Futures

Commission

Merchant

Activities

November 1995

Comptroller of the Currency

Administrator of National Banks

Washington, DC 20219
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Futures Commission

Merchant Activities Table of Contents

Introduction 1

Background 1

Board and Senior Management Oversight 4

Risks Associated with FCMs 9

Examination Objectives 24

Examination Procedures 25

Internal Control Questionnaire 41

Appendix — Sample FCM Request Letter 42
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Futures Commission 

Merchant Activities Introduction

Background

A national bank generally establishes a futures commission merchant (FCM)

operating subsidiary for one of two reasons. First, a FCM operating subsidiary

provides a bank that engages in futures and options transactions with more

direct access to these markets, thereby improving information flow and

reducing transaction costs. Second, establishing a FCM operating subsidiary

allows a national bank to provide an additional service — that of executing

and/or clearing futures and options contracts — to bank customers.

Under 12 USC 24(7) and other statutes, a national bank may establish or

acquire and operate an operating subsidiary, including a FCM, to engage in

activities that are part of, or incidental to, the business of banking. A FCM

operating subsidiary typically solicits or accepts orders to purchase or sell

financial or commodity futures contracts and options on these contracts on

major exchanges. With respect to national bank operating subsidiaries,

"financial futures" include those futures contracts and options on futures

contracts relating to assets that a national bank may purchase for its own

account; that is, United States securities and United States government

agency securities; domestic and Eurodollar money market instruments; bank

certificates of deposit, foreign currencies; and gold, silver, platinum and

palladium. “Commodity futures” include futures contracts and options on

futures contracts for all other financial (equities) and non-financial

(agricultural, petroleum, and metals) assets.

A FCM may extend credit or accept money, securities, or property to margin,

guarantee, or secure any trades or contracts resulting from its solicitation,

acceptance, or execution of orders. A FCM may act as intermediary between a

customer and exchange members that actually execute or clear trades. 

Additionally, a FCM may be a member of an exchange and serve as a clearing

member. Operating subsidiaries may offer advisory services, including financial

and market analysis, strategy development, research, and discretionary funds

management in connection with its FCM activities. The Office of the

Comptroller of the Currency (OCC) also permits FCM operating subsidiaries to

obtain membership in domestic and foreign futures and options exchanges,

clearinghouses, and to register with relevant monetary authorities.

A national bank that intends to establish or acquire a FCM operating

subsidiary, or to perform a new activity in an existing FCM subsidiary,

generally must submit an application and obtain prior OCC approval under

the procedures set forth in 12 CFR Part 5. National bank FCM operating

subsidiaries are subject to examination and supervision by the OCC. Unless
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otherwise provided by statute or regulation, all provisions of federal banking

laws and regulations that would apply to the parent national bank shall apply

to the operations of the bank's operating subsidiary. 

Domestic FCMs are also subject to the Commodity Exchange Act (CEA), as

well as rules and regulations issued by the Commodity Futures Trade

Commission (CFTC), the National Futures Association (NFA) (a self-regulatory

organization), and relevant exchanges. National bank FCM operating

subsidiaries that engage in transactions on foreign futures and options

exchanges will need to ensure compliance with the laws, rules and

regulations of the applicable jurisdiction. (Guidance in this booklet focuses

primarily on FCM activities as they relate to domestic exchanges). 

Specific OCC conditions that an examiner reviewing a bank’s FCM should be

aware of include:

C The operating subsidiary shall comply with OCC Banking Circular 277,

“Risk Management of Financial Derivatives” (October 27, 1993).

C Loans by the parent to, or any investment of the parent bank in, the

operating subsidiary (and its partnership interests) in the aggregate may

not exceed the legal lending limit at the time of the loan or investment. 

The parent bank shall not make investments of equity capital in the

operating subsidiary (or its partnership interest) that exceed the lending

limit without the OCC’s prior written consent. For the purpose of

calculating the lending limit in accordance with this investment

limitation, the parent bank’s investment in the operating subsidiary is

deemed unsecured.

C The parent bank may lend the operating subsidiary (or its partnership

interest) an additional 10 percent of the parent bank’s unimpaired capital

and surplus if secured by readily marketable collateral as provided in 12

USC 84.

C The operating subsidiary will not join any exchange or clearing

association that requires the parent bank or any other subsidiary of the

parent bank to guarantee or otherwise become liable for trades executed

and/or cleared by the subsidiary, other than for those trades executed

and/or cleared for and on behalf of the bank and any of its affiliates or

other operating subsidiaries.

