic stimulus, extraordinary liquidityprovision, and various regulatory agendas were difficult to assess.

Te Foreign Exchange Committee took a 360-degree view o eventslooking back to the crisis o 2007-08 toanalyze root causes and market perormance, and looking ahead to understand the challenges o large complexfinancial institutions, financial market interconnectedness, and systemic risk. Coincident with these initiatives,the Committee stepped up its dialogue with similar committees around the world. It hosted the Secretariat othe Bank o Englands Foreign Exchange Joint Standing Committee (FXJSC) at its May and October meetings.In addition, the Committee participated in a meeting o eight global oreign exchange committees in Singaporetoward the end o the year. Dialogue among the oreign exchange committees o the euro zone, the United

Kingdom, Canada, Japan, Hong Kong, Singapore, Australia, and the United States is active and ongoing.

As the year progressed, Committee discussions addressed the role o the U.S. dollar as a reserve currency,the timing and process o the eventual normalization o monetary policy, and the potential changes in theregulatory environment. During the summer, the first drafs o proposed U.S. financial market legislationappeared. Te Committee studied the language o this legislation and debated the prospective impact on theglobal oreign exchange market. Te work o our task orces intensified, as did our dialogue with the FXJSC inLondon, with whom we share some members.

In September, the FXJSC published a working paper on the oreign exchange market. Tis paper dealt withoreign exchange market size, scope, and structure; perormance during the crisis; and current market initia-tives. Te Committee, with its Buy-Side Subcommittee, decided to publish in November a similar U.S.-ocusedpaper to educate readers about the market and to clariy technical issues raised by proposed regulatory reorm

efforts. Specifically, our intent was to provide a basic overview o the oreign exchange market or those whomight be unamiliar with its scope and unction, to comment on its perormance during the crisis, to under-score the global nature o the oreign exchange market and thus the importance o global regulatory commu-nication, and to suggest urther risk mitigation efforts or the industry. Te Foreign Exchange CommitteesOverview of the OTC Foreign Exchange Market: 2009was published in the autumn.

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4/952 Foreign Exchange Committee 2009 Annual Report

Te Committees conclusions are consistent with those of its FXJSC colleagues in the United Kingdom.Te foreign exchange market is resilient, and the significant risk mitigation mechanisms developed over theyears (many of which have been documented in past Committee publications) have served participants, endusers, and the general public well. Opportunities to enhance transparency and risk mitigation remain, and theCommittee and its working groups will continue to focus on these priorities in 2010.

Troughout 2009, the Foreign Exchange Committee used its position to enhance knowledge and under-standing of the foreign exchange and related international financial markets. It will continue its work to promotethe efficiency and transparency of the foreign exchange market, pursue greater standardization of documenta-tion, improve its communication with both participants and those who regulate them, and sharpen its focuson crisis management. Although the financial and regulatory reform environment created by the recent crisisis uncertain, the Committee will continue to recommend best practices and educate market practitioners andthe public on the function and challenges of the global foreign exchange market.

For thirty years, the Committee has served as a forum to discuss foreign exchange issues, a source ofbest practices, and a channel of communication for both regulators and the general public. I leave this noblework to my colleagues, as 2009 marks the end of my sixteen-year involvement with this group. Tese men andwomen graciously serve a variety of constituenciesclients, shareholders, other professionals in the foreign

exchange industry, and the public interest. As this annual report and the ones that have preceded it demon-strate, their commitment is considerable. It has been an honor to serve with all my past and present colleagues.

Rich Mahoney

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Actions and Initiatives

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7/95Works in Progress for 2010 5

Works in Progress for 2010

During 2009, members o the Foreign ExchangeCommittee and its Buy-Side Subcommittee partici-

pated in three work streams, addressing oreignexchange market structure, risk management inoreign exchange, and Foreign Exchange Committeecommunications.

Te efforts o the work stream on oreignexchange market structure culminated in theNovember 2009 release o Overview of the OTCForeign Exchange Market: 2009on the Committeeswebsite. Te document highlights elements o themarket structure that helped support the oreignexchange markets operation during the recentfinancial turmoil. It also identifies opportunities

or urther improvement.

In 2010, efforts o the other work streamsremain active. Te work stream on risk manage-ment in oreign exchange has reviewed currentbest-practice guidance and noted opportunities torefine guidance in light o lessons learned duringthe recent period. Te Committee expects todraf and publish updated language accordingly.In addition, the Foreign Exchange Committeecommunications work stream has provided a seto recommendations or improving the Commit-tees external and internal communications goingorward.

Finally, as legislative proposals on regulatoryreorm continue to take shape in the United States

and abroad, Committee members will stay abreasto these developments and work to provideeffective guidance in support o a robust andefficient global oreign exchange market.

Efforts of the Working Groups

Te Chie Dealers Working Group will continueto support publication o the Survey o NorthAmerican Foreign Exchange Volume. Te groupwill also assist the Committee by providing

relevant and timely best-practice guidance onoreign exchange trading activities.

Te Operations Managers Working Groupwill review the current set o best practices ormanaging operational risk in oreign exchange.Additionally, it will continue to promote efforts tourther increase automation and straight-throughprocessing o oreign exchange option confirma-tions, consistent with commitments being madeto the supervisors o major dealers in over-the-counter derivatives.

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9/95Legal Initiatives 7

Legal Initiatives

Introduction to the FMLG

Te Financial Markets Lawyers Group (FMLG) isa committee o lawyers rom leading worldwidefinancial institutions that supports over-the-counter (OC) oreign exchange and otherfinancial markets trading. Te FMLG originatedin the late 1980s, when a group o lawyers ormedto develop a model master netting agreement ororeign exchange trading in the United States. TeFMLG advises the Foreign Exchange Committeeon many initiatives as well as pursues its owncapital markets initiatives. Te FMLG is sponsored

by, but independent o, the Federal Reserve Bank oNew York (FRBNY). A senior FRBNY legal officerchairs the group, and senior staff o the FRBNYsLegal Department are members.

Te FMLG provided support to the ForeignExchange Committee in the development andpublication in 1997 o master netting agreementsor oreign exchange transactionsthe Inter-national Foreign Exchange and Options MasterAgreement (FEOMA), the International ForeignExchange Master Agreement (IFEMA), theInternational Currency Options Market MasterAgreement (ICOM), and the International ForeignExchange and Currency Option Master Agreement(IFXCO). Recent accomplishments o the FMLGinclude the introduction, with cosponsors, o theindustrys first multilateral master confirmationagreement or non-deliverable orward (NDF) andnon-deliverable option (NDO) oreign exchangetransactions. Te FMLG also introduced theindustrys first oreign exchange master give-upagreement and cosponsored the 1998 FX andCurrency Option Definitions (1998 Definitions).Group members have participated in a number o

global initiatives, including the Global Documen-tation Steering Committee, the Hague Conventionon collateral accounts, and industry preparationor Y2K and conversion to the euro. Te FMLGcontinues to draf new trade documentation, best-practice recommendations, legal bries, commentletters, and policy papers associated with OCmarket developments.

Te FMLG maintains relationships with

OC industry associations and official institu-tions worldwide in order to maintain channelso communication and cooperation on issues oimportance to the oreign exchange and OCmarkets. Among the groups with which the FMLGenjoys close ties are EMA, Inc., the InternationalSwaps and Derivatives Association, Inc., and theSecurities Industry and Financial Markets Associ-ation, in the United States; the European FinancialMarkets Lawyers Group (EFMLG), sponsored bythe European Central Bank; the Financial MarketsLaw Committee and the Foreign Exchange Joint

Standing Committee, sponsored by the Bank oEngland; and CLS Bank. In 2009, the FMLG joinedrepresentatives o the EFMLG, the Financial LawBoard, and the Financial Markets Law Committeeat the annual quadrilateral meeting held by thegroups. Meeting participants discussed a widerange o issues, including the market turmoil,bankruptcy law and developments, governanceand controls, EU-U.S. global regulatory conver-gence, and netting and other documentationissues. FMLG members also joined a symposiumon documentation harmonization hosted by the

EFMLG in September.

FMLG Initiatives during 2009

Many o the FMLGs projects in 2009 underscorethe groups strong bond with the Foreign ExchangeCommittee. Other efforts reflect the FMLGs policyinterests and the cooperative relationship that hasevolved among legal-oriented industry groups inthe global community.

