U.S. FX Brokers Take Lead Over Banks In Adopting 'Switches' Guidelines

Banks in the U.S. have so far been slow to follow the lead set by FX brokers in implementing the late-September recommendations by the Federal Reserve's Foreign Exchange Committee regarding name substitution in the brokered foreign exchange market, known as "brokers' switches."

However, many say they do plan to comply, and some major banks that previously declined to participate in switches, have now expressed a willingness to operate within the committee's recommendations.

Implementing the guidelines will entail changes in management information systems at most banks and broking firms and some brokers have already begun making the necessary software changes.

Switches occur when two dealing institutions are matched by a broker on size and price of a transaction, but find they are not compatible on credit terms. Since the two banks have proprietary information at this stage, the broker must find a third party, or "clearing bank", that will "wash" the trade by acting as counterparty to both sides of the transaction. The Foreign Exchange Committee, which advises the Federal Reserve on market-related issues, wrote to FX market professionals recommending a number of "management principles" that dealing institutions should adopt (FX Week, October 11).

The purpose for such written procedures, the letter states, is "to distinguish switches from other foreign exchange transactions, thereby bringing switches within management control and permitting more dealing institutions to support the liquidity of the FX market by occasionally providing the facility of name substitution to other firms with whom they have available credit lines."

When the letter was mailed in September, says committee chairman and executive vice president at Bank of America Lewis (Woody) Teel, the trading practices subcommittee (which worked on the issue and drafted the letter) was concerned that bank executives failed to understand the practice and therefore often refused to participate in switches.

He also says that since the original trade may be off-market by the time the switch is done it is important that management exercises more control over switched trades. Therefore, the letter says, such trades should be flagged 'switch' on a bank's deal tickets so that management of the clearing institution understands why two contracts with identical rates were put on the books and why the credit risk and settlement costs were undertaken without apparent benefit. Teel says the subcommittee therefore advocates having a mechanism to let management know what is going on--and recommends having an audit trail.

"These controls are designed to prevent the abuses I think we all know are possible when trades are off-market," he says. "These also address concerns about liquidity, because when these management guidelines are satisfied, the letter urges management at banks to take the position that their trading rooms participate--to a reasonable extent--in switches that enhance the liquidity of the markets."

Teel says that at the last FX Committee meeting, December 2, more banks were taking this letter to heart and were beginning to set up guidelines for their trading rooms to allow them to participate. "The brokers say they have had a somewhat easier time with regard to switches, but that they really haven't received many letters from banks telling them which designated traders should be used--which is one of the recommendations. So I guess we're still waiting to see how it works out," he says.

An FX manager in New York says the letter is good news in terms of enhancing market liquidity, while at the same time it improves understanding of brokers' switches.

Switches are such a regular part of day-to-day activity that most FX brokers have separate boards itemizing them. Switches most commonly occur either when a counterparty's credit-worthiness is suspect or if credit lines for a particular bank are full. Brokers say many institutions have therefore become unwilling to accept the credit risk of being a clearing institution.

"We are in the business of helping provide liquidity but I do not think that people who are undercapitalized should have full access to the same liquidity," says a managing director at a New York bank. "It is not a question of counterparty risk--it is more a question of principle, whether lower capitalized institutions should have that same access to liquidity."

But this manager concedes that full credit lines can even affect the biggest of banks. This manager says he is also concerned that if his institution agrees to become a clearing bank, it could be the only one participating. "That would be our only concern, " he says. "So we are looking at a variety of ways that we think would ensure against that, such as trying to limit the number of times a bank can act as counterparty."

Another managing director at a bank on the FX Committee says the letter was well-received but the process of implementing the switching policy is taking more time and resources than originally expected.

The letter outlines four principles that should form the basis for internal management of switches by dealing institutions and brokers, thereby creating an audit trail to guard against abuse (FX Week, July 12). The letter also recommends that all dealing institutions maintain written procedures to implement these principles. "Basically, the letter is an encouragement for all sides to be operating with more accurate information," says a bank manager.

The first recommendation is that institutions designate authorized dealers who can decide whether or not to participate in a switched trade. Furthermore, management should tell brokers whether the institution is willing to be a clearing institution and identify the designated dealers.

The second recommendation is that brokers adopt procedures for recording switched trades, clearly identifying such trades as a 'switch' in their confirmations to the clearing parties.

Third, the clearing institution's confirmations to the two original counterparties should also be marked 'switch' and trading-room management should establish procedures for such record-keeping.

Fourth, compensation to a clearing institution (if any) must be agreed to by all the institutions involved, clearly recorded in all confirmations and readily subject to audit controls. "I do not know how this will work between the banks and I am sure there won't be any payment form. Instead," says a broker. "I think people will be doing switches on a reciprocal basis to try and keep liquidity in the marketplace."

This, says the broker, should eliminate the possibility of 'points' being used in return for being a clearing institution--which the Fed has firmly come down against--because the onus would now be on the banks to sort out any compensation. In London, the brokered market does use a 'points' system for switches, but under guidelines and auditing imposed by the Bank of England.

One of the trading practices subcommittee members, Chemical Bank's managing director David Puth, says his bank has not yet issued guidelines. However, he says Chemical will definitely be involved. "Chemical is interested in helping further facilitate market liquidity and this policy should help," he says.

Jim Borden, a senior vice president and FX executive at Chase Manhattan Bank in New York who serves on the committee, says his bank is taking formal steps to follow the letter's recommendations.

"We have been acting basically within the contents of the letter anyway, but I think it does give us an opportunity for some refinement in terms of specifically identifying individuals to authorize switches and to notify the various brokers," says Borden. He says Chase is aiming to start 1994 in compliance with the letter.

"There will be systems changes over time," he adds. "But the intent of the letter is to try to minimize that by suggesting that a management's information, rather than the bank's books, should contain this information," he says.

Meanwhile, some of the biggest foreign exchange broking firms have begun systems upgrades. John Nixon, president and chief executive officer at Tullett & Tokyo Forex in New York, says his firm and others are instigating software changes on confirmation systems to comply with the ideas in the switches letter.

Nixon, also a member of the trading practices subcommittee, says the brokers should have everything in place by early 1994. He adds that it will probably be mid-way through the first quarter before the letter's impact is felt throughout the marketplace.

Although Nixon says banks have yet to issue contact names, he says he has had positive responses from "quite a few" institutions seeking to help in clearing trades. "It is obviously the early days now, but it will probably be a two-way street--banks will give names and the brokers will solicit names," he says.

Robert McCully, president and chief executive officer of Harlow Meyer Savage Inc. North America, who belongs to the FX Committee, also says that no banks have issued his firm a list of names of persons able to authorize switches. He says a few banks are looking into it and some that previously opposed switches are now changing their position.

In the meantime, Harlow is implementing changes to its systems so that in future cases of switches, bills and confirmations will reflect which trades required a switching agent, or third-party institution, to clear the trade. McCully expects to have systems in place by the new year.

"I am sending a letter to banks, explaining that we are putting the necessary implementations to our systems to conform with the Committee's letter regarding switches. I am also asking to hear from them regarding their side of the equation," he says.

Chase's Borden says that FX Committee member banks are likely to respond to the letter faster than outside banks, which may be unfamiliar with the topic, and so require some time for the letter to filter through the layers of management.