C The operating subsidiary will not become a clearing member of any

exchange or clearing association that requires the parent bank to also

become a member of that exchange or clearing association unless the

parent bank obtains a waiver of the membership requirement.
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C The parent bank shall not guarantee or assume responsibility for any

liability of its operating subsidiary, other than for those trades

executedand/or cleared for and on behalf of the bank and any of its

affiliates or other operating subsidiaries.

Futures contracts must be traded on an organized exchange. In the United

States, pit trading — or trading that takes place in designated areas or “pits,”

— is the predominant form, although screen-based trading systems (Globex,

Project A, and NYMEX ACCESS) are having some limited success. According

to the CEA, which authorizes the CFTC to oversee the futures markets, trading

in futures contracts must be “open and competitive.” This means that futures

contracts are traded by a system of “open outcry”; that is, all orders must be

competitively bid and offered (exposed) in the pit (or over the screen-based

system). 

Consistent with this requirement, under exchange rules, trading may take

place only during the official trading hours in pits or over a network using

dedicated terminals. Prearranged trades, off-floor negotiation of trades, and

crossing of orders held, are examples of noncompetitive trades strictly

prohibited under the CEA. 

A futures exchange is a voluntary nonprofit organization of its members. 

Members have a right to trade on the exchange, to have a voice in the

exchange’s operation, and to sell their memberships. The exchanges are

responsible for maintaining records to monitor trading and must be able to

construct an audit trail to detect and deter violations of applicable rules and

regulations.

The main players in the futures market are: associated persons, introducing

brokers, commodity trading advisors (CTAs), floor traders, floor brokers, and

customers. With the exception of customers, all of these market participants

are required to register with the CFTC (or the NFA, where appropriate), and

to comply with certain minimum capital and financial requirements. They

also must maintain extensive records as required by the CFTC or the futures

exchanges, and they must comply with various reporting requirements. 

Associated persons are individuals affiliated with FCMs, introducing brokers,

or CTAs who can solicit or accept customers’ orders and funds for the

purpose of trading. CTAs are in the business of providing advice, either

directly or through publications, in writing or through the electronic media,

on futures trading or options on futures trading. Floor brokers purchase and

sell contracts for their own account and on behalf of customers, while floor

traders buy and sell only for their own accounts. Introducing brokers solicit

or accept contracts for future delivery, but do not accept money or collateral

to margin, guarantee, or secure trades.
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Individuals trading in the market fall into two categories: exchange members

trading for their own accounts or representatives of trading firms acting as

brokers and trading on behalf of customers. Further distinction can be made,

based upon the nature of the trading strategy. “Hedgers” are market

participants who engage in futures transactions to offset current, or expected,

positions in cash markets. “Speculators” are those market participants willing

to assume the risk offset by hedgers, with expectations that future price

movements will prove profitable. Speculators can further be distinguished by

the length of time a position is held: scalpers (seconds or minutes), day

traders, and position traders. Scalpers make it easy for brokers to accomplish

their trades, because they stand ready to buy from anyone who wants to sell

and to sell to anyone who wants to buy. These short-term traders hope to

profit from transitory price movements, or from buying at the lower bid and

selling at the higher offer, even though spreads in the futures markets are very

small (one or two tics). Without the scalpers, the futures markets would be

far less liquid and more costly to trade.

Board and Senior Management Oversight

The safe and sound operation of a FCM operating subsidiary is contingent

upon effective bank board and senior management oversight. It is incumbent

upon the bank’s board and senior management to understand the role the

FCM plays within the overall business strategies of the bank and the

mechanisms used to manage inherent risks.

To fulfill its responsibilities, the bank’s board must ensure that appropriate

written policies and strong control processes are guiding the actions of the

FCM’s management. Strong risk management and audit functions are critical

to ensuring that actions taken by the FCM’s management are consistent with

the strategies approved by the bank's board. In addition, effective oversight

reduces the likelihood that activities of the FCM may expose the bank to

litigation, financial loss, or otherwise damage the bank's reputation.

Policies and Procedures

The bank’s board must endorse written corporate policies that provide a

framework for the management of risk. As with other complex areas of

banking, written policies and procedures are necessary for FCM operating

subsidiaries to ensure proper identification, measurement, monitoring, and

control of risk exposures.

The board should ensure that the policy framework identifies managerial

oversight, assigns clear responsibility, and requires the development and

implementation of sufficiently detailed procedures to guide the FCM's daily

activities. Policies should detail the type and nature of the activity

authorized, articulate the risk tolerance of the bank through comprehensive
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risk limits, and require regular, independent risk position and performance

reporting.

