1995 Annual Report

I. Chairman's Report

II. Legal Initiatives of the Foreign Exchange Committee

III. Trading Practices Subcommittee Report

IV. Market Structure Subcommittee Report

V. Risk Management Subcommittee Report

VI. Membership Subcommittee Report

VII. Advisory Role of the Foreign Exchange Committee

VIII. Meetings of the Foreign Exchange Committee

IX. Subcommittee Assignments for 1995 and 1996

X. Selected Documents
Guidelines for Foreign Exchange Trading Activities

Committee Letter Regarding its release of the Revised Guidelines for Foreign Exchange Trading Activities
Guidelines for Foreign Exchange Trading Activities, January 1996

Comments on the Basle Committee's Proposal Regarding the Supervisory Treatment of Foreign Exchange Risk

Committee Letter on Confirmation Best Practices

Principles and Practices for Wholesale Market Transactions

Foreign Exchange and Options Master Agreement

29 pages / 77 k

International Currency Options Master Agreement
25 pages / 65 k

Guide to the International Currency Options Master Agreement 25 pages / 85 k

Example of a Currency Option Confirmation
1 page / 7 k

ICOM Close-Out Example 4 pages / 13 k

Example of Confirmation for an FX Knock-Out/Knock-In Option 5 pages / 143 k

Committee Letter in Support of the National Association of Insurance Commissioner's Proposed Changes to their Model Act

Committee Letter on Historical Rate Rollovers

April 1995 Survey of Foreign Exchange Market Activity in the United States

The Foreign Exchange Committee's Document of Organization

XI. Foreign Exchange Committee 1995 and 1996 Membership

Chairman's Report

Throughout 1995 the Foreign Exchange Committee (Committee) spent significant time assessing and discussing important issues facing the global foreign exchange market. As a result of these discussions, the Committee undertook several projects in the areas of trading practices, market structure, and risk management. Among the Committee's most significant 1995 accomplishments were the newly revised Guidelines for Foreign Exchange Trading Activities (Guidelines), Principles and Practices for Wholesale Market Transactions, the creation of standardized transaction documentation for barrier options, and Comments on the Basle Committee's Proposal Regarding the Supervisory Treatment of Foreign Exchange Risk.

During the course of the year, the Committee also discussed various developments in market practices. Perhaps the two most notable were the resurgence in demand for historical rate rollovers (HRR) and the increasing use of accounting system arbitrage. Because both of these practices entail considerable financial risk, the Committee highlights them in this report. The demand for HRRs has reportedly grown in recent months, particularly in Asian Markets. To brief the foreign exchange community about the risks associated with HRRs and its recommendations on dealing with those risks we present the Committee Letter on Historical-Rate Rollovers, dated December 26, 1991, on page 118.

During 1995 the Committee also examined the market practice referred to as "accounting system arbitrage." It found that the practice is often motivated by inappropriate financial incentives and can result in transactions that have no, or even negative, economic value to a firm. As a result of these findings, the Committee incorporated a section called "Accounting for Forward Transactions" to the newly revised Guidelines for Foreign Exchange Trading Activities. A discussion of the issues to consider in accounting for forward foreign exchange transactions appears on page 25.

The Guidelines, first written in 1980, have been updated periodically. Their revision underscores the Committee's belief that the issues raised continue to require the consideration of all market participants. To make the Guidelines as accessible as possible, in 1995 the Committee published them separately from the Annual Report for the first time and included all of the supporting documents that were only referenced in previous versions. The revised Guidelines were distributed to the more than 1,500 members of FOREX USA, Inc., the Association Cambiste International's organization in the United States. In 1996 the Committee is planning to present the Guidelines to the public.