FMLG Cross-Currency NDF and NDOTemplate Working GroupTe FMLG continued its efforts to developcross-currency templates that would providestandardized rate sources to smooth the tradingand confirmation process or cross-currencyNDFs and NDOs. Te working group plans todevelop a set o rate source definitions or hardcurrency pairs.

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Foreign Exchange Novations ProtocolTe FMLG continued to work with the OperationsManagers Working Group (OMWG) to develop astandard protocol or oreign exchange novations,given their increasing use in the market. Te

working group will collaborate with the Inter-national Swaps and Derivatives Association,Inc., to draf a protocol to reduce the incidenceo settlement and collateral ails associated withoreign exchange novations.

Prime BrokerageTe FMLG, with the Foreign Exchange Committee,published its white paper on prime brokeragereverse give-up relationships, which defines ormarket participants the different types o relation-ships that have emerged and provides an overview

o key legal and operational issues associated withreverse-give-up trading activities.

Te FMLG also established a working group toinvestigate the viability o streamlining the primebrokerage designation notice process by way o anautomated, single-platorm electronic system toreplace existing traditional media. Te workinggroup, together with the OMWG, discussed thepossibility o developing an electronic platormthat would be a repository o data containinginormation already ound in designation notices.

Electronic ConfirmationsTe FMLG established a working group to examineissues arising rom the growing trend o electronicconfirmation use. Te working group anticipatesreviewing Foreign Exchange Committee best-practice and other guidance on confirmations aswell as examining the enorceability o electronicconfirmations in major jurisdictions.

Legislative, Regulatory, andJudicial ActionTroughout 2009, the FMLG closely ollowedpending legislation and regulation that could affectthe oreign exchange and financial markets as well

as events associated with the financial crisis.Te FMLG assisted the Foreign Exchange

Committee in the publication o its paper Overviewof the OTC Foreign Exchange Market: 2009,whichprovides an overview o the oreign exchangemarketplace, describes certain tools availableto mitigate oreign exchange risks, and recom-mends priorities designed to urther strengthenthe oreign exchange marketplace. Te FMLGalso drafed a comment letter or the Committeeto respond to the Financial Industry RegulatoryAuthoritys proposed Rule 2380, which would

impose a leverage limitation on retail oreignexchange transactions.

OpinionsTe FMLG continued its long-term efforts tocoordinate the annual compilation and updatingo legal opinions on IFEMA, ICOM, FEOMA,and IFXCO. In 2009, David Miller o the FMLGsolicited updated opinions rom more than thirty

jurisdictions in which member firms are active.

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Publications

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13/95Foreign Exchange Prime Brokerage Reverse Give-Up Relationships 11

I. Introduction

Foreign exchange prime brokerage allows clientsto source liquidity rom a variety o executingdealers while maintaining a credit relationship,placing collateral, and settling with a singleentitythe prime broker. Te product emergedin the early 1990s and gained momentum whenseveral financial institutions entered the primebrokerage business with more ormal opera-tional controls, procedures, and processes. Tisapproach laid the oundation or an expansion othe client base to include hedge unds, commoditytrading advisors, asset managers, small banks,and other oreign exchange market participants.Te undamental concept in a plain vanillaprime brokerage arrangement is the give-upwhereby a prime broker accepts oreign exchangetrades executed between its client and a dealer. Inthis arrangement, the prime broker is interposed

between the dealer and its client as counterpartyto offsetting oreign exchange trades.

Since the late 1990s, oreign exchange primebrokerage has evolved rom the plain vanillagive-up model into a more complicated set oreverse give-up relationships among multipleprime brokers, give-up parties, and their clients.Clients in this area include hedge unds and assetmanagement companies that execute trades withseveral dealers or their own accounts, or theaccounts o financial institutions, or or hedgeunds that maintain accounts at financial institu-tions. Additionally, reverse give-up relationshipsarise when clients manage money or hedge undsthat transact with different prime brokers or when,or business or credit reasons, clients desire touse multiple prime brokers. In a reverse give-up,the prime broker, to whom the oreign exchangetrades o its clients have been given up, in turnenters into offsetting transactions with anotherfinancial institution that may or may not be aprime broker.

Te Financial Markets Lawyers Group(FMLG) seeks to explain to market participantsthe different types o reverse give-up relationshipsthat have emerged and provide an overview okey legal and operational issues that they shouldconsider when engaging in reverse give-up tradingactivities. Tese issues are distinct rom thosethat arise in the plain vanilla prime brokerage

context; thus, they require an understanding othe complexity o the relationships and associateddocumentation. Recognizing that market practicesor defining the legal relationships and processeso reverse give-up relationships are diverse, theFMLG aims to heighten awareness o the key issuesto enable counterparties to negotiate and engagein reverse give-up relationships in a productivemanner that appropriately addresses relevant risksand processes.

II. Reverse Give-UpParticipants andRelationships

A. No Reverse Give-UpsA plain vanilla prime brokerage relationshipinvolves three partiesthe client, the prime broker,and the executing dealer. Te client conducts atrade with the executing dealer or give-up to itsprime broker. When the prime broker is notifiedo the trade by the client and executing dealer andaccepts the trade, the prime brokerrather than

the clientbecomes the party to the transaction.Tis relationship is documented under the primebrokerage agreement between the client and primebroker, and under the master give-up agreementbetween the prime broker and executing dealer.

Foreign Exchange Prime BrokerageReverse Give-Up Relationships:Overview of Key Issues and Analysisof Legal Framework

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In Diagram 1, assume that the prime brokersclient is a hedge und or an asset managementcompany that executes trades with severalexecuting dealers. Te client trades or its ownaccount and manages hedge und accountsserviced by the prime broker. Te trades aregiven up to the prime broker under the termso each master give-up agreement between theprime broker and each executing dealer and othe prime brokerage agreement between the

prime broker and the client. Te prime brokerenters into offsetting trades with the client andwith the hedge unds, as instructed by the client.Te offsetting trades are typically governed bymaster agreements, such as the ISDA (Interna-tional Swaps and Derivatives Association) MasterAgreement or the Foreign Exchange CommitteesIFEMA (International Foreign Exchange MasterAgreement) or FEOMA (International ForeignExchange and Options Master Agreement),between the prime broker and the client, or theprime broker and the hedge unds.

o address risks arising rom the plainvanilla give-up relationship, the Foreign ExchangeCommittee published in 2005 the first industryMaster FX Give-Up Agreement, ollowed by bestpractice recommendations.1 Te agreement andrecommendations address several key relationship

issues, such as the scope o the give-up relationship,trade notification, trade acceptance or rejection,and post-trade events. Specifically, the Master FXGive-Up Agreement addresses: (i) the types otrades that the prime broker will accept and thecredit limits that apply to the give-up relationship;(ii) when the client and/or executing dealer mustprovide trade notifications to the prime broker;(iii) the rights and obligations o the prime brokerconcerning acceptance or rejection o trades,

including notices (i any) to be provided by theprime broker; and (iv) the party responsible ordetermination and notification o post-tradeevents. Tese key issues are urther developed inreverse give-up relationships, as described below.

B. Reverse Give-Up PartyA reverse give-up relationship introduces a ourthparty to the prime brokerage relationship amongthe client, the prime broker, and the executingdealer. Te ourth party is a reverse give-up party,ofen a financial institution that acts as custodian

or hedge und accounts or which the client tradesas manager. Te give-up party may also permitthe client to trade or its proprietary book. Tisrelationship is typically documented under areverse give-up agreement among the primebroker, the give-up party, and the client.

1For more on the development o the prime brokerage product and the Foreign Exchange Committees best practicerecommendations or the industry, see Foreign Exchange Prime Brokerage: Product Overview and Best PracticeRecommendations, published December 19, 2005 (available at http://www.newyorked.org/xc/2005/xc051219a.pd ).he Master FX Give-Up Agreement and an accompanying Compensation Agreement are available at the websites noted inootnote 3.

Dealer

Prime broker 1

Diagram 1

Dealer Dealer

Dealer

Master give-up agreementsand transactions

Prime brokersclient

Trade execution

Master agreements andoffsetting transactions

Prime brokersclient/fund

Prime brokerage agreement

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In Diagram 2, assume that the prime brokersclient is a hedge und or an asset managementcompany that carries out trades with severalexecuting dealers. Te client manages hedgeund accounts or which the give-up party actsas custodian and trades or the give-up partysown account. Te trades are given up to theprime broker, under the terms o each mastergive-up agreement between the prime broker andeach executing dealer, and the prime brokerageagreement between the prime broker and theclient. Te prime broker then enters into offsettingtrades with the give-up party, under the terms othe reverse give-up agreement between the primebroker and the give-up party (and typically theclient). Te give-up party enters into offsettingtrades with the hedge unds managed by theclient. When the client trades or the give-up

partys own account, trades are internally bookedto that account.