The board should review and endorse significant changes to policies. At least

annually, the board, or a committee thereof, also should approve key policy 

statements, particularly those related to risk tolerance and limits. Meeting

minutes should document these actions.

Risk Management

Risk management is the process through which the various risk exposures are

identified, measured, monitored, and controlled. The risk management

process serves as a communication tool for senior management and the board

when evaluating whether management actions are consistent with board

strategic objectives. The fundamental elements comprising risk management

are: exposure limit systems, risk measurement capabilities, risk monitoring

and reporting mechanisms, and segregation of critical operational and control

processes. The board and senior management must provide adequate

resources (financial, technical expertise, and systems technology) to

implement effectively these elements.

Banks establishing a FCM operating subsidiary must possess risk control

functions commensurate with the extent and complexity of the FCM’s

activities. The underlying risks associated with FCM activities are not new to

banking, although their measurement and control can be more complex than

for other traditional products or activities. For example, measuring credit risk

in futures transactions involves consideration of margin determination and

collection, issues not common to direct lending or over-the-counter (OTC)

derivatives transactions. Therefore, the OCC considers a strong risk control

function to be critical. The OCC considers the lack of an adequate risk

control function, relative to the level of bank FCM operating subsidiary

activity, to be an unsafe and unsound banking practice.

The OCC expects banks with a FCM operating subsidiary to ensure the effective

operation of an independent risk control function. This function should be a

separate unit — it need not be standalone for the FCM and may perform risk

control activities for other areas of the bank — reporting directly to executive

management, the board, or a designated committee thereof. The risk control

function should perform independent evaluations of risk-taking activities on an

ongoing basis. These evaluations would include assessing the propriety of risk

levels and the adequacy of the risk management processes. The risk control

function should monitor the development and implementation of applicable

control policies and risk measurement systems. Observations should be

periodically communicated to senior management and the board.
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Risk Measurement

Accurate measurement of FCM-related risks is necessary for proper

management and control. Risk measurement at the board and senior

management levels is generally accomplished on a portfolio basis and

aggregated according to type of risk. At a line management level, risk may be

more appropriately measured by product, market factor, or other

characteristics. All significant risks should be measured and considered in

the assessment of risk on a bankwide basis. For example, measuring credit

risk at the bank level should also take into consideration exposures arising

from activities of the FCM operating subsidiary.

Management should recognize that measurement of some types of risk is an

approximation. Certain risks, such as liquidity risk, can be difficult to

quantify and can vary with economic and market conditions. At a minimum,

the board and management should assess the FCM's vulnerability to each risk

associated with futures and options activities, on an ongoing basis, in

response to changing circumstances. The sophistication and precision of risk

measurement methods will necessarily vary by the types and volumes, as

well as the riskiness, of activities undertaken.

Risk Limits

The board of directors should approve aggregate risk-taking limits at least

once a year. Limits should be directly related to the nature of the bank's

strategies, historical performance, and the overall level of earnings or capital

that the board is willing to place at risk. An effective risk management

process will also ensure that the board reassesses limits when necessary, with

appropriate revisions made to reflect changes in resources or market

conditions. For example, in periods of abnormal market volatility, the board

may request FCM management to lower open interest limits, so as to reduce

liquidity risk exposure to the FCM.

In addition to providing a means of control over aggregate exposure, the

board and senior management should use limits and exposure measurement

systems to foster communication of changes in the FCM's overall risk profile. 

Bank senior management should require FCM managers to be accountable

for adhering to limits. FCM management should also promptly report

unanticipated changes and progressively deteriorating positions, as well as

other significant issues arising in their positions, to the risk control function

and responsible management. Reports from risk control units to senior

management or the board should never disclose a breach of limits that

business managers have not previously reported.

When establishing the FCM operating subsidiary’s overall limit structure,

bank senior management and the board should consider the interrelationship

between risk assumed by the FCM and risk assumed by other affiliates
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(including the bank). The nature of bank operating subsidiary FCMs is such

that the primary risk exposures at the FCM will be related to credit and

operational issues. Because credit and operational risk are affected by

changes in price risk and liquidity, senior management and the board should

evaluate the probability and impact of market events, counterparty defaults,

or other financial scenarios which might impact the business of the FCM,

directly or indirectly, through a contagion effect.

Evaluation of Risk Versus Return

Fundamental to an analysis of risk-taking is an assessment of return. This

risk/return analysis should reflect the purpose or intent of management when

establishing a FCM operating subsidiary. For each capacity in which a FCM

might function (nonmember, executing member, or clearing member), the

risks are slightly different and the return should be analyzed accordingly.

