Managing the Foreign Exchange Risk

Dr. Prakash Apte, a distinguished Professor of Economics and Finance, was a faculty member at Indian Institute of Management, Bengaluru from1997 till 2012 during which period he was also the Director of the Institute from 2002 to 2007. A Mechanical Engineer from IIT Delhi, a PGDM from IIM Calcutta and a PhD in Economics from Columbia University, he is currently an Adjunct Professor at National Institute of Bank Management (NIBM), Pune. Besides being a Visiting Faculty at K.U. Leuven, EDHEC Lille, France; Gothenberg University, Sweden and AESE Lisbon, he was also the former Chairperson of SEBI's Secondary Markets Advisory Committee and a Member of the Planning Commission's Expert Committee chaired by Dr. Abhijit Sen, to examine the impact of futures trading on commodity prices. He has authored four books in the area of International Finance and Economics and several papers in refereed professional journals.

 

Exchange rate fluctuations and its uncertainties affect all firms in the economy, with the extent and nature of impact crucially depending on the nature of a firm's business. The fluctuations affect net importers and net exporters quite differently. They also affect purely domestic firms, those without exports or imports, due to its impact on the firm's suppliers and customers.

Though often used interchangeably, the terms exposure and risk are not identical. Exposure is a measure of the sensitivity of the value of an item (asset, liability or cash flow) to changes in exchange rate, while risk is a measure of the variability of the value of the financial item attributable to the risk factor. A firm may have a large exposure to currency fluctuations because of large imports or exports, but, if the exchange rate is highly stable the risk is quite small.

Between April 1993 and July 1995, the exchange rate between Rupee and the US dollar was almost rock steady.

• A firm trading with the US would have readily agreed that its operating cash flows were very sensitive to the rupee-dollar exchange rates, if it had significant exposure to the dollar. At the same time, it would have said that it did not perceive any significant risk, given the stability of the exchange rate during that period.

• Exposure to contractually fixed payments and receipts in foreign currency, such as export receivables, import payables, interest payable on foreign currency loans and so forth are known as transactions exposures. This is a measure of the sensitivity of the home currency value of assets and liabilities, which are denominated in foreign currency, to unanticipated changes in exchange rates, when the assets or liabilities are liquidated.

Another kind of short-term exposure is translation exposure, also called Accounting Exposure. A multinational firm may have the assets and liabilities of a foreign subsidiary denominated in a foreign currency, which are not going to be liquidated in the foreseeable future. However, the governing accounting standards could require that at the end of the fiscal year, they would have to be translated into the home currency of the parent company and reported in the parent company's balance sheet, thus creating the translation exposure. Translation risk is the related measure of variability in the translation.

The second group, classified as long-term exposures, consists of operating exposure and strategic exposures. The principal focus here is on items which could impact the future cash flows, which could have a serious impact on the firm's competitive status forcing it to restructure its business and redefine its long-term strategy. In the long run, an exchange rate change could affect both future revenues, operating costs and operating income, forcing firms to restructure its business, change its markets, sources of raw materials and even the location of its production facilities.

The currency risk management function consists of three major tasks. First is the selection of a target performance variable which should normally be cash flows.

The second task is assessing and, if possible, quantifying the impact of exchange rate fluctuations on the target performance variable. The third aspect is the choice of an appropriate mechanism or instrument to eliminate, reduce or shift the risk.

It is up to the top management to lay out the risk management policy. The major considerations are:

1. Whether the risk management posture is to be conservative or aggressive?

2.The time horizon to be adopted in making risk management decisions.

3. Who should get involved in the establishment and implementation of the policy?

4. Performance measurement and control systems.

For multinational corporations with world-wide operations, a critical issue is whether to centralize exposure management or leave it to the individual units in different countries.

A large variety of financial products are available for managing transactions exposure, which arises out of contractually fixed payables or receivables in foreign currency. The simplest and most conservative way to hedge a foreign currency payable or receivable is through a forward contract.

• In a forward contract, the firm agrees to buy or sell a specified amount of a foreign currency on a specified future date, at an exchange rate agreed upon on the date of the contract. This rate is the “forward rate”. The counterparty to the contract is a commercial bank, which specifies the forward rate. On the expiry date of the contract, the two parties must conclude the transaction at the agreed rate irrespective of the prevailing spot exchange rate. If a company has entered into a forward contract to buy one million dollars three months later at the rate of `60/- per dollar, it must buy and the counterparty – the bank – must sell that amount at that rate irrespective of the prevailing market rate.

• A forward contract at the market rate has zero value at the time it is entered into. However, it develops a positive or negative value as the markets move. It can be cancelled before expiry. Depending upon how the market has moved, one of the two parties has to pay the other.

 

 

Currency futures are like forward contracts in the sense, that the two parties to the contract agree to exchange a given amount of currency 'A' against currency 'B' on a future date, at a rate agreed upon on the date of the contract.

There are a few differences between forwards and futures. Forward contracts are tailor-made to the specifications of one of the two parties. The firm can specify the exact amount of the currency it wishes to buy or sell, the maturity date of the contract and the mode of delivery and that it is an OTC product. In a futures contract, the amount of the currency to be delivered, the date of expiry and the mode of settlement are specified by the Exchange on which the contract is traded. Also, the Clearing House guarantees the performance of the contract, so that the two parties do not have to be concerned about credit risk. Unlike a forward contract, changes in the value of the contract are settled on a daily basis. With expiry dates and contract sizes being fixed, futures are regarded as unsuitable for managing currency risk.