Tis reverse give-up relationship raises thekey issue o whether the give-up party is a passiverecipient o trades, or i it actively imposeslimits on trades allocated to it and on proceduralrequirements or notices. Te give-up party mayseparately limit the clients trades outside o thereverse give-up relationship with the prime broker.

C. Two Prime BrokersA reverse give-up relationship can also involve afifh partya second prime brokerin additionto the client, the first prime broker, the executingdealer, and the give-up party. A second prime

broker can be involved when the client managesmoney or unds that have relationships withdifferent prime brokers, preers to diversiy itsbusiness with other prime brokers, or already hasused extensive lines with dealers through the firstprime broker. Te reverse give-up relationshipbetween two prime brokers is typically documentedunder a reverse give-up agreement or a mastergive-up agreement between them, while the clienthas entered into a prime brokerage agreementwith each o the prime brokers, as illustrated inDiagram 3.

Assume that the client is a hedge und or anasset management company that executes tradeswith several executing dealers or its own accountand or the give-up partys own account at thesecond prime broker; it also manages hedge undaccounts or which the second prime broker actsas prime broker. Te trades are given up to thefirst prime broker, under the terms o each mastergive-up agreement between the first prime brokerand each executing dealer, and the prime brokerage

Dealer

Prime broker 1

Diagram 2

Dealer Dealer

Dealer


Prime brokersclient

Trade execution

Reverse give-up agreements

and offsetting transactions

Give-up party


Signatory to reversegive-up agreement

Account

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agreement between the first prime broker and theclient. he irst prime broker then enters intooffsetting trades with the second prime broker.Te prime brokers can have in place a reversegive-up agreement between them (and possiblythe client), as well as separate prime brokerage

agreements with the client, that governs thesetrades. However, it is also possible to documenta reverse give-up under the master give-upagreement between the first prime broker, actingas dealer, and the second prime broker, acting asprime broker. Te second prime broker then entersinto offsetting trades with hedge unds managedby the client and with the give-up party. Tesetrades are governed by the terms o master agree-ments in place with these parties. In addition, thesecond prime broker enters into offsetting tradeswith the client, which are typically governed by

the terms o the master agreement between theprime broker and the client.

Tis scenario raises the legal issue o whetherthe second prime broker, in the reverse give-uparrangement with the first prime broker, takeson the role o a passive give-up party or insteadtakes on the role o a prime broker that activelycontrols the trades given up to it and requiresnotices. It also raises a Wall issue or the firstprime broker, in that trades executed on the sales

side could, depending on the documentation, beconducted under the same give-up lines as tradesthat have been reverse given up in the primebrokerage business. As discussed in Part III.E.1,financial institutions typically maintain a Wallthat restricts the flow o inormation between

their prime brokerage business and their tradingand sales desks.

D. Multiple RelationshipsIn reality, trades given up to a prime broker aresplit in several ways among other prime brokers,give-up parties, and client unds or accounts. Teexistence o multiple relationships among theseparties raises issues such as transparency o tradesbeginning with the first prime broker, disclosureto clients o ees charged by both prime brokers,and operational risk.

In Diagram 4, assume that the first primebrokers client is a hedge und or an assetmanagement company that executes trades withseveral executing dealers. Te client manageshedge und accounts or which there are multipleprime brokers, trades or one or more give-upparties with accounts at multiple prime brokers,and trades or its own account. Te trades aregiven up to the first prime broker under the termso a master give-up agreement between the first

Dealer

Prime broker 1

Diagram 3

Dealer Dealer

Dealer


Prime brokersclient

Trade execution

Master give-up agreement noticeor reverse give-up agreement

and offsetting transactions

Give-up party



Prime broker 2

ISDA master agreements/IFEMA/FEOMAand offsetting transactions


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prime broker and each executing dealer, and theprime brokerage agreement between the firstprime broker and the client. In turn, the firstprime broker enters into several offsetting tradeswith:

i)hedge unds managed by the client;

ii)the give-up party; and

iii)the client, with respect to trades or theclients own account.

Tese offsetting trades are governed by theterms o several different documents:

i)the master agreements between the firstprime broker and the hedge unds;

ii)the reverse give-up agreement between the

first prime broker and the give-up party; andiii)the master agreement between the first

prime broker and the client.

In addition, the first prime broker enters intooffsetting trades with the second prime broker(and possibly other prime brokers). Te offsettingtrades are executed under the terms o a reversegive-up agreement entered into on a bilateral

basis between the prime brokers or, alternatively,under the terms o a master give-up agreementbetween the first prime broker, acting as dealer,and the second prime broker, acting as primebroker. In turn, the second prime broker (and

possibly other prime brokers) enters into severaloffsetting trades:

i) with hedge und accounts managed by theclient;

ii)with a second give-up party; and

iii)with the client, with respect to trades or theclients own account.

Each o these offsetting trades is governed by theterms o several different documents:

i)master agreements between the second

prime broker and the hedge unds;ii)the reverse give-up agreement between

the second prime broker and the give-upparty, and the master agreement betweenthe second prime broker and the give-upparty; and

iii)the master agreement between the secondprime broker and the client.

Dealer

Prime broker 1

Diagram 4

Dealer Dealer

Dealer

Master give-up agreementsand offsetting transactions

Prime brokersclient

Trade execution

Reverse give-up agreementsand offsetting transactions

Give-up party



Prime broker 2

ISDA master agreements/IFEMA/FEOMA and

offsetting transactions


Account

Give-up partyPrime brokersclient/fund

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III. Key Relationship Issues

A. Credit LimitsPrime brokerage arrangements require active

credit-limit monitoring against the limits setorth in governing legal agreements. In the primebrokerage agreement, the prime broker estab-lishes limits or acceptance o the clients trades. Inthe master give-up agreement, the prime brokerestablishes limits or acceptance o the clientstrades vis--vis the executing dealer. Reversegive-up arrangements require the analysis oadditional relationships among the client, theprime brokers, the give-up parties, and the clientaccounts in determining the applicability o creditlimits. Te key issues concerning administration

o limits in reverse give-up arrangements are:1. Would a give-up party impose limits or the

trades it accepts rom a prime broker?

2. Would a prime broker impose limits or theoffsetting trades it enters into with a give-upparty?

3. When there are two prime brokers, do bothprime brokers limits apply to the clientstrades given up to the second prime broker?

Would a give-up party impose limits for the trades

it accepts from a prime broker?When deciding whether to impose limits ortrades it accepts rom a prime broker, a give-upparty will consider several actors. One key actoris the capacity in which the give-up party is actingor the client. I the give-up party assumes the roleo an active prime broker, it would be inclined toimpose limits in order to control the amount oits exposure as a result o entering into offsettingtrades with hedge und accounts managed by theclient. A secondary concern o the give-up partywould be to control the amount o the give-up

partys line with the prime broker that the clientmay use. Alternatively, i the give-up party isacting in another capacity, such as a custodian orthe client, it would be less likely to impose limitsor the trades it accepts rom the prime broker,unless line usage is an issue. In making thisdecision, the give-up party would consider thesize o current limits with the prime broker and

the sensitivity o the clients trades vis--vis thecurrent limits. However, the give-up party mayseparately impose limits on the clients tradingactivity outside o the reverse give-up relationshipwith the prime broker. Te give-up party may

do so by speciying limits in its ISDA masteragreement with the client, i it executes offsettingtrades with the client. Alternatively, i the give-upparty is an end-user, limits may be specified inthe investment management agreement betweenthe give-up party and the client.

Would a prime broker impose limits for theoffsetting trades it enters into with a give-up party?

A prime broker that accepts a clients trades withan executing dealer and gives them up to anotherparty by entering into offsetting trades incurscredit risk against the give-up party. Te primebroker may or may not decide to impose limits onoffsetting trades that will be entered into with thegive-up party. Te prime brokers main concernwould be credit line usage, although there isa divergence o views and practice in this area.In the past, prime brokers did not impose theirown limits on give-up parties because they couldcontrol the amount o trades they would acceptthrough lines with clients and executing dealersin the prime brokerage and give-up agreements.Any limits on the give-up partys side would be asubset o lines extended to the client. However,

recently, prime brokers have become concernedthat clients could use the prime brokers creditline with the give-up party, which the primebroker would preer to use or its own proprietarytrading or its own customers. In such a case, theprime broker would impose separate limits onoffsetting trades with the give-up party.