The return on capital invested in a FCM operating subsidiary is typically

derived from three sources: commissions from trades, commissions from

clearing services (as applicable), and savings realized from executing and

clearing trades for the parent bank and affiliates (as applicable). The

proportion each of these sources contributes to the overall return on bankinvested capital will depend on the strategic and business objectives of the

FCM and the parent bank. 

When orders are accepted, the customer is charged a fee. The fee includes a

transaction processing fee, an exchange fee, the clearinghouse fee, and some

additional increment to compensate the FCM for market access services. A

nonmember FCM passes along the exchange, clearinghouse, and floor broker

fees via payments made to the member FCM used to execute and/or clear the

customer’s requested trade, as appropriate. Alternatively, a FCM which is an

exchange member itself will incur all the risks and associated costs derived

from serving in a trade execution and clearing capacity; in return, it will earn

the full amount of the fee charged to the customer. A FCM that executes

and/or clears trades for the parent bank or affiliate provides a return to capital

by eliminating the fees paid to another FCM for executing and clearing

futures and options on futures transactions. 

Regardless of the revenue-generating strategy, the risk/return analysis should

provide the board and senior management with meaningful information

about levels of risk and adequacy of return. The volume of FCM activities

and dedication of resources to these activities should determine the level of

sophistication needed for the risk/return analyses.

Ideally, management should measure performance against capital, adjusted

for strategic, credit, liquidity, transaction, compliance, and reputation risks

confronting the business. All banks with FCM operating subsidiaries should

have a method for ensuring that adequate capital is in place to support
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potential exposures. The evaluation of capital adequacy should extend

beyond the determination of compliance with regulatory minimum capital

requirements and should consider the amount of capital needed to support

the level and complexity of the FCM’s risk-taking activities. Such evaluations

are useful in assessing performance and ensuring that capital is allocated

efficiently.

Audit Coverage

Audit coverage of FCM activities should focus on internal controls and

systems reliability. Audit coverage should be provided by professionals such

as internal auditors, external auditors, or some combination thereof who have

sufficient independence and expertise. Auditors should be knowledgeable of

the risks inherent in futures and options on futures trading, executing, and

clearing, and the risk management methodologies needed to control these

activities. Audit reports should promptly identify and disclose internal

control weaknesses and systems deficiencies to FCM management and to

bank senior management and the board.

Audit coverage should assess the internal organization of the FCM and

identify any organizational weaknesses. The individuals and units performing

risk control functions should be independent from the units engaged in the

business and trading functions. This separation helps mitigate the risk that

arises when the self-interest of an individual employee conflicts with the

goals of the FCM or of the parent bank.

Auditors also should conduct compliance testing of FCM activities. (This

testing may be performed by the audit team or by the FCM compliance staff). 

The testing process should evaluate the FCM’s compliance with the rules and

regulations governing futures activities, in addition to compliance with bankapproved policies and procedures. Bank management should ensure that the

audit team selected to review the FCM have the appropriate technical

background and expertise to test for compliance with regulatory

requirements, which may vary depending on the nature of the FCM’s

business.

Information Systems

The board should receive information periodically that illustrates exposure

trends, the adequacy of, and compliance with, policies, risk limits, and

risk/return performance. The frequency and composition of this information

should depend upon the nature and significance of the FCM's activities. For

example, a FCM engaging solely in futures transactions for risk management

purposes by the parent bank or affiliates should focus board reports on

clearinghouse risks and risk management effectiveness. On the other hand, a

FCM with aggressive customer solicitation practices should ensure the board

is kept informed of changes in credit administration practices, margin
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controls, and compliance procedures used to reduce the likelihood of

customer litigation. 

Effective management information systems tailor the level of detail to the

intended audience, providing greater detail in reports prepared for line

management than for senior management or the board. Management directly

responsible for risk-taking activities should have reports that provide 

information in sufficient detail to assess risk, return, and the ability to meet

stated objectives.

Affiliates

If a bank establishes a FCM operating subsidiary to broker trades for the bank

and other related entities, it is incumbent upon bank senior management and

the board to establish a control framework to ensure accurate monitoring of

transactions between affiliates and the FCM. The board and senior

management should establish policies and procedures that address FCM

transactions for affiliates. At a minimum, the policy should describe the

nature of acceptable affiliate transactions and require that transactions for

customers take priority over the interests of the FCM and its affiliates. Senior

management should ensure that affiliate transactions comply with such

policy.