As Chairman of the Foreign Exchange Committee, in 1995, I had the honor of co-chairing the committee that authored the Principles and Practices for Wholesale Financial Market Transactions (Wholesale Code) in August 1995. The creation of the Wholesale Code was a collaborative effort involving several groups representing over-the-counter financial market participants, including the Foreign Exchange Committee, the Emerging Markets Traders Association, the International Swaps and Derivatives Association, the New York Clearing House Association, the Public Securities Association, and the Securities Industry Association. The Wholesale Code was prepared in order to clarify the relationship between market participants and to articulate a set of best practices for over-the-counter financial markets transactions.

The 1995 Annual Report summarizes the Committee's productivity and discusses the major projects completed during the year:

The Market Structure Subcommittee researched and drafted the Committee's response to the Basle Committee's proposed treatment of foreign exchange risk and worked exhaustively with the Financial Markets Lawyers Group (FMLG) and British Bankers Association (BBA) to develop standardized transaction documentation for barrier options.
Trading Practices Subcommittee drafted the Committee Letter on Confirmation Best Practices, which outlines issues related to confirmation processing. The subcommittee agreed to undertake the periodic review and updating of the Committee's Guidelines for Foreign Exchange Trading Activities.
The Risk Management Subcommittee continued conducting presentations of the Committee's paper, Reducing Foreign Exchange Settlement Risk (October 1994), and discussed options for the next phase of the project to reduce settlement risk. The subcommittee also undertook a general study of how different types of institutions approach liquidity management.
The Financial Markets Lawyers Group worked with the Committee and the British Bankers Association to develop standardized transaction documentation for barrier options, a new Foreign Exchange and Options Master Agreement, and an updated International Currency Options Master Agreement. In addition, the FMLG drafted the Committee's letter supporting the National Association of Insurance Commissioner's (NAIC) proposed amendment to its Model Act. The NAIC's proposed amendment addresses the enforcement of close-out and netting provisions of master agreements relating to derivative transactions.
The Committee also assisted the Bank for International Settlements with the design of its triennial foreign exchange turnover survey. The survey revealed that the foreign exchange market has continued to grow rapidly, though at a slower pace than in the 1980s. A summary of the North American survey responses is included in this Annual Report on page 120.

We describe each of the projects further in the Subcommittee sections that follow and present selected Committee documents completed during 1995.

I hope that the work completed by the Committee this year will be of value to all market participants and will help to encourage productive international discussions on many of the topics.

Lewis W. (Woody) Teel
Chairman

LEGAL INITIATIVES OF THE FOREIGN
EXCHANGE COMMITTEE

The Foreign Exchange Committee's legal initiatives aim to promote greater understanding of the laws and statutes that govern foreign exchange trading and to enhance the integrity of the foreign exchange market by encouraging the adoption of sound trading practices. The Committee, with the assistance of the Financial Market Lawyers Group (FMLG), continues its commitment to these objectives through its creation of standard transaction documentation. The development of standard documentation is the statutory underpinning of the global foreign exchange market:

In 1995, the FMLG and the British Bankers Association continued their joint effort to obtain the legal opinions of local counsel in several countries on the enforceability of the termination and close-out netting provisions of the International Foreign Exchange Master Agreement (IFEMA) in foreign jurisdictions. The FMLG has obtained opinions from the following countries: Belgium, England, France, Singapore, Japan, Switzerland, Cayman Islands, Sweden, Germany, and the United States. Additional opinions have been commissioned and will be available at a later date. The FMLG also intends to track the enforceability of IFEMA provisions by obtaining updated information from other countries on an annual basis.

In 1995, the Committee, working in conjunction with the FMLG and the BBA, drafted and issued standard documentation for barrier options (see page 115).
The Committee also endorsed the FMLG's new Foreign Exchange and Options Master Agreement (FEOMA). This new agreement contains standard provisions covering foreign exchange deals, including options transactions (see page 51).

The Committee endorsed a newly revised International Currency Options Master Agreement (ICOM). This new agreement incorporates standard netting provisions into the original ICOM agreement. In 1996, the FMLG will coordinate with the BBA to determine from which countries legal opinions should be obtained regarding the enforceability of the ICOM provisions.