When there are two prime brokers, do both primebrokers limits apply to the clients trades given upto the second prime broker?

Te first prime broker has daily settlement or net

open position limits and can reject the clientstrades with a particular executing dealer that donot all within these limits. When this happens,the trade is never submitted to the second primebroker and, in effect, the first prime brokerslimits affect the reverse give-up relationship.Alternatively, a trade may be accepted by the firstprime broker, which has entered into the trade

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with the executing dealer, but not all within thelimits established by the second prime broker.Tis situation occurs when a client attempts toallocate a trade over its limits established with thesecond prime broker. Te agreement between the

first prime broker and the client would requirethe client to reallocate the trade by the end o theday, such as to a third prime broker or a und thatthe client manages. Alternatively, the client mayobtain rom the second prime broker its consentto exceed the limit in exchange or additionalcollateral. I all else ails, the trade could beunwound and the client may be responsible orcompensating the executing dealer or any lossesunder a compensation agreement.

Te first prime broker may want to consol-idate its limits with the limits applicable when the

second prime broker is acting as a prime broker.Conversely, the second prime broker may want toconsolidate its limits against trades accepted romthe first prime broker, regardless o the capacityin which the first prime broker is acting. Tat is,with a particular client, the first prime broker maybe acting as a prime broker by accepting tradesthe client enters into with other executing dealers(and then entering into offsetting trades with thesecond prime broker), and also may be acting asan executing dealer by entering into trades withthe client that are given up to the second prime

broker (resulting in a trade between the twoprime brokers and an offsetting trade betweenthe second prime broker and the client/und orgive-up party). I the second prime broker seeksto consolidate limits on all trades accepted romthe first prime broker, this would raise Wallissues or the first prime broker, as discussed inPart III.E.1.

B. Trade NotificationsIn a typical give-up relationship, the executingdealer and the client are required to notiy theprime broker once a trade has been executed,inorming the prime broker o the material termso the trade. In reverse give-up situations, proce-dures or notification o executed trades dependon how the parties view their relationships.

1. Would a give-up party require notices otrades to be provided by the client and/or theprime broker?

2. Would the give-up party accept trades only ithe notices match?

3. When there are two prime brokers, whatnotices will be required and which party willneed to give them?

A give-up partys position on whether and romwhom it will require trade notices will vary based

on the relationship o the parties and how thegive-up party obtains legal certainty that theprime broker and the client are bound to a tradewith certain terms. A give-up party that has takenon an active role such as that o a second primebroker may require matching trade notices romthe prime broker and the client, as i the primebroker were an executing dealer. More typically, aconventional give-up party receives trade noticesonly rom its client or only rom the prime brokerand later confirms trades with the prime broker.Te give-up party would obtain the agreement o

the prime broker or the client that the trade noticeprovided by the other party would be sufficientevidence o the terms o the trade to which it isbound. In the give-up context, this arrangementtakes the orm o a trading authority agreement,under which the client acts as agent and attorneyin act or the prime broker (or vice versa) orpurposes o notices.

When there are two prime brokers, mostcommonly the first prime broker would receivetrade notices rom the executing dealer and theclient while the second prime broker would

require matching trade notices rom the firstprime broker and the client. Te second primebroker views the client as the one who went tothe first prime broker and executed a bulk tradegiven up to the second prime broker in part. Tefirst prime broker acts as an executing dealer. Tesecond prime broker enters into a mirror tradebased on the terms o the trade between itseland the first prime broker, and thereore requiresmatching notices in order to protect itsel rombasis risk between the trades booked againstthe client and the first prime broker. However,

the second prime broker may agree to receivenotice rom the investment advisor that handlestrade allocations rather than rom the first primebroker. Tere is a risk to the second prime brokerin doing so that can be addressed by obtaining theagreement o the first prime broker that it mayact on a notice rom the client. A und may alsonotiy the second prime broker o the trade it hasaccepted an allocation o, i the client trades orthe und.

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C. Trade Acceptance and RejectionOnce the prime broker receives notice o a trade,it has certain rights and obligations with respectto the acceptance or rejection o the trade, andit must determine i a trade meets the appli-

cable conditions o the prime brokerage andmaster give-up agreements. Te prime brokermay reject a trade i it is not within the scope opermitted transactions specified in the give-upagreement with the executing dealer, i it is notwithin the specified tenor limits, i it is not withinthe specified credit limits, or i the trade detailsprovided by the executing dealer and the clientdo not match. A reverse give-up relationshipintroduces the possibility o trade rejection by agive-up party and any other prime brokers thatare part o the reverse give-up arrangements. Te

procedures or trade acceptance and rejection areparticularly critical in reverse give-ups because,ultimately, the client will need to appropriatelyallocate trades to the give-up parties and accountsor which it acts as manager.

1. Would a give-up party reserve a right to rejecttrades?

2. When there are two prime brokers, whatare the second prime brokers notificationobligations to the first prime broker, i any?

3. When a trade is rejected, who bears the

risk that a trade will not be allocated to theappropriate client account?

A give-up party will typically reject tradesi they exceed credit limits, assuming that thegive-up party has determined to apply limitsto trades accepted rom the first prime broker.Give-up parties rarely, i ever, reject trades as aresult o process issues such as ailure to receivetrade notices on a timely basis.

I a second prime broker decides to rejecta trade, it would typically do so on the same

day that the trade has been given up to the firstprime broker i notified on such date. As notedin Part III.A, the client agrees that all trades willbe allocated, and any unallocated trades will goto the clients account directly, or the client willreallocate the trades to a give-up party or a undmanaged by the client. Te client will be respon-sible or allocating all trades given up to the firstprime broker by the end o the day. Accordingly,

the first prime broker does not bear the risk othe second prime brokers trade rejection. Insome relationships, second prime brokers do notnotiy first prime brokers o trade acceptance orrejection, but typically confirm trades to first prime

brokers in the ordinary course. By comparison,in other relationships, second prime brokers sendfirst prime brokers notices o trade acceptanceor rejection. In addition, the executing dealer isnot concerned about whether the second primebroker will accept the trade. Te executing dealerhas a binding trade with the first prime broker. Ithis trade is ultimately unwound, the client mayhave agreed to compensate the executing dealeror any associated losses.

D. Post-Trade Events

Structured transactions involve post-trade eventsthat could give rise to market or basis risk or theprime broker. Basis risk occurs when the partiesinterpret post-trade events differentlyorexample, whether a barrier has been broken andan option has been knocked out. In the case onon-deliverable orward oreign exchange trans-actions, the parties may not agree on the ratesat which the fixing o such transactions shouldoccur or purposes o valuation and settlement.

1. When a give-up party or a second primebroker is involved, who is responsible or the

determination and notification o post-tradeevents?

2. When a give-up party or a second primebroker is involved, who assumes the basisrisk associated with varying interpretations opost-trade events by the parties?

Te issue o who is responsible or the deter-mination and notification o post-trade events isa complicated one. In the plain vanilla primebrokerage relationship, the prime broker seeksto pass on to the client determinations made by

the executing dealer. A give-up party or a secondprime broker that is a major dealer may or maynot agree to such an approach, but may be lessconcerned i it is matched on either side o thetrade. I the give-up party or second prime brokeragrees to this approach, the determination andnotification o post-trade events would flow romthe executing dealer to the first prime broker tothe second prime broker.

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However, the proprietary desk o the give-upparty or second prime broker may not becomortable with another dealer (the executingdealer) being the sole calculation agent and mayseek to be joint calculation agent with the first

prime broker. In this situation, the first primebroker will also seek to be joint calculation agentwith the executing dealer on the other side o thetrade. I it does not do so, the first prime brokerwill bear the basis risk should the executingdealer and the give-up party/second prime brokerdisagree on whether a barrier has been breachedor on the interpretation o some other post-tradeevent.