Forwards and Futures completely eliminate the uncertainty about the price at which the deal has to be done. However, if you are locked in a forward deal you cannot benefit from favorable movement in the exchange rate. Thus, if a firm has entered into a forward contract to sell a three month dollar receivable at a price of sixty rupees per dollar, it has eliminated the uncertainty pertaining to the rupee value of its dollar receivable. But three months later, if the dollar has risen to sixty two rupees, it cannot benefit from that favorable movement.

Currency options are more flexible for managing currency risk. The buyer of an option acquires the right to buy or sell a specific amount of foreign currency at a specific rate, with no obligation to carry out the transaction. Thus a firm with a six month Euro payable can buy a six month call option on Euro which gives it the right to buy Euros at a specific price, but with no obligation to do so. The strike price specified in the contract is the rate at which it can buy Euros, if it chooses to do so. Thus, if it has a call option with strike price of ` 75, on the expiry date it has the right to buy Euros at a rate of ` 75 but with no obligation. If the Euro is below ` 75 it can buy it at the ruling market rate; if it is above ` 75 it can exercise its option and the option seller must provide Euros at a rate of ` 75. For a foreign currency receivable it can buy a put option which gives it the right to sell the foreign currency at a specific price without the obligation to do so. The option buyer has to pay an up-front fee known as option premium to the option seller. 

Steering Destinies with Portfolio Management Stewardship

Dr. Shan Rajegopal, Director and Advisor to the SQS Group, leading authorities on innovation and portfolio management. Having worked closely with CEOs and CIOs across a wide range of companies such as Shell, BP, Jaguar, Ford Motors, Barclays Wealth, Credit Suisse, Deutsch Bank, UBS, CIMB Malaysia, Australia's Gold Coast City Council, Singapore's National Health Group and India's HCL to name a few, his extensive research into Innovation, Portfolio Investments, and Quality Delivery Management with Value Realization are a boon to companies looking to radically improve their performance.

Shan is a much sought after international speaker, who also sits on the Board of Aberystwyth University (Wales) and Essex Business School. He is the author of several books such as “Project Portfolio Management: How to Innovate and Invest in Successful Projects”, “Sun Tzu and the Project Battleground: Creating Project Strategy from the Art of War” and “Strategic Supply Management: An Implementation Toolkit”. 

Project Portfolio Management Stewardship is moving from the “nice-tohave” realm into the “must-have” category.

A client once told me that it provides a negotiation platform. “Participants in the decision making process can debate about a given set of projects at a strategic level. Decision making becomes more objective and is no longer an emotional process.” Another client in the financial sector calls it a "trading platform": “We've decided on these projects through a systematic way of weighing the pros and cons”.

What are these components and imperatives that capture and sustain the attention of senior executives? Why should we care about them and where do we start in making them work in an organization?

Everybody's Doing It: According to Forrester Research, in 2007 only a third of companies were into portfolio management. Another 56 percent said they were initiating some effort in that direction. I see four reasons for this dramatic upswing:

1.Government sectors, specifically in the UK, have raised the bar of financial accountability for programs and projects, rendering a new level of visibility to portfolio management within government agencies.

2. Senior executives are demanding greater visibility and accountability for their portfolios. This has led to the generation of reliable reports and metrics that lay out the present and what's coming next. Executives who appreciate its positive impact on the organization tend to carry with them the tools and techniques learned, as they move to the newer areas. 

3. Having been around for 10 to 12 years, a lot of research has gone into the process, best practices have surfaced and implementations are fast maturing.

4. The technology offerings have also matured and are helping organizations create the desired kind of visibility and accountability.

What it does, is to help businesses or agencies in measuring three broad parameters:

• Benefits: What is the financial and strategic impact of the project on the organization?
• Risks: What is the probability of the project delivering the benefits/value within the anticipated time-frame and budget?
• Constraints: What is the capability and capacity of the organization to meet initial and on-going monetary investment levels and resource requirements?

The ultimate outcome of portfolio management efforts will depend on the type of organization you're in. The elements that influence these efforts are:

• Cultural: The readiness to work in a more robust and transparent way.
• Environmental: Awareness of the prevailing legal environment and statutes.
• Maturity Level: Expectations of outcomes and an understanding of the appropriate entry point in the portfolio management process.
• Executive Buy-in: Collective will of the leadership to adopt a more systematic and accountable way for managing their project investments.

Counting the Imperatives for Portfolio Stewardship: With businesses demanding to “do more with less”, CIOs are under pressure to demonstrate the contribution of IT investments to the business. They are thus on to optimizing the use of scarce financial resources. The more progressive ones are into portfolio stewardship, to guide project chartering, evaluation, prioritization and execution. After initial successes, a common set of challenges have emerged: resistance from line staff to excessive bureaucracy, executive disengagement from the process and the birth of fast-track decision-making processes which circumvent and undermine the core prioritization process.

