The Banking Supervision Department’s actions to lower conduct risks in trading activities

  • This review is presented as part of the Banking Supervision Department’s policy to increase the transparency of its activities.  Accordingly, the Banking Supervision Department publishes a periodic review of its actions in certain areas, with the aim of minimizing emerging risks and increasing the banks’ fairness toward their customers.
  • The Banking Supervision Department has acted in recent years in a variety of channels to improve the banks’ trading activity in various financial instruments for its customers.
  • This activity follows a series of large financial scandals that have taken place around the world in recent years as a result of misconduct by trading room dealers at large banks.
  • It should be emphasized that no such incidents have taken place in the Israeli banking system.
  •  Even so, the Banking Supervision Department attributed a high potential risk to such activity, and it acts accordingly to prevent the realization of such risks similar to events that have occurred abroad.
  •  Within this framework, the Banking Supervision Department conducted a comprehensive review of the conduct at Israeli banks compared with selected principles that have been set out in an international code that constitutes a new global standard in this field—the FX Code.  This review is meant to ensure the proper behavior of trading room dealers, with an emphasis on foreign exchange, in terms of fairness toward the customer, transparency, and efficiency.
  •  Our review found a number of strengths in the Israeli banking system. For instance, the compensation mechanism for dealers that is customary in Israel is generally more conservative than what is common in many developed economies, such that there is less of an incentive to achieve and report on profits. It also found that there is room to improve behavior in a number of areas, mainly in terms of fairness and transparency toward the customer when executing trades, managing communication between dealers and customers and other parties, and the way in which that communication is monitored and supervised.  These improvements are necessary in order to minimize the probability of realizing risks and losses in the Israeli system.  Accordingly, the Banking Supervision Department has demanded that the banks study the principles of the FX Code and act in an informed manner to close the gaps that have been found.
  • In addition to this review, the Banking Supervision Department conducted field examinations on this topic in the banks’ trading rooms, and it is advancing new Proper Conduct of Banking Business directives in this area.  In the examinations that were conducted, a number of banks were required to set out detailed rules of conduct for dealers, and to improve their monitoring of the dealers’ communication channels.
  • The Banking Supervision Department continues to monitor progress in the matter, and continues to examine ways to advance the efficiency, fairness, and transparency of trading room activity (in foreign exchange and other financial instruments) and to promote market integrity.
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Background

 In recent years, the Banking Supervision Department has been acting in a variety of channels to improve the banks’ trading activity in various financial instruments for its customers.  This activity includes conducting a series of examinations at the banks regarding various aspects of trading room activity (see the Press Release from July 15, 2018[1]), formulating Proper Conduct of Banking Business directives to regulate the activity, and an in-depth systemic review, the details of which are below.

 

This activity by the Department follows a series of large financial scandals that have taken place around the world in recent years as a result of misconduct by trading room dealers at large banks.  It should be emphasized that no such incidents have taken place in the Israeli banking system.  Even so, and even though the volume of trading activity at Israeli banks is much lower than that of many banks around the world, the Banking Supervision Department attributes a high potential risk to such activity, and it acts in accordance with this assessment to prevent the realization of such risks similar to incidents that have occurred abroad.

 

Over the past two years, the Banking Supervision Department conducted a systemic review to examine and assess whether there are weaknesses in the trading room rules of conduct at the Israeli banks, and how they are enforced and monitored.

 

The review was mostly conducted in reference to updated principles set out in an international standard called the FX Global Code.  The Code, which was published in May 2017, was developed by an international working group following the widespread financial scandals around the world and the lessons learned globally in this area.  The Code sets out principles and good practices, including proper and ethical behavior of trading room dealers toward customers and other parties.  Despite being defined as voluntary and not a binding standard, it has become a common global standard.[2]

 

Risks in trading room activity

 

The large financial scandals that have taken place around the world were due to the misconduct of dealers in the trading rooms of large banks, which had a significant impact on the public and the markets.  Main failures that were exposed included market manipulations where dealers colluded over years to influence foreign exchange rates and interest rates, and cases where dealers made unauthorized trades while concealing deals and loss positions.[3]  In Israel, the domestic banks are the main participants in the NIS/FX market.  As such, they provide services to corporate customers and institutional entities interested in foreign currency/shekel exchanges.  As usual in trading rooms, the deals are closed between dealers very rapidly, through constant interaction with price fluctuations, and encompass very large volumes.[4]

 

In this situation, there is a very large structural challenge to effectively controlling and supervising trading room activity and making sure that it really is done properly and according to the approved policies and procedures.  Weaknesses in control and supervision of the trading room may in some situations lead to losses for the bank itself, in other situations to losses for its customers, and when there is market price manipulation as happened abroad, to losses for the broad public, pension funds, etc.

 

The findings of the review of banks’ trading room activity vis-à-vis the FX Code, and the requirements raised as a result

 

Our review found a number of strengths in the Israeli banking system. For instance, the compensation mechanism for dealers that is customary in Israel is generally more conservative than what is common in many advanced economies, such that there is less of an incentive to achieve and report profits. It also showed that there is room to improve behavior in a number of areas, mainly in terms of fairness and transparency toward the customer when carrying out trades, managing communication between dealers and customers and other parties, and the way in which that communication is monitored and supervised.  These improvements are necessary in order to minimize the probability of realizing risks and losses in the Israeli system. 