These documents are reprinted in this Annual Report. Electronic versions are also available from the Committee's Executive Assistant.

TRADING PRACTICE SUBCOMMITTEE REPORT

The Trading Practices Subcommittee monitors issues raised by the trading behavior of market participants and makes procedural recommendations to promote sound trading practices and enhance the integrity of the foreign exchange market.

During 1995, the Trading Practices Subcommittee held discussions and worked on updating the Guidelines for Foreign Exchange Trading Activities. One of the group's discussions ended with the decision to add a new section to the Guidelines entitled "Accounting for Forward Transactions" (see page 25).

GUIDELINES FOR FOREIGN EXCHANGE TRADING ACTIVITIES
The Guidelines first appeared in the Committee's 1980 Annual Report and were titled Selected Issues Relating to the Management of Foreign Exchange Trading Activity. Since then, the Guidelines have been updated several times. Like the foreign exchange market itself, the Guidelines have continued to grow over time and are now twice their original length. To appeal to a wider audience, the Committee dropped the term "Management" from the Guidelines title. The Subcommittee convened a group of senior traders to assist with the revision. This group recommended that the Committee distribute the document to all parties involved in foreign exchange markets, rather than only those who manage these activities. This same group provided valuable input by raising many new issues that were added to the document during the revision process.

The Guidelines represent a significant achievement in that they showcase much of the Committee's work over the years. This work and the topics it addresses continue to affect individuals and firms that trade foreign exchange. The latest revision incorporates the committee's prime undertaken since 1992, when the Guidelines were last revised. These initiatives include changes in the Guidelines for broker switches and recommended best market practices for dealing with foreign exchange settlement risk.

Although the Guidelines are published each year in the Annual Report, the Committee is also making the Guidelines available under separate cover with appendices that include all supporting documents. In addition, the Guidelines were distributed to the Committee's mailing list as well as to the members of FOREX USA (Association Cambiste International's U.S. organization). In all, the Committee distributed approximately 2,500 copies to foreign exchange market participants.

The Committee's aim is to make the Guidelines accessible to as many market participants as possible. The distribution of the Guidelines to the extended list of market participants is a step toward this goal.

To further underscore the Committee's commitment to the Guidelines, the Trading Practices Subcommittee will provide additional guidance to institutions that would like more detail on one or more issues raised in the Guidelines. The Committee's revised Guidelines, without the appendices, are reprinted in this Annual Report beginning on page 28.

MARKET STRUCTURE SUBCOMMITTEE REPORT

The Market Structure Subcommittee considers issues and developments that are likely to affect the structure and character of the foreign exchange market over the long term. During 1995, the Subcommittee's two principal projects were to develop standard documentation for barrier options and to draft the Foreign Exchange Committee's formal response to the April 1995 proposal of the Basle Committee on Bank Supervision regarding the treatment of foreign exchange risk. The document Comments on the Basle Committee's Proposal Regarding the Supervisory Treatment of Foreign Exchange Risk presents the Committee's point-by-point views on the BIS's proposal and appears on pages 29-33.

STANDARD DOCUMENTATION FOR BARRIER OPTIONS
In early 1995, the Committee became aware of the special risks associated with barrier options. Like many new types of market transactions, barrier options began as infrequent, individually negotiated contracts. As trading volume has increased, however, the need for a standard market definition and treatment has also grown. The Committee has created a standardized framework for the barrier options market to increase the market's efficiency, assist the growth of the market, and avoid trading disputes. Before the introduction of standard barrier option documentation, dealing in barrier options required the negotiation of numerous contract-specific details (for example, defining a trigger event). Overlooking a detail or assuming standard treatment could result in a mistake. In the absence of standard documentation, the Committee also believes that trade disputes are more likely to occur.

Together with the FMLG and the BBA, the Market Structure Subcommittee proposed standard market treatment for barrier options. This proposal was then incorporated into a set of standard documentation guidelines. This documentation clearly outlines the variables of barrier option contracts and allows for their default treatment unless otherwise negotiated. Although this standard documentation is recommended by the Committee, the parties involved in barrier options transactions are ultimately responsible for tailoring it to fit their specific circumstances. The barrier options standard documentation is reprinted in this Annual Report on pages 92-115.