The adoption of the following steps could help streamline the process and avoid the colored perception of bureaucracy: 

• Triage Proposal Reviews: CIOs must proactively focus their attention on only the most pressing prioritization questions. A common mistake is to pass on all review of project proposals to steering committees - but leading companies are triaging the proposal queue to focus executive review only on the most difficult, borderline projects.
• Use a Common Business Case Yardstick: Meaningful prioritization requires that discretionary projects be evaluated against a standard set of criteria. The precise criteria vary according to an organization's strategic drivers but should include traditional project financials, measures of business and IT alignment and an assessment of execution risk.
• Supplement the Justification of Foundational Infrastructure Projects: Foundational infrastructure projects cannot be fully justified on the basis of direct and measurable cost savings or value creation. Such projects should be treated as a separate investment class and
  assessed against non ROI-based criteria such as risk-mitigated or capabilities-enabled ones.
• Embed Sponsor Accountability for Business Case Realization: Inflated claims about the potential benefits of projects challenge the integrity of the portfolio stewardship process. Leading organizations surmount this challenge by holding business sponsors accountable for
  realization of benefits through either ex post facto audits or budget adjustments.
• Systematically Track Organizational Risks: To streamline the red tape of portfolio stewardship, many organizations mistakenly neglect risk assessment, when reviewing projects. With the help of lightweight models to track risks, before and during execution, the IT steering committee can make better prioritization decisions and proactively course-correct troubled projects to minimize failure rates.

The Portfolio Cost and Its Payback: The journey into portfolio management isn't inexpensive. The initial investment will be influenced by the process, technology, maturity of execution and the culture of your company in accepting change, transparency and accountability.

On the flip side, when done correctly the payback is impressive. Both Forrester and Gartner have studied this specifically among IT organizations and come up with fairly comparable numbers:

• One to five percent reduction in annual project costs and annual resource costs.
•  15 to 30 percent reduction in project cost overruns.
• 20 to 30 percent reduction in project and portfolio related operational costs.
• Five to eight percent reduction in lifecycle investment costs.
• 10 to 20 percent reduction in application maintenance costs.
• Besides the above tangibles, the intangibles are:
• Improved decision making and improved success of decisions.
• Reduced risk
• Improved resource utilization and satisfaction thereon.
• Improved organizational agility and operational efficiency.

Starting on the Road to Portfolio Excellence - A Tested Approach: Implementation necessitates a multi-pronged, holistic approach that involves processes, governance, enabling technology and organizational change. There are proven holistic solutions that are integrated with core service offerings, program leadership and disciplined delivery culture – with frameworks covering all levels, from the project office to the boardroom. 

One of the effective frameworks contains three core elements, which are indivisible.

• Portfolio Planning and Prioritisation.
• Active Benefits Management
• Performance/Portfolio Delivery Management

Implementation is cantered on an “initial investment appraisal”, using an Analytical Hierarchical Process (AHP), where strategic values are assessed. Using a toolkit, the achievability of the projects within the portfolio and their attractiveness within the overall strategic direction are then assessed.
Thereafter, using a Portfolio Analyser the best mix of initiatives to deliver strategic targets and tangible benefits within the existing constraints are identified.

The Active Benefits Management Framework is based on the principle that many projects are created without any business case, and many programs are created with a business case, but fail to substantiate the benefits and ensure that there is a plan for their realisation. The differentiating factor is the active management, through which the benefits are not just identified, but are also tracked accurately against agreed and realistic realisation plans. This provides an “integrity check” by continually validating and updating the benefits-realisation profile of the portfolio. Establishing such a process allows you to remedy detected weaknesses and to monitor and actively steer benefits delivery during program execution.

Finally, we create a Performance Management regime which monitors delivery. With board members and senior executives having little time to deal with project-level information, board-specific business scorecards, based on validated data, are devised to provide the essential decision support information. This information format, aligned with rigorous and robust gateway processes and governance, facilitates, the stop/go decisions which the board will have to make, introduces a culture of “kill early, kill often”.

There are five key considerations that need to be embedded within the portfolio governance framework as part of the stewardship:

• Tier IT Governance Bodies: By tiering governance structures, CIOs can ensure that the time of the senior most executives is reserved for the most strategic investment decisions. The less significant portfolio decisions are handled by a different set of business executives.
• Anticipate Key Points of Contention: Highly effective CIOs are in continual dialog with key businesses, with the aim to uncover expected conflicts in the portfolio stewardship process ahead of review meetings.
• Streamline Documentation: Leading organizations develop one-page summaries for each project, enabling business partners to quickly get up to speed on portfolio decisions and to allow easy reference at meetings.
• Use Executive Time Wisely: A warning sign of impending failure is when key business executives regularly send proxies to steering committee meetings. To maintain key business partner engagement, CIOs need to keep meetings short and focused on key decisions.
• Reinforce the Enterprise Perspective: In addition to establishing the tone and focus of the steering committee meetings, the CIO plays a pivotal role in ensuring that all players come to the table with an enterprise perspective and that outcomes are optimal for the organization at large.The effective functioning of a performance management regime requires, that it be underpinned by proven PM infrastructure (governance processes, robust plans, fit-for-purpose PMO capability and tools) to deliver visibility, insight and control.
   

  

Finally, portfolio management approach and stewardship is no longer in the back seat. Many senior executives are moving it forward. If you want to drive and steer the destiny of your company in a way to say where it needs to go, this is a powerful approach.

Wealth Management for the Upwardly Mobile

Ganesh Rathnam is the Founder and Chief Investment Strategist at boutique, fee-only wealth management firm - Arkanis Capital, a SEBI-registered investment adviser. Arkanis manages its client funds across a portfolio of Indian equities, International equities and precious metals using a contrarian, bottom up “value investing” strategy. After earning a Master's degree in Aerospace Engineering & Mechanics and later also an MBA from the University of Minnesota, Ganesh worked at Morningstar, Chicago, heading the bank's research team before moving to Fidelity Investments. All that was before Arkanis. Alongside a deep interest in history, travelling and gaming his writings have been published at the Ludwig von Mises Institute, FirstPost, the Industrial Economist and the Money Mantra Magazine, besides others.

