December 26, 1991

Dear Sir/Madam:

The Foreign Exchange Committee's recently revised Guidelines for the Management of Foreign Exchange Trading Activity (December 1990) raised questions about the use of historical rates in pricing forward contracts. The Committee recommended that non-market rates should not be permitted in interbank dealing and should be permitted in other circumstances only with strict management oversight.

In recent Committee discussions, however, members have concluded that the risks involved in rolling contracts at historical rates are often not fully appreciated in the marketplace, notwithstanding well-publicized problems involving the use of such rollovers. At a time when market practices and risk controls are the subjects of increased focus in the financial community, the Committee has decided to draw attention to the potential dangers of historical-rate rollovers and to suggest ways to help management limit the risks, should they continue to provide such services to their customers.

Historical-rate rollovers involve the extension of a forward foreign exchange contract by a dealer on behalf of his customer at off-market rates. In a typical rollover, the customer will ask his dealer to apply the historical rate of a maturing contract to the spot end of a new pair of contracts which, in effect, extends the maturing contract, thereby deferring any gains or losses. Historical-rate rollovers virtually always involve the extension of credit by one party to the other. If the customer has a loss on the maturing contract, the rollover would in effect represent a loan by the dealer to his customer. If the customer has a profit, the dealer would in effect be borrowing from the customer. The resulting loan or borrowing amount and associated interest rate charges are typically built into the forward points the dealer quotes his customer. While accounting conventions do not require that these amounts be recognized in the books as loans or borrowings, proper risk control requires that they be treated as such.

Certain uses of historical-rate rollovers may be justified, as when used by a company seeking to hedge the currency risk of a commercial or financial transaction with an uncertain date. Companies, for example, may hedge the currency risk of a purchase of foreign goods based on an estimated delivery date, but subsequently "roll" the hedge out or in so as to coincide with the actual date of the delivery. In this way, corporate treasurers can avoid the cash flows which might occur if the gain or loss on the forward hedge does not coincide with the currency gain or loss on the underlying commercial transaction.

However, because rollovers could be used to shift income from one institution to another or from one reporting period to another, they can also serve illegitimate purposes. A dealer who routinely offers to rollover his customers' maturing contracts at historical rates could unwittingly participate in efforts to conceal losses, evade taxes, or defraud his or another trading institution. His involvement in these efforts could potentially subject him and his bank to legal action, not to mention damage his and his institution's reputation.

Even a dealer who carefully examines each request for off-market trades may face serious problems if senior management at both the corporate counterparty and his own institution have not fully evaluated and approved of the transaction. At the counterparty firm, failure to insure that senior management has understood and signed off on the deal may risk the possibility that the terms of the transaction come into dispute. This is particularly common if the trader who arranged the deal has left the customer firm. At the dealer institution, failure to record the implied loan or borrowing amount in an historical-rate extension could threaten centralized control over the management of interest rate and credit risks.

Thus, use of historical-rate rollovers introduces risks above and beyond those normally faced by dealing institutions in the day-to-day trading of foreign exchange, including: (i) the risk that the dealer institution unknowingly aids and abets illegal or inappropriate activities; (ii) the risk that customer management is unaware of the special nature of the transaction and/or of the associated credit exposures; and (iii) the risk that management at the dealer institution is unaware of the special nature of the transaction and/or of the associated credit exposures.

Recommendations of the Foreign Exchange Committee

The Foreign Exchange Committee believes that rolling contracts at historical rates is a dangerous practice which should be avoided absent compelling justification and procedural safeguards. Because of the special risks, the Committee urges dealers that continue to accommodate customer requests for historical-rate rollovers to take the following three steps: (i) inquire about the customer's motivation in requesting an off-market rate trade to gauge the commercial justification; (ii) make sure that senior customer management is aware of the transaction and the special risks involved; and (iii) obtain the informed consent of one's own senior management to take on the additional risk and any effective credit extension.

The Committee further recommends that all dealer institutions have written procedures for historical-rate rollovers. An example of procedures that satisfy the above conditions would include the following:

• A letter from senior customer management (treasurer or above) should be kept on file explaining (i) that the customer will occasionally request to rollover cotracts at historical rates; (ii) the reasons why such requests will be made; and (iii) that such requests are consistent with the customer firm's internal policies; this letter should be kept current;
• The dealer should solicit an explanation from the customer for each request for an off-market rate deal at the time the request is made;
• Senior management and/or appropriate credit officers at the dealer institution should be informed of and approve each transaction and any effective extension of credit;
• A letter should be sent to senior customer management immediately after each off-market transaction is executed explaining the particulars of the trade and explicitly stating the implied loan or borrowing amount; and
• Normally, forward contracts should not be extended for more than three months, nor extended more than once; however, any extension of a rollover should itself meet the requirements of (b), (c) and (d) above.

Attached is the 1991 membership list for the Foreign Exchange Committee. Please feel free to contact myself, members of the Committee, or the Committee's Executive Assistant with any questions or comments regarding this letter.

Very truly yours,

John T. Arnold
Chairman