E. Other Key Relationship Issues

1.Wall between trading and prime brokeragebusiness

When a prime broker gives up trades to anotherprime broker, it needs to consider the effect othe Wall that typically exists between its primebrokerage business and its trading and salesdesks. Tis Wall generally restricts the primebroker rom giving inormation on its clientstrades to trading and sales personnel. As a result,i it effected reverse give-ups to the second primebroker under the same give-up lines that it useswhen its sales desk executes a trade with the

second prime brokers clients, its trading andsales personnel may need to see the line usageor the reverse give-up trades in order to monitorwhether there is availability under the line ortheir uture trades. Te problem would arisebecause the Wall would ofen restrict the tradingand sales personnel rom having this access.

Te prime broker can avoid this problemby conducting the reverse give-up trades undera different give-up line rom that used or thegive-ups executed by its sales desk. Tis separateline could be documented under the same master

give-up agreement as used or the sales giveupsbut both prime brokers would have to track thetrades very careully to avoid conusion overwhich line they should be charged to. Morecommonly, prime brokers in this situation woulddocument the reverse give-up trades under aseparate reverse give-up agreement with thesecond prime broker.

2. Transparency of clients trading activities to theprime broker

As with any other relationship, a prime brokercould ace reputational risk with respect to itsrelationship with its clients. A prime broker could

incur harm to its reputation i the client or one othe clients employees, or example, were to engagein raud or other improper activities through itsoreign exchange trading. At the same time, whena client splits trades among several prime brokersand give-up parties, the clients activities are lesstransparent to the prime broker. A prime brokershould be prepared to investigate a complaint byan executing dealer, give-up party, or anotherprime broker that a client may have engaged inillegal or unethical trading practices. Te primebroker should evaluate the reputational risk posed

to it and assess whether it should modiy its roleor cease acting as prime broker or the client.While the prime broker is not legally responsibleor ensuring that any o these parties or its clientcomply with applicable law and regulation, theprime broker should ascertain whether the clientstrading activity affects any legal or regulatoryobligation on the part o the prime broker.

3. Fees charged to the client

When two prime brokers are involved in therelationship, the client potentially aces two ees

or the same trades. Prime brokers should beaware o and consider the issue o transparencyo ees to underlying accounts. Te investmentmanager should make disclosures to the under-lying accounts regarding the ees that it will incurby using two prime brokers.

IV. Addressing KeyRelationship Issuesin Documentation

A. The Prime Brokerage AgreementTe Prime Brokerage Agreement, which is exe-cuted by the prime broker and its client, establishesthe ramework under which the client executestrades with executing dealers that are given up tothe prime broker. In the context o plain vanillaprime brokerage (without reverse give-ups),

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the Prime Brokerage Agreement would addressseveral significant issues in this relationship.Tese issues include the trading authority o theclient; the types o trades and limits that apply totrades that are given up to the prime broker (or

example, size o trades, net open position limits,and settlement limits); and the ees that the primebroker charges the client. Te prime broker alsotypically undertakes to maintain the confidential-ity o the clients trading activities on the primebrokerage side and not share confidential clientinormation with trading and sales personnel. Inthe context o reverse give-ups, additional keyissues should be addressed in the Prime BrokerageAgreement: (i) the clients undertaking to allocateand, i necessary, reallocate trades to unds andgive-up parties, and the process or allocation and

reallocation o trades;

2

(ii) identification o thegive-up parties; and (iii) is the party responsibleor notiying the reverse give-up party o trades.

B. The Master FX Give-Up Agreement/Compensation Agreement

Te Master FX Give-Up Agreement, whichis entered into by the prime broker and eachexecuting dealer, provides the terms and condi-tions under which trades between the executingdealer and the client are given up to the primebroker. In 2005, the Foreign Exchange Committee

published a Master FX Give-Up Agreement thatcontains generally accepted standard provisionsaddressing most aspects o the give-up relationshipbetween a prime broker and a dealer, as well as amodel Compensation Agreement. Te Compen-sation Agreement may be entered into by the clientand the executing dealer in order to establishliability or losses vis--vis these two parties inthe event that the prime broker does not accepttrades that were intended to be given up to theprime broker. Tese agreements are available orindustry use to address the key relationship issuesraised in the plain vanilla give-up relationship.3Te terms o these agreements address plain

vanilla prime brokerage relationships and do notaddress reverse give-up issues. However, i thereare two prime brokers who document a reversegive-up relationship under an existing Master FXGive-Up Agreement, they may do so through adesignation notice or a side letter that addressesall relevant terms.

C. The Reverse Give-Up AgreementTe Reverse Give-Up Agreement, which isentered into by the prime broker and the give-upparty or a second prime broker, should addressthe key relationship issues between these parties

described in this document. Te Reverse Give-UpAgreement may also be signed by the client as atri-party agreement, or, alternatively, the clientmay sign a side letter agreeing to the terms o thereverse give-up process described in the ReverseGive-Up Agreement. In the Reverse Give-UpAgreement, the parties should define whetherany limits apply to trades that a give-up party (ora second prime broker) will accept rom a primebroker, or to offsetting trades that a prime brokermay enter into with the give-up party. Te partiesshould also delineate the operational procedures

associated with reverse give-ups, including:(i) which parties are responsible or providingtrade notices upon which the give-up party orsecond prime broker will rely in accepting trades;(ii) the processes or trade acceptance andrejection by the give-up party or second primebroker, and or allocation and reallocation otrades by the client; and (iii) the processes orconfirmation o trades. Te Reverse Give-UpAgreement should also speciy which parties inthe reverse give-up relationship act as calculationagent(s) or purposes o interpretation o post-trade events.

D. The Master FX AgreementsTe Master FX Agreements used in the reversegive-up context include the ISDA Master Agree-ments and the Foreign Exchange CommitteeMaster Agreements (IFEMA, ICOM [InternationalCurrency Options Market Master Agreement],and FEOMA). All parties involved in reversegive-up relationships ordinarily execute close-outmaster netting agreements with each other thatprovide the underlying terms and conditions otheir oreign exchange trades. Te Master FXAgreements generally do not contain provisionsthat specifically address reverse give-up issues,although this may be possible in certain contexts.For example, a give-up party may set limits in theMaster FX Agreements on the trades it will enterinto with a client or a und, which would applyto trading activity generated by reverse give-ups aswell as other trading activity with the client or und.

2See Part III. C.

3Te Master FX Give-Up Agreement is available at http://www.newyorked.org/xc/masterxgiveupagreement.pd.Te Compensation Agreement is available at http://www.newyorked.org/xc/compagreement.pd.

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23/95Committee Letter 21

Committee Letter

Announcing the Publication of Overview of the OTC Foreign Exchange Market: 2009

November 9, 2009

Dear Market Participant,

In early 2009, the Foreign Exchange Committee organized a working group to consider the effectiveness of theforeign exchange market over the recent period of financial market instability and to determine lessons thatcould be learned to improve the resiliency of the marketplace going forward. Te group concluded that whilethe foreign exchange market continued to function well throughout the periodallowing investors to continueto execute necessary transactions and manage currency exposurescertain opportunities exist for additionalimprovement.

Accordingly, the working group prepared the accompanying paper to provide an overview of the foreign

exchange marketplace and to describe some of the current tools available to mitigate foreign exchange risks.Te paper also recommends priorities designed to further strengthen the marketplace. Te Foreign ExchangeCommittee and its Buy-Side Subcommittee endorse the paper and would like to share it with you.

Te document is organized as follows:

I. Introduction

II. Brief Overview of FX Market

a. Liquidity of the Global Foreign Exchange Market

b. Use of the Foreign Exchange Market by Corporations and Investors

c. Te Role of the U.S. Dollar in the Global Foreign Exchange Market

III. Selected Tools for Effective Risk Management in the Global Foreign Exchange Market

a. Availability of Continuous Linked Settlement (CLS)

b. Important Factors Mitigating Counterparty Credit Risk in the OC FX Market

c. Significant Efforts to Manage Operational Risk and Strengthen Legal Documentation UnderpinningForeign Exchange ransactions

IV. Looking Ahead: Priorities for the Industry

V. Conclusion

We hope that you find the paper helpful and informative.