The world around us is changing at a rapid pace, more so the investment space in India. So much so,the upwardly mobile have a few things to watch out for in 2014 to keep up with the Joneses and Jamsheds as far as their wealth is concerned.

Move from Commission-based to Fee-based Management: Nearly all competent asset managers in the developed world work on fee-based compensation schemes. Most commonly, in the US or UK, asset managers charge a percentage of assets under advisement as a fee for their services. Several elite managers such as hedge funds charge performance fees as well. Moreover, the fee structure is much more transparent and only a tiny fraction of wealth is managed via commission-based products, from the likes of insurance companies.

Unlike the developed world, compensation for investment advisers in India is still overwhelmingly commission-based product sales,such as ULIPs. However, over the past few years, there has been an increasing shift to feebased compensation where advisers, rather than charge a commission for selling a product, charge a fee for their services. This move has recently received a fillip from SEBI, as the supervising body has sought to separate out product selling from investment advice, and has asked advisers to choose one or the other, i.e., the commission or fees way, to be compensated but not both.

Still, only a fraction of investment advisers have registered with SEBI, as many fear a drastic reduction in their compensation and most of all, accountability to their clients. An adviser who works on commission gets paid a large sum up front and after that, the performance of that product isn't really his problem. Moreover, most commission products offer the seller a trail income for the entire period the client holds the product. An adviser who works for fees typically cannot charge large fees up front, and must return to the client at the end of the contract period to collect his compensation at which time he will be answerable for its performance. And his future compensation is based on satisfactory performance over the previous period.

All else being equal, I believe fee-based management will produce superior long-term results for investors which, happily, are the end goal of wealth management. This is mainly for two reasons, the investment costs are transparent and cheaper as they come directly from the client (who hopefully will negotiate a good deal) and this setup holds the adviser accountable for his investment choices. Since all investment advisers desire to build a financially rewarding career over many years, and because they must meet clients periodically to collect fees and additional investment contributions, they must do a good job with their investment choices.

Given this, I believe it is the responsibility of clients to educate themselves more about fee-based wealth management and push for this change from their advisers.

Optimal Asset Selection: As an investment manager, I believe today's generation, unlike past generations, perhaps spoiled by the (relative) abundance since the 1990s reforms, has moved decisively to a “spend first, save later” mentality, i.e., India has moved from Thriftville to Squanderville in the space of 20 years. In my view, this shift, if left unchecked, will result in a society eating its seed corn or, like in Aesop's Ant-Grasshopper fable, burning through the “winter” reserves. We all know how that story ended.

However, with a little bit of imagination, one can have their cake and eat it too, albeit a bit later. The first step is to begin investing early, really, there's no excuse to not begin investing right from your first ever pay check. The next step is to invest in a careful selection of dividend paying stocks of great businesses instead of bank FDs, etc. and reinvesting dividends to enable compounding. If this process is maintained for a decade or so, then the dividend income from this portfolio alone should provide the wherewithal for splurging even as the principal grows over time along with the business. 

Return of Inflation as the Bogeyman: In my opinion, inflation will be the biggest story over the rest of this decade. The argument for inflation is simple: nearly every nation state in both the developed world and the developing world is heavily indebted. Politicians have promised, and are still promising, their citizens ever greater benefits and freebies to get elected, and this is now catching up with world governments. To give someone something for free, it must first be appropriated from someone else, and therein lies the problem. When the appropriated is unwilling or unable to carry the load, the system will eventually collapse.

In the beginning stages of this collapse, politicians can resort to money-printing or inflation to paper over the cracks of the welfare state. In fact, that is exactly what the governments in the West have done using a sophisticated euphemism called “quantitative easing”. However, if prosperity could come from a printing press, why isn't the whole world full of millionaires? Eventually, this will end in tears with massive wealth transfers from holders of paper assets to holders of real assets.

If an investor hasn't already done so, he must sit down with a knowledgeable adviser and inflation-proof his portfolio, such that his portfolio returns match or outpace the inflation rate over the coming years.

Internationalize Investments, Look Beyond India: International investing is a much neglected area. Nearly all investors suffer a home bias, Indians are no exception here, and therefore keep over 99% of their assets within the borders of their home country. The fact is, India represents only 1/40th of the global economy. Several countries are less corrupt and more business friendly than India. Therefore, by extension, some of the best companies such as Johnson & Johnson, Apple, etc. are domiciled abroad. Also, industries such as energy, basic materials and high technology are more advanced in foreign countries with little to no government intrusion. Therefore, handsome rewards await the intrepid investor who is willing to look for decent investment options outside India.

I suggest investors look to invest at least 20% of their investable assets outside India for starters. Keep in mind, simply buying foreign investments doesn't guarantee success. All the usual caveats of investment success are still applicable. Only invest in assets, securities or businesses you understand. And keep an eye on valuations. All else being equal, starting valuations will determine eventual returns. Lower starting valuations will produce superior returns and vice versa. If necessary, the help of a knowledgeable adviser is a must.

Clearing the Cobwebs of Settlement

                                                             By Rajiv Gada
                                                          Asst Vice President
                                                           Thinksoft Global

Capital markets are witnessing sea changes in the way “Clearing and Settlement” functions are being conducted. Across the globe, major transformations are on the anvil.