 

Setting out rules of conduct

 

The review found that the Israeli banks must broaden and expand the rules regarding the conduct expected from trading room dealers vis-à-vis customers. In the absence of rules, the dealers frequently remain without direction in the situations and dilemmas they encounter under normal circumstances.  Setting out clear rules of conduct is a significant step on the part of the banks’ management, which will help dealers, as well as control functions that are responsible for examining the propriety of activities.  The following are some examples of issues where the lack of rules may cause damage to customers or to the bank:

-          By their very nature, dealers are exposed to information that they can exploit in favor of the bank or to their own advantage.  For instance, they will sometimes receive information about expected large-scale foreign exchange purchases by customers such as importers, which are expected to influence the exchange rate.  In such a situation, dealers may exploit the information by taking positions that will generate profits for them or for the bank when the exchange rate changes, at the expense of customers.  As a result, the bank must define what is permitted and what is prohibited for dealers in such situations.

-          Foreign exchange deals involving the bid/ask spread that the bank sets, such that the price at which the bank is prepared to purchase is lower than the price at which it is prepared to sell.  Rules should be set out for fairness of the spread, including showing the spread and helping customers understand how it is determined, such that the customers will be able to compare prices and obtain a competitive price.

-          In many cases, dealers tend to provide their customers with insights and information that support the relevant decision, in order to provide them with effective banking service and create a relative advantage over competitors. Such provision of information may naturally lead to sharing classified information with the customer, which is prohibited, such as information on other customers.  As a result, it is important to set rules regarding what is permitted and what is prohibited in this area.

 

Monitoring communication channels

 

-          The scandals that occurred around the world regarding the setting of foreign exchange rates and LIBOR rates had a great deal to do with collusion between dealers at the banks and at other financial corporations.  This increased the importance of effective monitoring and supervision of the communication channels between the dealers and these corporations (such as chatrooms on the Bloomberg system).  There is currently legislation in the US and Europe requiring trading rooms to conduct their communication with their customers only through monitored means.  In contrast, the review showed that at the Israeli banks, not all of the dealers’ communication channels with their customers are monitored.  For instance, there is no on-going monitoring of communication through mobile phones, certain chatrooms or email.

-          The technological innovation that has developed in the financial world in recent years has led to the development of advanced computerized monitoring systems that markedly increase the effectiveness of communication channel monitoring and the ability to locate unusual conduct patterns.  Most banks in Israel are still in the early stages of studying and implementing these systems, such that monitoring is still done through unsophisticated means and relatively small samples, and is not sufficiently effective.

 

In view of the foregoing, the Banking Supervision Department continues to monitor progress in the matter, and has demanded that the banks study the principles of the FX Code and conduct a detailed review of the gaps between its recommended good practices and the actual situation.  Based on the results of this review, the banks will be able to better assess the existing risks, make more informed decisions regarding the implementation of the principles from the Code that are relevant to their operations, and strengthen control over their activity.

 

Complementary examinations that the Banking Supervision Department has already carried out at various banks show various deficiencies.  For instance, in one case, a bank made large-scale opposing derivatives transactions  at a customer’s request, even though the economic logic of those transactions was doubtful.  In another case, the business level at the bank prevented a report on a customer exceeding his approved facility, since it was considered temporary, by putting dummy derivatives transactions into the customer’s account.  In the examinations, the banks were required, as relevant, to set out detailed rules of conduct for dealers, including examples and dos and don’ts. Banks were also required to improve the monitoring of dealers’ behavior through various means of communication—including through examining the integration of advanced technological systems, increasing the involvement of the risk management and compliance function in these areas, setting adequate listening samples, and more.

 

The Banking Supervision Department continues to monitor progress in the matter, and continues to examine ways to advance the efficiency, fairness, and transparency of trading room activity (in foreign exchange and other financial instruments) and to increase market integrity to benefit the entire economy.



[2] The standard is being implemented by central banks (such as the Federal Reserve Bank of New York), the world’s leading banks, large nonfinancial entities (such as Airbus), and the major foreign exchange trading platforms such as Bloomberg and Reuters.  The Bank of Israel recently announced its commitment to implement the Code as well.

[3] A prominent example was the incident dubbed the Forex Scandal, in which dealers at a number of leading banks around the world coordinated exchange rate manipulations for years in a way that would benefit the banks over their customers, causing huge estimated losses to the public.  Among other things, it was estimated that the losses to pension funds in the UK alone reached $11.5 billion per year.  As a result, in 2014, seven banks were fined 410 billion by authorities in the US and the UK.  Another example similar to the first concerned the manipulation of LIBOR rates.  A prominent example of losses due to another type of misconduct is the loss of $9 billion caused to JP Morgan in 2012 due to deals made by a dealer who bypassed the bank’s controls.

[4] To illustrate, Bank of Israel data show that foreign exchange trading volume by the domestic banks in the fourth quarter of 2018 averaged $8 billion per day.​