COMMITTEE'S COMMENTS ON THE BASLE COMMITTEE'S PROPOSAL REGARDING THE SUPERVISORY TREATMENT OF FOREIGN EXCHANGE RISK
In April 1995, the Basle Committee on Bank Supervision, which meets under the auspices of the Bank for International Settlements, released a set of proposed risk-based capital guidelines for state member banks and bank holding companies regarding the treatment of foreign exchange risk. Following the release of the paper by the U.S. Board of Governors of the Federal Reserve System, the Market Structure Subcommittee was directed by the Chairman to draft a formal comment on the BISs proposal for submission to the Board in the name of the Foreign Exchange Committee. Work on the comment began in May. The Committee's comments addressed two major points of the BIS proposal: (1) the level of capital needed to support the risk assumed by an institution and (2) the proposed regulatory model.

The Committee believes that the amount of capital required under the proposal to cover trading is too conservative. It bases this view on its study of the level of historical foreign exchange risks, which showed that the proposed capital weightings well exceeded the potential risks. The BIS proposal also outlines a regulatory model with minimum quantitative standards for assessing foreign exchange risk. However, the Committee contends that the regulatory model would be redundant because many institutions will continue to use their own. Instead, the Committee recommends that regulators review banks' models to ensure that the minimum standards have been met. The Committee's formal comment was submitted to the Secretary of the Federal Reserve's Board of Governors on July 25, 1995. The text of the Committee's comment is reprinted in this Annual Report on pages 29-33.

RISK MANAGEMENT SUBCOMMITTEE REPORT

The Risk Management Subcommittee facilitates the understanding of risk management issues and promotes improvements in the quality of risk management techniques in foreign exchange and related financial markets. During 1995, the Risk Management Subcommittee concluded its Reducing Foreign Exchange Settlement Risk global tour with a January seminar in Tokyo. Given the positive reception of the Subcommittee's settlement risk seminar by the financial communities in North America, Europe, and Asia in 1995, the Subcommittee began researching and writing a netting implementation case study. This netting "how to" manual is expected to be published in 1996. The research began with a survey to assess the current state of netting in Committee members' firms. Based on the firms' survey responses, the Subcommittee's paper will outline the steps necessary to implement netting systems and to resolve the problems that may occur.

In 1995, the Committee also discussed the issue of funding liquidity management. The Subcommittee's deliberations on this issue revealed that the nature of a financial institution's business primarily dictates its approach to managing funding liquidity. Any financial institution may fund itself by issuing corporate debt. However, a commercial bank (a deposit-taking entity) is likely to augment corporate debt with deposit liabilities, while an investment bank will generally fund itself to whatever extent is possible with corporate debt. In the event of a liquidity crisis, the two types of institutions are likely to implement different crisis management measures. For example, investment banks will generally rely upon secured borrowing facilities, while commercial banks may be more oriented toward selling assets and securing discount window loans. The Subcommittee recognizes the importance of having effective funding liquidity systems and crisis management plans in place.

MEMBERSHIP SUBCOMMITTEE REPORT

The Membership Subcommittee advises the Federal Reserve Bank of New York on potential candidates for membership in the Foreign Exchange Committee. The Subcommittee also makes recommendations regarding Subcommittee assignments and considers organizational changes for the Committee. Given the rapid changes in the nature of the foreign exchange market, in 1995 the Subcommittee recommended that the Committee admit a new type of member-- "other dealers." The proposed change was adopted by the Committee effective January 1, 1996.

The Committee's Document of Organization (on pages 127-128) was updated to reflect the change and now reads:
The composition of the Committee should include: New York Banks; Other U.S. Banks; Foreign Banks; Investment Banks and other Dealers; Foreign Exchange Brokerage Firms (preferably to represent both foreign exchange and Euro-deposit markets); the president of FOREX USA, Inc. (ex officio); and the Federal Reserve Bank of New York (ex officio).