Background: The financial crisis of 2008 highlighted the risks associated with the OTC derivatives trade and the necessity of insurance against counterpart risk. The default of Lehman Brothers and bail out of AIG are some glaring examples. The market suffered from certain weaknesses:

• Trades were bilateral between counterparties. They were unregulated in the sense that they were not being traded on exchanges and there was no central counterparty clearing.
• The contracts negotiated between two parties governed the trade events like Netting, Termination and Valuation on termination.
• Contracts included clauses vis-a-visvariation margins but initial margins were not strictly enforced.
• The overall exposure of counterparties in the market could not be ascertained.

This prompted the regulators to monitor the OTC derivatives market, thereby highlighting the importance of the Central Counter Party (CCP) in clearing operations. CCPs were thus supported and mandated by regulators across the globe.

Today, with regulations such as the Dodd Frank Act (US) and European Market Infrastructure Regulation (EMIR) being implemented, many more issues are being addressed:

• Standardization of Over The Counter (OTC) derivatives contracts and its clearance through CCC.
• Reporting of OTC derivatives contracts to trade repositories
• Creating a framework for regulation of CCPs and trade repositories.

Worldwide, stress is also being laid on reducing the settlement cycle time and the settlement risk.

What does this mean for Market Participants?

• Regulated vs. Free Market: Equities, the traditional asset class was always traded on the exchanges and hence cleared and settled by a clearing corporation. Now, OTC derivatives contracts like the Interest Rate Swap (IRS), can be traded OTC but need to be reported to the CCP for clearing. Hence, the positions of the participants can be monitored for regulatory intervention.
   Free market advocates who found it difficult to digest these moves, are slowly coming around.
• Increased Cost of Trades: The cost of trading these contracts has increased since CCP reported trades are margined, which necessitates the deposit of appropriate collaterals that adds to the cost.
• Reduced Volume of Trade: The position taken by banks in the highly traded OTC derivatives market is contracted and is restricted based on the availability of clean collateral that can be parked with the CCP.
• Increase in Safety: The market is becoming much more reliable in honoring commitments against contracts, thus minimizing the counterparty risk.
• Reduced Settlement Cycle: All the markets are implementing systems and procedures to reduce the settlement cycle, so that collaterals can be freed up quickly.
  Being a continent of many small nations with their own clearing and Central Securities Depository (CSD) infrastructure, cross-border settlements are fragmented in Europe. With the Euro being the common payment currency across, there is an increase in the flow of money and investment across these nations. With cross border settlement of securities, it takes time to conclude final settlements, thus locking up securities and collaterals.
  The European Central Bank (ECB) is implementing a major infrastructure project; Target2Securities (T2S) to enable cross border settlement in the “Delivery Versus Payment” (DVP) mode, thereby reducing complexity. The emphasis is on collateralization and their
  optimum utilization to increase the trading activity, which will be managed by T2S.
• Multiple CCPs: Today multiple CCPs clear different types of contracts, geography wise:
  - LCH Clearnet (UK) – IRS
  - LCH Clearnet (France) - CDS
  - Eurex clearing – IRS and CDS
  - CME Clearing – CDS
  - SGX Asia Clear (Singapore) – IRS
  - ASX Clearing (Australia) - IRS
   

Challenges ahead:

• Valuation of Contracts and Quantification of Risk: One of the major challenges faced is the valuation of contracts. Sophisticated mathematical models value them and the corresponding risks over a period of time. However, such valuations would be put to test only under
  extreme market conditions and how they stand up to these would be debated.
• CCP – Too Big to Fail: With the increased use of CCPs and the volumes they handle, they become too big to fail. Nonetheless, if a CCP fails, it would pose an enormous systemic risk. Monitoring mechanisms and norms prescribed by regulators, thus become critical.
• Collateral Management: Participants involved in multi-asset clearing would be associated with multiple CCPs. Collaterals being scarce, their optimum utilization is the key to increasing trading limits and reducing the cost of trades, valuing collaterals correctly and making them
  available for margins against the multi-asset class, is the need of the hour. Hence, CCPs and clearing firms would need to evolve strong collateral management policies. 

Fragmentation of trades across CCPs leads to locking collaterals at different locations. Going forward, a Global CCP concept could evolve that helps reduce the margins across hedged positions, thereby reducing collateral requirements. Also, when the positions are squared off at one CCP and there are larger positions at another, the time lost in movement of collaterals, resulting in a temporary need for more collateral and the additional costs involved, would accentuate the need for a Global CCP.

Opportunities for IT Service Providers: 

All the market participants; CCPs, Investment firms (Buy side and Sell side) and regulators are currently revamping their systems to support functionalities such as:

* Multi-asset
* OTC Derivatives Clearing
* Regulators Reporting
* Collateral Valuations
* Increased level of Straight through Processing
* Connectivity and Interfaces.

 

All systems would have to be revamped to handle the changes to workflow, both at the CCP and the investment firm's end.

Pre-implementation, detailed System Integration Testing (SIT) and post-implementation, detailed User Acceptance Testing (UAT) would be required before “Go Live”. 

Conclusion: Considering the various business aspects and regulatory changes, this industry is set to proactively seek increased efficiencies in the coming years.

                                                                                                                     
                                                                                                  

Dimensions of Card Fraud

By Sudha Kiran Pentela

Principal Consultant

Thinksoft Global

     

A discernible trend in global payments is the unabated growth of non-cash transactions in both mature and developing markets. Payment cards continue to gain market share at the expense of every other non-cash instrument, in every region. According to the World Payment Report 2013, globally the credit card and debit card transaction volumes recorded double digit growth of 12.3% and 15.8% respectively. Simultaneously, however, the fraud rates have increased significantly as well. For example, recent FICO data showed that in the US the fraud rate rose by 17% between January 2011 and September 2012.