Richard MahoneyChairForeign Exchange Committee

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Foreign Exchange Committee Member Firms

Banco Ita S.A.Bank of AmericaBank of MontrealBarclays CapitalBNY MellonCalyonCitigroupCredit SuisseDeutsche BankGoldman Sachs & Co.ICAP North AmericaJP Morgan ChaseMorgan Stanley & Co.Royal Bank of ScotlandStandard Chartered BankState Street Global Markets

D SecuritiesTomson Reutersradition Financial ServicesUBSUnion BankWells Fargo

Buy-Side Subcommittee Member Firms

AllianceBernsteinArtemis Financial Advisors LLCCalPERS InvestmentsFischer Francis rees & WattsFortress Investment Group LLCGeneral Electric Companyudor Investment Corporation

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25/95Overview of the OTC Foreign Exchange Market 23

I. Introduction

Following the recent period o financial marketdisruption, over-the-counter (OC) marketshave garnered significant attention. Te ForeignExchange Committee (FXC) and its Buy-SideSubcommittee have prepared this paper toprovide a concise overview o the wholesaleover-the-counter oreign exchange (FX) market1and to highlight various eatures o the market-place that can help investors and corporationsmore effectively manage the risks associatedwith maintaining an international portolio. Teoreign exchange market is one o the most matureand transparent o the OC markets, and its depthand transparency are important to investors,borrowers, and corporations. Historically, theFX market has withstood a number o disrup-tions, including various currency crises in the1990s; the adjustment in global equity markets in2000; a series o corporate events, including thebankruptcies o WorldCom, Enron, and Reco;and the most recent financial crisis, which in-

cluded the bankruptcy o Lehman Brothers.

Te FXC and its Buy-Side Subcommitteebelieve that the FX market unctioned well andremained transparent, accessible, and relativelyliquid during the most recent crisis. (Tisconclusion is consistent with findings o theForeign Exchange Joint Standing Committee ina September 2009 paper.2) Participants were ableto execute trades and manage their currencyexposure on an uninterrupted, twenty-our-hourbasis in a relatively liquid market. Te orward

FX market was affected by the challenges in thewholesale U.S. dollar (USD) unding markets,leading to significantly higher unding costs orUSD positions, and elevated FX implied and

actual volatility, leading to a widening o bid/offerspreads. Nevertheless, the market continued tounctionprices were made, deals were trans-acted, and trades were settled. Still, the crisishighlights opportunities to urther bolster thestrength o the OC FX market. Tis papercontains a discussion o some o those opportu-nities, many o which are being actively pursuedby various industry groups, including the FXCand its counterparts abroad.

II. Brief Overview ofFX Market

a. Liquidity of the Global ForeignExchange Market

Te global oreign exchange market is oneo the most liquid financial markets in theworld. According to the most recent Bank orInternational Settlements (BIS) survey o globaloreign exchange volume, conducted in April2007, global daily average turnover in traditional

oreign exchange instruments was estimated tototal $3.2 trillion.3

Liquidity in the oreign exchange marketstems in part rom the vast number o partici-pants located around the globe and rom theavailability o a wide range o electronic commu-nication networks that provide brokerage servicesand direct-dealing capabilities. Te wide varietyo trading venues, which range rom telephonecontact with dealer trading desks to single-dealerelectronic portals or multibank portals, captures

and reflects the total liquidity o the market andallows nontraditional institutions, investmentmanagers, and corporations direct access to themarket and significant price transparency. Tese

Overview of the OTC Foreign ExchangeMarket: 2009

1Te wholesale OC FX market is composed o spot FX, orward FX, FX swap (equivalent to a spot and orward deal conductedsimultaneously), and FX option transactions. FX orward contracts may settle through exchange o the underlying currencies(that is, on a deliverable basis) or by payment o the in-the-money amount calculated in accordance with the terms o thecontract (that is, on a non-deliverable basis). In a non-deliverable orward contract (NDF), one o the currencies is typically thato an emerging market and the party purchasing the currency has no need to take physical possession o it. NDF and deliverableorward contracts serve as important hedging instruments in the market.

2Te paper is available at http://www.bankoengland.co.uk/markets/orex/xjsc/xpaper090923.pd.

3Te survey is available at http://www.bis.org/publ/rpx07t.pd?norames=1.

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institutions have augmented the liquidity that hastraditionally been provided by large commercialand investment banks, resulting in deeper, moreconsistent liquidity virtually twenty-our hours aday during the business week.

Moreover, the depth o continuous liquiditythroughout the twenty-our-hour oreignexchange trading day is a critical componento the efficient unctioning o other U.S. capitalmarkets. Tese eatures significantly reduce therisk that a reduction in trading activity couldleave an investor unable to liquidate, und, oroffset a position at or near the market value o theasset.

b. Use of the Foreign ExchangeMarket by Corporations andInvestors

Each day, FX market participants enter intomillions o transactions across the globe. Tegrowth o global investing and internationallydiversified corporations has contributed to signi-icant expansion o the oreign exchange market inrecent years. Corporations and investors requireaccess to the FX marketplace or a number oreasons.

Corporations regularly participate in theoreign exchange market to:

n repatriate earnings rom abroad;

n export goods abroad/import goods to thedomestic market;

n make payments to nonlocal suppliers andservice providers;

n invest in plant, equipment, and businessesabroad;

n und cross-currency balance-sheet needs; n hedge net investment exposure or oreign

balance-sheet/income-statement positions;

n hedge net income, bid-to-award risk, andflows associated with royalties and dividends.

Investors regularly participate in the oreignexchange market to:

nrepatriate earnings rom abroad;

nensure adequate liquidity to meet obligations

to pension owners, 401(k) owners, and otherinvestors;

nsettle the purchase or sale o oreign assets,or example, by allowing oreign investors topurchase U.S. assets;

nhedge the currency risk associated withholding oreign assets;

noffset sovereign risk;

ntake currency views to manage portolio riskand return.

Given the diversity o these needs, it is critical orcorporations and investors to access a wide rangeo OC FX products and to tailor the settlementdates o such products to their business require-ments. Te flexibility o OC FX markets andproducts allows these corporations and investorsto manage their risk, and their day-to-day businessoperations, more effectively.

c. The Role of the U.S. Dollar in theGlobal Foreign Exchange Market

Te U.S. dollar is widely viewed as the worlds

premier reserve currency. It plays a critical role inacilitating global trade and investment:

nMore international contracts aredenominated in USD than in any othercurrency.

nCommodities and many other globally tradedgoods are typically priced in USD.

nTe United States is historically a recipient osae-haven flows during crises and times oglobal economic and market disruptions.

Tis critical role played by the dollar underscoresthe importance o maintaining an accessible andefficient marketplace. Additionally, the USDscentral role in currency markets makes it easieror investors to hold dollar-based assets andresults in lower borrowing costs or dollar-based debtors. It also provides a competitiveadvantage or U.S.-based corporations (which have

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correspondingly less FX risk than comparablefirms based outside the United States). Tereore,the special role o the U.S. dollar, coupled with thetransparent and liquid nature o oreign exchangemarkets, is a major actor underpinning global

trade and capital markets.Although more than 80 percent o all FX

trades are estimated to involve the USD,4 theUnited States is eclipsed by the United Kingdomas the largest FX trading center. According to themost recent regional oreign exchange committeeturnover surveys, conducted in April 2009,average daily turnover in OC oreign exchangeproducts in North America was less than hal theturnover reported in the United Kingdom.5

III. Selected Tools for EffectiveRisk Management in theGlobal Foreign ExchangeMarket

Te FXC would like to highlight some o theeatures o the oreign exchange market thatcontributed to its robust unction and that servedto mitigate some o the core risks, includingsettlement risk, counterparty credit risk, and

operational risk.

a. Availability of Continuous LinkedSettlement (CLS)

o reduce systemic settlement risk, the industrycreated CLS Bank in 2002 at the behest o centralbanks around the world. Settlement risk reersto the capital at risk rom the time an institutionmeets its obligation under a contract (through theadvance o unds or securities) until the counter-party ulfills its side o the transaction, which can

occur many hours later in a different jurisdiction.CLS Bank dramatically reduces settlement riskor FX payments by perorming settlement ona payment-versus-payment basis. Settlement oboth legs o each FX trade is simultaneous, thus

eliminating any time lag between the flows othe two settlement currencies that gives rise tosettlement risk. CLS does not guarantee settlement,but instead protects against loss o principal byensuring that neither leg o the FX trade will settle

unless both legs can be settled at the same time.CLS currently settles seventeen currencies andsettles payments arising rom a range o oreignexchange products, including FX spot, orwards,swaps, non-deliverable orwards, and the exerciseo options. In May 2008, the BIS released Progressin Reducing Foreign Exchange Settlement Risk, areport drafed by the Committee on Payment andSettlement Systems.6Te report surveyed oreignexchange trading activity across 109 institutionsand estimated average daily FX settlement obliga-tions or those institutions at $3.8 trillion. O that

amount, $2.1 trillion, or 55 percent, was estimatedto settle through CLS Bank.