ADVISORY ROLE OF THE FOREIGN EXCHANGE COMMITTEE

A principal purpose of the Foreign Exchange Committee is to advise the Federal Reserve Bank of New York on issues related to the foreign exchange market. At the Committee's monthly meetings at the Federal Reserve Bank of New York, members from dealing institutions provide their assessment of recent exchange rate trends and trading conditions. Members from foreign exchange brokerage firms comment on recent trends in the volume of transactions and on issues pertaining to the bank-broker relationship. Such discussions are particularly useful during periods of increased market stress or heightened volatility.

Perhaps the most important project of 1995 pertaining to the Committee's advisory role to the Federal Reserve was its comments on the Basle Committee on Banking Supervision's proposal to amend risk-based capital guidelines. The proposal, which was released for public comment in April 1995, outlined revisions to the risk-based capital guidelines regarding the supervisory treatment of foreign exchange risk. Because the policies outlined in the proposal have important implications for foreign exchange dealing banks and the market in general, the members of the Foreign Exchange Committee elected to submit a comment. The Market Structure Subcommittee was subsequently directed by the Chairman to draft the Committee's comments. The Committee's comments are reprinted on pages 29-33.

MEETINGS OF THE FOREIGN EXCHANGE COMMITTEE

The Committee held eleven meetings during 1995. Most Committee meetings are held at the Federal Reserve Bank of New York. The meeting is usually a luncheon meeting or late afternoon meeting; occasionally, members of the Committee host dinner meetings at their institutions.

MEETINGS IN 1995

SCHEDULE FOR 1996

January 5 January 11

February 2 February 1

March 2 March 7

April 6 April 11

May 4 May 2

June 1 June 6

July 6 July 11

September 7 September 5

October 5 October 3

November 2 November 7

December 7 December 5

SUBCOMMITTEE ASSIGNMENTS FOR 1995

MARKET STRUCTURE		MEMBERSHIP
Co-Chairmen:		Chairman:
William A. Dueker, Jr.		Peter R. Fisher, FRBNY
Thomas J. Hughes

Members:		Members:
Bruce Cobb		James P. Borden
Christopher Kelson		Matthew Lifson
Lars P. Lidberg		John D. Nixon
William Rappolt		William Rappolt
Klaus Said
Susan Storey

RISK MANAGEMENT		TRADING PRACTICES
Co-Chairmen:		Co-Chairmen:
John Finigan		Richard Mahoney
Heinz Riehl		John D. Nixon

Members:		Members:
Chris Deuters		Lloyd C. Blankfein
Martin Dooney		James P. Borden
Paul Kimball		Anthony Bustamante
Ian MacKay		Kikou Inoue
Andrew Siciliano		David Puth
Robert A. White		Jamie K. Thorsen

SUBCOMMITTEE ASSIGNMENTS FOR 1996

MARKET STRUCTURE		MEMBERSHIP
Co-Chairmen:		Chairman:
William A. Dueker, Jr.		Peter R. Fisher, FRBNY
Thomas J. Hughes

Members:		Members:
Bruce Cobb		James P. Borden
Christopher Kelson		Matthew Lifson
Lars P. Lidberg		John D. Nixon
William Rappolt		William Rappolt
Klaus Said
Susan Storey

RISK MANAGEMENT		TRADING PRACTICES
Co-Chairmen:		Co-Chairmen:
Paul Kimball		Richard Mahoney
Lewis W. Teel		Jamie K. Thorsen

Members:		Members:
Thomas J. Hughes		Lloyd C. Blankfein
Michael Kukanza		Anthony Bustamante
Lars P. Lidberg		Christopher Kelson
Ian MacKay		Matthew Lifson
Robert M. Rubin		John D. Nixon
Julian M. Simmonds		David Puth
Susan Storey