Major brands like Visa, MasterCard, American Express, Diners Club, UnionPay and JCB averaged fraud losses of 6.13 basis points or 6.13 cents for every $100 spend, excluding merchant costs; up from the 5.07 cents in the previous study. Interestingly, the United States (US) accounted for 47.3 percent of such losses, despite generating just 23.5 percent of the total transactions for goods and services.

There are several factors shaping card fraud trends. They include changes in the underlying card technology, security standards, consumer payment preferences, legal and regulatory rules regarding liability for unauthorized payments, the structure of the payments industry, definitive initiatives from stakeholders like central banks, card schemes and approval/fraud detection techniques for debit and credit card transactions.

Major brands like Visa, MasterCard, American Express, Diners Club, UnionPay and JCB averaged fraud losses of 6.13 basis points or 6.13 cents for every $100 spend, excluding merchant costs; up from the 5.07 cents in the previous study. Interestingly, the United States (US) accounted for 47.3 percent of such losses, despite generating just 23.5 percent of the total transactions for goods and services.

There are several factors shaping card fraud trends. They include changes in the underlying card technology, security standards, consumer payment preferences, legal and regulatory rules regarding liability for unauthorized payments, the structure of the payments industry, definitive initiatives from stakeholders like central banks, card schemes and approval/fraud detection techniques for debit and credit card transactions.

An important dimension of card fraud mitigation relates to the technologies such as magnetic stripe cards, chip cards and EMV that issuers rely on. In Europe, the implementation of EMV(Chip and PIN) technology has been a key factor in reducing payment fraud. The use of EMV specifications for cards and terminals, together with the use of PINs, makes card transactions more secure. By using a chip instead of a magnetic stripe, stronger cryptographic algorithms can be used to authenticate cards. On the flip side, with implementation of EMV technology fraudsters have shifted to targeting cross-border and card not present (CNP) transactions.

The US on the other hand has been very slow in adopting the EMV system due to constraints in upgrading the 8 million odd legacy systems at merchant sites writes Joshua Brustein in the Bloomberg BusinessWeek of December 23, 2013. Quoting Jason Oxman, CEO of the Electronic Transactions Association, a trade group for the payments industry, Brustein notes that the credit card industry in the US downplays concerns about fraud dismissing them as very rare occurrences..

However, the delay on the part of US issuers to implement EMV-based systems has repercussion for issuers in other regions: European card issuers are now facing increased cross-border fraud losses in overseas markets, especially in the US. The ECB’s Report on Card Fraud of 2012, a 2% share in transactions is contrasted with a 25% share in fraud value for payments acquired outside the Single Euro Payment Area (SEPA)., Prior to the adoption of chip-and-PIN cards, only about 25 percent of the total fraud for UK-issued cards occurred on transactions outside of the UK, but today it is over 60 percent.

CNP fraud is another increasingly important element in this overall picture.

• The ECB notes that, ‘for delayed debit and credit cards’ and ‘debit cards’, CNP was the most used fraud channel, accounting for 68% and 48% respectively of all fraud. CNP transactions accounted for 56% of all fraud and were the main drivers of fraud rates in the previous year. FICO data also indicates a growth of 25% in CNP fraud rate between January 2011 and September 2012!
  
  
• CNP fraud becomes significant as fraudsters get to be more sophisticated. Data breaches and emergence of ‘Fraud as a Service’ (FaaS)/‘Cybercrime as a Service’ with Research, Crimeware, Cybercrime Infrastructure and Hacking all as services exacerbate the situation. A Symantec study found that the list of most popular items for sale, as well as the most requested for purchase is credit card data. The potential worth of all credit cards observed for sale during Symantec’s yearlong reporting period was estimated to be $5.3 billion Yet another dimension is ATMs and PoS terminals. Counterfeited cards continue to be the most common type of ATM fraud, while it is lost and stolen cards at PoS terminals. For delayed debit and credit cards within SEPA, fraud occurrence at PoS terminals and ATMs accounted for 25% and 7% respectively. For debit cards, these figures stood at 34% and 18% respectively. Card fraud acquired at ATMs grew by 7.4% from 2010 to 2011, while fraud acquired at PoS terminals decreased by 24.2%. This decrease was mainly driven by a 43% reduction in counterfeit fraud at PoS terminals. In 51% of cases, ATM and PoS fraud was conducted with counterfeit cards and in 40% of cases with lost or stolen cards.

Turning to India, according to Visa’s country manager for India and SE Asia, Uttam Nayak, as reported by Zeebiz.com, compared to other nations, as of February 2013, India witnessed the lowest number of fraud cases, thanks mainly to a banking system with robust checks and balances. The central bank RBI’s move in securing CNP transactions, through mandatory second factor authentication has ensured that industry is well placed. The domestic sales to fraud ratio for credit cards and debit cards in India stand at 1.06 bps and 0.19 bps respectively.

Implementation of EMV standards for issuance and acquisition have resulted in reduction of ‘card present’ fraud, forcing fraudsters to shift to cross-border and CNP transactions. To mitigate the risk associated with CNP transactions, central banks and card schemes and issuers are implementing solutions like 3D secure and one time password.