Te importance o settlement risk in theoreign exchange market reflects certain keycharacteristics. First, FX spot and orwardcontracts are ull notional contracts that requiresettlement o ull cash amounts; they are notcontracts or differences that require settlemento net profit or loss. For investors and corpora-tions that make payments in oreign currency andhedge FX exposures, the ability to physically settlecontracts is central to their use o the FX market.Second, each currency transaction involves morethan one sovereign currency, so there is ofen atime-zone difference in the settlement o the twosides o the transaction. Given the scale o the FXmarket, any one participant could have settlementrisk exposure to many hundreds o millions odollars between the time the Asian currenciesare settled locally and the time payment is madeon the USD legs in New York. In the aggregate,systemic risk exists because a breakdown in FX

settlement could produce a chain reaction inwhich firms ail to receive payments, causingthem to be unable or unwilling to make paymentsto others. Te industry created CLS Bank tobetter manage this risk within the FX market.

4According to the April 2007 BIS triennial survey, approximately 86 percent o reported FX spot, swap, and outright orwardmarket turnover included the USD. Te survey is available at http://www.bis.org/publ/rpx07t.pd?norames=1.

5Average daily turnover in total OC FX products was $1,269 billion in the U.K. market, according to a report issued by theForeign Exchange Joint Standing Committee, compared with $527 billion in the North American market, as reported in theForeign Exchange Committees turnover survey.

6Te report is available at http://www.bis.org/publ/cpss83.pd.

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Additionally, CLS is supported by a robust legalframework that ensures finality of settlement andfunding in its system.

Following the September 14, 2008, announce-ment of the imminent default of Lehman Brothers,

payments among financial institutions settlingin CLS continued uninterrupted. CLS served itsstated function of reducing systemic risk andensuring that despite the large notional size oFX trades around the world, financial institutionshad the confidence to make payments into thesystem because they were protected against theloss o principal. Indeed, or those active in theOC FX market over the past two years, it became

very clear that use o payment-versus-paymentsettlement services, such as CLS, was critical tomaintaining market integrity and unctioning

and to preventing urther spread o the financialcrisis.

In addition, CLS acts as an inormationrepository, providing real-time inormation tomembers as well as reports to the central bankswhose currencies settle in CLS on the grossand net cash flows per currency that will resultrom the daily settlement cycle. Te repositoryis currently being enhanced to expand reportingflexibility and the range o instruments captured.

b. Important Factors MitigatingCounterparty Credit Risk inthe OTC FX Market

Counterparty credit risk in the OC FX market,as in markets or other traded products, ismanaged through counterparty credit analysisand risk management, which ofen involve insti-tuting appropriate credit support arrangementsbetween the trading parties. It is important tonote that because the vast majority o transac-tions in the OC FX market are short-dated(under one year in duration), there is relatively

less credit risk associated with them comparedwith that o products whose average tenor islonger. Additionally, the transparency andliquidity o the OC FX market acilitate accuratecalculation o the exposure associated with openOC FX trading positions, which in turn allowsinstitutions to have a higher level o confidencethat collateral posted to secure obligations underthese transactions will be sufficient to cover theoutstanding exposure.

Te efficient exchange o collateral betweeninstitutions to offset the risk associated withunrealized gains and losses or open OC FXcontracts is a highly effective tool in managingthe credit risk o the transactions. Collateral

exchange is typically provided under the terms ocredit support annexes (CSAs) to master agree-ments or FX transactions. In effect, CSAs providemany o the risk-reducing benefits o a centralexchange while maintaining the flexibility offeredby an OC market, but without engendering thepractical challenges that a country-specific centralcounterparty model would likely ace in a highlyinternational marketplace.

c. Significant Efforts to ManageOperational Risk and Strengthen

Legal Documentation UnderpinningForeign Exchange TransactionsVarious processes take place between executionand settlement o an FX transaction. Teseprocesses are typically supported by the opera-tions division o financial institutions, and therisks associated with that responsibility orm thecore o operational risk. Managing these risksrequires a solid understanding o products as wellas processes to confirm and control the liecycleo a transaction. Similarly, having robust andwell-understood legal documentation is central

to reducing risks in the FX market. Te FX industryled by various international FX committees andindustry groups, such as the International Swapsand Derivatives Association, Inc. (ISDA), EMA(a trade association or emerging markets), andthe FXChas undertaken considerable work inrecent years to improve the operational inra-structure and the legal contracts underpinningtransactions within the FX market.

On the operations ront, industry partici-pants in the FX market joined representativesrom other asset classes in making a series o

commitments to regulators in October 2008 tourther strengthen the operational inrastructureor OC derivatives. Tis effort emerged rom thework initiated by the Presidents Working Groupon Financial Market Developments.7

Te 2008 commitments made to regulatorson behal o the OC FX market build upon previ-ously completed industry efforts to improve theoperational inrastructure o the OC FX market.

7Details on other ongoing efforts to improve the operational inrastructure o the OC derivatives markets can be ound athttp://www.newyorked.org/newsevents/otc_derivative.html.

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Since October 2008, the FX industry has continuedto work to meet specific targets related to theincreased automation o transaction processing.Te commitments also include providing trans-parency in the orm o metrics around OC FX

contract execution and demonstrating increasedelectronification o those contracts.

On the legal ront, FX industry participantshave continued to seek opportunities to enhanceand standardize trade documentation improve-ments that would also help acilitate increasedautomation o the confirmation process. Somekey successes include standardization o non-de-liverable orward and non-deliverable optionconfirmations in selected emerging market juris-dictions, creation o common orms o give-upagreements and compensation agreements or

use in OC FX prime brokerage arrangements,and development o master confirmation agree-ments. Tese efforts have been urther supportedby CLSs sponsorship o protocols through whichmarket participants have agreed to best practicesor FX and non-deliverable orward trades,practices such as legally binding confirmationsand standard terms or trades processed in CLS.

Te FX industrys efforts to strengthendocumentation are ongoing. Te FinancialMarkets Lawyers Group (FMLG),8 in collabo-

ration with the FXCs Operations ManagersWorking Group (OMWG)9and ISDA, is currentlydrafing a standard orm o novation protocolor use with FX products. Te FMLG, OMWG,ISDA, and EMA are also working together todevelop definitions or new emerging marketcurrency pair combinations as well as a standardorm o confirmation or various exotic products.Another FMLG initiative involves the creation o acontractual inrastructure to permit parties usingcertain trading and settlement platorms to relyon the electronic execution notice generated bythose systems as a legally binding confirmation.

Additionally, the FXC and similar committeesabroad produce best-practice recommendationsor the FX industry that cover trading as well as

operational activities. Tese best-practice recom-mendations are cited as a benchmarking tool.10

IV. Looking Ahead: Priorities

for the Industry

For many years, the global oreign exchangemarketplace has helped oster the growth o inter-national business and the prudent managemento risks associated with global business andinvestment portolios. Because the oreignexchange market is so central to the globaleconomy, ensuring a liquid and robust market-place is o utmost importance.

O course, more can and will be done by

the industry. In some cases, industry efforts arealready under way; in others, the FXC and itsBuy-Side Subcommittee believe that particularinitiatives need to be identified and prioritized.

First, payment-versus-payment settlementservices, such as CLS, proved very effective inmitigating systemic risk. We believe that urtherexpansion o such services is warranted andin the best interest o both the industry andthe regulatory community. In particular, werecommend the ollowing:

nPayment-versus-payment settlement services,such as CLS, should be expanded to cover agreater array o currencies, regions, and products.

nTe largest FX market-makers should beencouraged to become direct members oCLS, i eligible to do so.

nAny large and significant counterpartiesthat indirectly participate in CLS through amember institution should, as a best practice,have a collateralized line or the exposuresuch participation presents to its member.

On this point, a number o efforts are already inprogress. For example, CLS currently has effortsunder way to implement same-day and next-daysettlement within CLS or additional trades, to

8 Te FMLG comprises lawyers in leading worldwide financial institutions who support oreign exchange and other financialmarket trading. Te FMLG advises on legal issues relevant to OC oreign exchange and other OC financial markets.