The issuers and acquirers are also focusing on fraud detection solutions. As banks amend their techniques, fraudsters shift to weaker links and into identifying newer vulnerabilities. As Frank Abagnale Jr. in the movie Catch Me if You Can says, “you're gonna have to catch me first!” For financial institutions, often it has been an exercise of catching up with ‘innovative’ fraudsters. A wide range of anti-fraud solutions are based on rule based neural networks and analytics. Tackling payment card fraud requires a holistic, layered and multi-pronged strategy that accounts for customer experience without compromising on fraud detection.

Testing of fraud detection solutions requires an understanding of business rules and the end to end authorization processes. Simulating transactions to address specific strategies and rules throws up many challenges. Experience shows that it is pertinent to consider decimal variations w.r.t. currencies (zero decimal, two decimal and three decimal) and the amounts. As a transaction could traverse through switches, behavior-risk based decision systems for over-limit transactions and finally fraud-detection, scoring systems and the issuer host, it is important to ensure that authorization response is in line with business expectations.

Germany’s High Frequency Trading Act – Consequences for foreign trading participants

Günther Neurohr

Fimas GmbH – Financial Market Solutions

With a diploma in business administration from the University of Giessen in Germany and the University of Huelva in Spain, Günther Neurohr has been a consultant and business analyst at Fimas. He has participated in several projects and was involved in implementing requirements concerning the EMIR regulation for a big national bank. Currently Günther is involved in analyzing processes, risks and controls within a big international Custody Bank.

The German government has been working on a High Frequency Trading (HFT) Act since July 2012. The law came into force on 15th May 2013, with an implementation period of six to nine months.

As one of the first jurisdictions to introduce legislation designed to control high-speed trading, Germany’s rules are being closely watched by the wider financial industry. In many ways, the rules mirror proposals planned for inclusion in a revised version of the EU’s trading rulebook; the Markets in Financial Instruments Directive, MiFID II, which is set to come into force no earlier than 2015.

The legislation applies to almost all market participants in electronic trading of financial products and introduces requirements intended to mitigate the potential risks arising from algorithmic or high-frequency trading techniques, which are defined as “…system determination of order initiation, generating routing or execution without human intervention for individual trades or orders” (MiFID II Draft).

Among other measures, under the HFT Act, exchanges will be required to determine a minimum tick size and an order-to-trade ratio that is appropriate for each specific instrument and that will be measured per trading participant and product over one month. Additionally, exchanges will be obliged to charge separate fees for excessive usage of exchange systems.

The final version of the rules omitted a minimum holding period for trades, which is seen as a way to slow the pace of computerized trading, but it has controversially maintained a licensing requirement. This means all HFT firms that trade directly or indirectly on German markets will need to be authorized by German regulator BaFin. This liability is considered as the most worrying part of the German rules and market participants can start questioning whether it is worth continuing to trade in Germany, particularly as the rules could be overtaken by MiFID II.

However, the German lawmakers added an exemption for foreign trading participants, from countries within the European Economic Area (EEA), intending to provide cross-border services into Germany or to establish a branch in Germany: Participants who own a license in their domestic location have the possibility of applying for a European passport and transfer their license into Germany. In such cases, the supervisory authority of the institution‘s home country needs to notify BaFin according to Art.31 and Art.32 MiFID.

Firms are granted a period of six months (ending November 2014) for complying with the new law. This transitional provision is also intended for EEA-participants which already hold an authorization for dealing on own account and intend to use the European passport.

No exemptions will be available for any non-EU firms. The rules will therefore be toughest for foreign firms that trade in Germany and do not have regulatory approval in any EU state. The options facing these firms are to obtain an EU license and passport it into Germany within the transitional period, or set up a German legal entity for approval by BaFin by February 14, 2014.

Healthy banks under healthy regulation

B. Yerram Raju PhD.

Dr Yerram Raju is distinguished banker turned economist and management consultant; currently a Director at the Development and Research Services Hyderabad and a consultant to the Govt. of Andhra Pradesh on cooperative reforms in banking and law. His four and half decades of multi-sector experience spans 3 decades with the SBI, with stints with LBSNAA Mussoorie, ASCI, IIPE and the IIE. He was Regional Director, Professional Risk Managers' International Association; Hyderabad Chapter till May 2013. Briefly the editor-in-chief of Asian Economic Review, a visiting Professor at IDRBT Hyderabad and the ISED Cochin. Author and prolific writer, he was a Member of the Jury for the Asia Pacific Bankers' Congress in Manila in 2004 and 2005 and a short term consultant to the World Bank, GTZ, FNF, UNIDO and UNDP.

Post recession 2007, world over there were unsparing attacks on regulatory lapses with India alone being excluded, thanks to the then RBI Governor Y.V.Reddy’s sagacity. Capital account convertibility and derivatives were asked to wait at the gates of the regulator and this measure kept at bay the contagion effect. The trust deficit that has been shaking the foundations of the Indian Government with scandals galore has not touched the portals of the financial sector while in the US and Europe it is the financial sector that had to face the brunt of the crisis. These countries had to rebuild the trust with great effort.

Six years down the line, the US, Europe (post the Libor scandal) and even the UK have been re-engineering their regulatory regimes. The need arose mainly because of the high leverage ratios, limited capital buffers and little attention to operational and reputational risks. The recession shocks created tremors all over the world resulting in NINJAs in the West and Europe and destabilized several Asian economies as never before. The Markets were quick to react with falling indices and devaluation of stocks across the globe. The pension funds and mutual funds were affected. The interest rates were unstable for longer than expected. Several countries reeled under inflationary pressures. Even in USA and Europe with UK being no exception, banks were nationalized to protect the depositors’ interests.

In many countries, there is an outcry that there is an overdose of regulation and this burden could be reflected as red herrings on their balance sheets before long. At a recent conference, at tea time, a few top bankers were wondering whether they should continually review their capital and see how much of it could be put to better use so that the bank progresses. Several bank CEOs confide in private that the regulatory mandates on MIS and Risk management would finally make business opportunities ornamental and customers irrelevant. It is this backdrop that made me choose a review of most of the regulations with a bearing on capital allocation and financial stability across nations.

It is strong regulation followed by effective monitoring and supervision by the Reserve Bank of India (RBI) that saved the Indian banking system from the global financial turmoil in 2007. This is despite the risks arising from the inter-linkages between institutions and markets both in India and abroad! Like elsewhere, the Indian banking system also engages in acceptance of deposits, lending of depositor’s money and investments of funds in Government bonds and other long term securities of corporations. However, the Reserve Bank has laid down certain safety norms as the funds belong to public and banks cannot fritter them away by taking undue risks.

Statutorily, regulation of banking is governed by the Provisions of RBI Act 1934, Banking Regulation Act 1949 and Foreign Exchange Management Act 1999. The Reserve Bank has prescribed certain guidelines keeping in view the economic environment, the need for financial soundness and the risks banks face in the ever increasing integration of international economies and the unending emergence of innovative and exotic financial products. There was neither over-regulation nor any impairment of the freedom of financial institutions to carry on businesses as usual during and after the crisis. While there were political, social and economic pressures to extend finance to seemingly high risk sectors like farming, micro and small enterprises, retailers, exporters, housing, education etc., the regulator’s learning from the failures of international banks enabled adequate firewalls preventing failures of a similar nature. Adequate checks and balances over risky advances have received continual attention by way of certain exposure norms for individual and group borrowers. Bulk of a bank’s investments is in Government securities because of the Governments’ dependence on these funds and for want of a corporate bond market. These investments are guided by certain parameters that factor in market risk in terms of interest and price fluctuations. Equity market exposure is permissible within limits and that too only under close surveillance.

Basel norms viz., capital adequacy, are in place and they are being progressively improved upon, in tune with requirements. Asset liability management has been rigorously pursued and the banking system has developed the skill and expertise to closely monitor the cost of funds, liquidity gaps and maturity mismatches in terms of interest and principal amounts, off balance sheet management with permissible products like derivatives, guarantees etc. The RBI provides liquidity support and influences the market rates of interest through its monetary intervention tools like CRR, REPO and Reverse REPO rates. However, the insulation from the impact of the crisis is not everlasting. India has to keep its eyes and ears open. There are still gaps on the governance front because of the perception that compliance and conformance to regulatory regimes is all that good governance means.

USA had to put in place, the Dodd Frank Act and has brought in new regulations to rein in credit rating institutions and the Volker’s rule. Realizing that these did not take them far, it has been made clear that all banks and financial institutions are to abide by the rigor of Basel III capital allocations, leverage ratios, governance and liquidity norms. ‘SAI Global Compliance’ announced the findings of its 2013 Financial Services Industry Compliance Benchmark Study. As a result of the growing number of new and updated regulations emerging over the past year, firms cited mitigating new risks created by Dodd-Frank and demonstrating compliance effectiveness as their top priorities for 2013. “As individual regulations continue to ensure implementation of the Dodd-Frank legislation, financial services firms are stepping-up their game in terms of compliance and risk management”.

In most nations, measurement and management of the liquidity risk has been a concern for over 20 years. The document of the first ‘Basel Committee on Banking Supervision; (BCBS) on sound practices in liquidity risk management was issued in 1992. It was superseded in 2000 by 14 guiding principles. The crisis of 2007 has increased the regulatory attention to liquidity risk. Consequently, in 2008, the BCBS issued an updated document comprising of 17 guidelines -- but there were still no binding requirements. In December 2010, in response to even more heat generated by the crisis, BCBS unveiled new liquidity rules in a document called "Basel III: International framework for liquidity risk measurement, standards and monitoring." This paper introduced two key minimum reporting standards for liquidity: a 30-day liquidity coverage ratio (LCR) and a longer-term structural ratio called the net stable funding ratio (NSFR). The LCR, from a net cash flow perspective, will force banks to boost their short-term liquidity pool and to hold a minimum liquidity to survive 30 days of stress. The NSFR, on the other hand, is designed to mitigate maturity mismatch, and will serve as an early indicator for regulators to intervene when structural liquidity is insufficient.

In July 2013, barring Argentina, Indonesia, Russia and Turkey the rest of the nations including the US, embraced the Basel III regulation framework with introduction to commencing from April 2013 and the maturity date being April 2018.

Regulation of banking is necessary for supporting the growth of the economy, for ensuring the health of regulated institutions and for insulating nations from the repercussions of any emerging global crisis. From this angle, the warnings that overdoing regulation is no answer to regulatory wrongs are not acceptable. {The Legatum Institute and the Tax Payers’ Alliance cautioned that intensive financial regulation is ‘harmful, costly and potentially dangerous for the growth of world economy.’ (bustle@belfasttelegraph.co.uk)}. Regulatory wrongs are also the lessons from the world financial turmoil and they need to be adequately addressed. Well calculated regulatory risk to prevent/minimize business risks and failures can only be beneficial and any excess can bring in unexpected damage. The new liquidity risk ratios, along with monitoring metrics, are a fundamental part of the Basel III regulation, and represent the first step toward international and globally harmonized liquidity measurement standards. They will also facilitate liquidity comparisons between financial institutions.