9 Te OMWG is a standing working group o the FXC that advises on operational issues relevant to OC FX markets.

10 Te FXC website provides more inormation (http://www.newyorked.org/xc/).

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work with several jurisdictions to add urthercurrencies to the settlement service, and to workwith orums involving buy-side firms to extendparticipation. Efforts are ocusing on efficienciesin straight-through-processing, FX protocols and

standards, and participation in NDFs to enhanceindustry matching. Tere is an active campaignunder way to educate the broad FX market-place on the risk-mitigating benefits o utilizinga payment-versus-payment settlement service.Te number o participating entities usingCLS settlement has grown 35 percent since thebeginning o 2009, bringing total CLS use to morethan 6,000 third-party participants in addition tothe 57 direct settlement members.

Second, the use o CSAs or counterparty riskmanagement should be expanded. Clients that

deal in oreign exchange as an asset class and takelarge speculative or highly leveraged positionsshould adequately collateralize the positions.

Tird, ongoing efforts to standardizedocumentation and to improve the operationalefficiency o the OC oreign exchange marketare critical and must continue to be a priority.Future commitments will likely take the ormo higher levels o electronification o vanillaand barrier option products as well as increasedstandardization and electronification o complex

exotic products.Fourth, it is imperative that any efforts to

improve the resilience o the marketplace takeinto account the global and twenty-our-hournature o the oreign exchange market. Eachoreign exchange transaction involves at leasttwo sovereign currencies. Te marketplace itselis spread across a series o liquid trading centersin different time zones and operates twenty-ourhours a day, each business day. Absent suchconsideration o these key characteristics othe oreign exchange market, the potential or

negative unintended consequences o any effortsto improve market resiliency is quite large.

Fifh, it is important to note that this paperis intended to address the wholesale oreignexchange market. Te FXC has been clear in itsbelie that the retail market or oreign exchangerequires prudent regulation.11

V. Conclusion

Te volatile financial conditions that began insummer 2007 and peaked ollowing the deault oLehman Brothers in September 2008 provided a

significant test o the oreign exchange marketsability to withstand major disruptions andcontinue operating in a manner that protects theend-user. Te market unctioned well, despitestrains seen in international unding and creditmarkets, and enabled participants to measure andmitigate risk dynamically in a global marketplace.During this time, transaction costs were elevated,owing to the volatility and spillover rom U.S.dollar unding challenges. However, systemicrisk mitigants built into the OC FX marketstructure over the years proved successul in

providing a liquid and continuous market despitethe volatility, deaults, and disruptions o the lasttwo years.

Despite this success, opportunities existor urther improvement in the FX market. TeForeign Exchange Committee believes thaturther expansion o the availability o payment-

versus-payment services, such as CLS, is a highlyeffective way to mitigate settlement risk. Similarly,broader use o credit support annexes could leadto sizable reductions in counterparty credit risk.Significantly, both efforts can be accomplishedglobally without the challenges inherent in aregulatory effort coordinated across countries.

Te Foreign Exchange Committee and itssubcommittees and working groups remaincommitted to ostering risk managementimprovements in the FX market. o that end,we will continue to offer recommendations andguidelines and to support actions that acilitategreater contractual certainties or all parties activein oreign exchange.

11 Guidance on this matter can be ound at http://www.newyorked.org/xc/2005/xc051209.pd.

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31/95Committee Letter 29

Committee Letter

Commenting on Proposed Rule to Establish a Leverage Limitation for Retail Forex

February 20, 2009

Ms. Marcia E. AsquithOffice of the Corporate SecretaryFINRA1735 K Street, N.W.Washington, D.C. 20006-1506

DearMs.Asquith:

Te Foreign Exchange Committee respectfully submits this letter in response to the issuance by the FinancialIndustry Regulatory Authority (FINRA) of proposed FINRA Rule 2380, which would establish leverage

limitation on retail foreign exchange currency transactions (the Rule). Te proposed Rule was published inRegulatory Notice 09-06 on January 21, 2009 (the Notice). Tis letter addresses certain of the ForeignExchange Committees general concerns with the potential adoption of the Rule and, specifically, the leveragelimitation that would be imposed on retail foreign exchange transactions to a ratio of no more than 1.5 to 1.

Te Foreign Exchange Committee (FXC) was formed in 1978 under the sponsorship of the FederalReserve Bank of New York and includes representatives from major domestic and foreign commercial andinvestment banks and foreign exchange brokers. Te FXC represents many of the most significant participants inforeign currency trading in the United States.1

Overview

During the past decade, the retail foreign exchange currency trading (retail forex) market has experiencedsignificant growth, due largely to the fact that the forex market is a useful tool that allows investors to hedgetheir foreign currency exposure and provides risk mitigation and hedging opportunities for highly correlat-ed products that might not trade twenty-four hours a day. We understand and share the concerns that havebeen raised by FINRA regarding participation by retail investors, particularly those who are less sophisticatedand may engage in more speculative transactions. However, there are sufficient protections in place toaddress these concerns, and artificial limitations on leverage will serve only to restrict the market and deprivemarket participants of necessary hedging tools.

Congress recently enacted the CFC Reauthorization Act (CRA) as part of the larger Food, Conservation, andEnergy Act of 2008. Te CRA amended the Commodity Exchange Act (CEA) to make clear the CommodityFutures rading Commissions (the Commission) comprehensive regulatory authority over retail forex trans-actions, except as otherwise provided for in the CEA. Tis language was intended to eliminate any confusion as

to the Commissions authority over retail forex transactions, created by the passage of the Commodity FuturesModernization Act of 2000. Te CRA also clarified that the antifraud provisions of the CEA extended to theoffer and sale of all transactions made to retail customers on a leveraged or margined basis and requires retailforex dealers registered with the National Futures Association (NFA) to maintain at least $20 million in capital.Tese antifraud provisions and net capital requirements are designed to protect the retail forex customer trad-ing through an NFA-registered entity from fraud or bad faith actions on the part of the forex dealer.

1Te FXC members in 2009: Banco Ita S.A., Bank of America, Bank of Montreal, Bank of okyo Mitsubishi-UFJ, Calyon,Citigroup, Credit Suisse, Deutsche Bank AG, Goldman Sachs & Co., ICAP North America, JP Morgan Chase, Morgan Stanley &Co., RBS, Reuters, Barclays, Standard Chartered Bank, State Street Corporation, D Bank, FS Brokers, Te Bank of New YorkMellon, UBS, UniCredit, and Wells Fargo.

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Congress focus on antifraud and net capital requirements for NFA-registered retail forex dealers underscoresits judgment that these are the appropriate tools that should be applied to retail forex transactions entered intoby otherwise regulated entities, such as registered broker-dealers. Tere is no indication in the legislation, orelsewhere, that Congress intended restrictions on leverage to be imposed as a means of protecting retail partici-pants. While we applaud the laudatory goal of protecting retail forex customers, we believe that the approach

taken in the Notice and the proposed Rule raises several important public policy concerns.

Comments of the Foreign Exchange Committee

Te FXC believes that the protections currently in place with respect to retail forex transactions are adequate toprotect retail market participants and that the proposed Rule is unnecessary and potentially counterproductive.

Te Current Regulatory Regime Provides Adequate Safeguards. In addition to the regulatory framework developedby CRA for the retail forex market, the current forex industry operates under a best practices environment thatseeks to protect the customer from fraud and manipulation, as well as the reputation of the financial counter-party. In 2005, the Financial Markets Lawyers Group (FMLG)2was asked to provide the FXC with its views onthe legal framework underlying the retail-wholesale boundary in the foreign exchange market.3 Tis documentsets forth guidelines for firms engaged in forex transactions and established that when firms enter into a trans-

action, firms must take into account the sophistication of a counterparty, the nature of their relationship withthe retail customer, and the type of transaction being contemplated or executed. Te letter suggests that if thecounterparty is relatively unsophisticated, the firm should take additional steps to adequately disclose the risksof specific transactions. Finally, the letter noted the importance for firms to take a flexible approach to workingwith their customers, to ensure the best possible outcome.

In addition, FINRA Regulatory Notice 08-66, dated November 4, 2008,4 has already established appropriatestandards and principles to be applied to the retail forex market under NASD Rule 2110, which would apply toall FINRA members. NASD Rule 2110 governs the Standards of Commercial Honor and Principles of radeand FINRA rightly expects its broker-dealer members to comply with NASD Rule 2110.

Te combination of the best practices established by the forex community and the widespread implementationof NASD Rule 2110 will go far to ensure that forex customers are protected from fraudulent transactions and

market manipulation in the future. While we appreciate FINRAs concern for retail

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