Risks Associated with FCMs

For purposes of the OCC’s discussion of risk, examiners assess banking risk

relative to its impact on capital and earnings. From a supervisory perspective,

risk is the potential that events, expected or unanticipated, may have an

adverse impact on the bank’s capital or earnings. The OCC has defined nine

categories of risk for bank supervision purposes. These risks are: Credit,

Interest Rate, Liquidity, Price, Foreign Exchange, Transaction, Compliance,

Strategic, and Reputation. These categories are not mutually exclusive, any

product or service may expose the bank to multiple risks. For analysis and

discussion purposes, however, the OCC identifies and assesses the risks

separately.

The applicable risks associated with domestic FCM activities are: strategic,

reputation, credit, liquidity, transaction and compliance. Generally, bank

operating subsidiary FCMs do not assume price risk because they do not

trade for their own account. Price risk indirectly impacts a FCM’s credit risk

however, and this interconnection is discussed further in the credit risk

section of this introduction under the discussion of “margin.” (If the FCM

engages in proprietary trading, the examiner should refer to the price risk

management guidance contained in the “Risk Management of Financial

Derivatives” booklet of the Comptroller's Handbook.)
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Strategic Risk

Strategic risk is the risk to earnings or capital arising from adverse business

decisions or improper implementation of those decisions. This risk is a

function of the compatibility of an organization’s strategic goals, the business

strategies developed to achieve those goals, the resources deployed against

these goals, and the quality of implementation. The resources needed to

carry out business strategies are both tangible and intangible. They include

communication channels, operating systems, delivery networks, and

managerial capacities and capabilities.

Strategic Risk Management Practices

Strategic risk associated with FCM activities can be controlled if the bank

board carefully analyzes what it hopes to achieve by establishing a FCM

subsidiary and by requiring ongoing communication between FCM

management and senior management and the board of the parent bank. 

Before establishing a FCM subsidiary, senior management of the parent bank

should conduct a cost/benefit analysis to determine how the FCM business

will mesh with the corporate strategies of the parent bank. The board and

senior management should ensure that adequate resources are dedicated to

the FCM for staffing, technical, and operational needs. Once established, the

parent bank should establish an oversight framework, similar to that

discussed above, that allows the bank to maintain ongoing, independent

evaluation of the risks associated with the FCM business.

Reputation Risk

Reputation risk is the risk to earnings or capital arising from negative public

opinion. This affects the institution’s ability to establish new relationships or

services or continue servicing existing relationships. This risk can expose the

institution to litigation, financial loss, or damage to its reputation. Reputation

risk exposure is present throughout the organization and is why banks have

the responsibility to exercise an abundance of caution in dealing with its

customers and community. This risk is present in activities such as asset

management and agency transactions.

A bank with a FCM operating subsidiary should recognize that the culture

fostered by senior management of the FCM will directly impact the amount of

reputation exposure faced by the bank. The bank’s board should ensure that

the management of the FCM possesses the necessary experience in futures

trading, brokerage, and operations activities. FCM activities are unlike most

other areas of banking. FCM management requires specialized skills and

familiarity with the futures industry and with exchanges. Integrating the

management styles and philosophies of the futures industry into the banking

industry can be difficult. Bank management should ensure that policies and
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procedures guiding the activities of FCM management direct and reinforce

actions which are consistent with the risk profile approved by the board. 

While experienced in the technical aspects of the industry, futures industry

management may not be familiar with the risk management philosophies

common to a typical commercial bank. For example, the transaction-oriented

nature of FCM business generally is different from the relationship-oriented

nature of commercial banking. When a commercial bank approves a

customer transaction for a loan or other extension of credit (for example, an

OTC derivative or a letter of credit), the bank considers whether the

proposed transaction can meet the financial needs of the customer, whether

the customer has the financial wherewithal to engage in the transaction, and

whether the customer appears to understand the risks applicable to the

proposed transaction. Because commercial banks devote significant

resources to building banking relationships with customers which extend far

beyond individual transactions, the development and maintenance of

customer relationships may have a different priority for the bank than would

be typical for a FCM. 

The regulated nature of the futures markets makes it likely that FCM

management is experienced in issues of sound trade practices. For example,

the rules of the CEA and CFTC require a FCM employee to receive ethics

training that stresses honest and fair dealing practices which are in the best

interest of the customer. 

Reputation Risk Management Practices

In some areas, a clear separation of the functions between a bank and its

FCM subsidiary is needed to reduce the bank's exposure to losses stemming

from potential customer complaints involving the FCM. This separation is

designed to offset, as much as possible, damage to the bank's reputation. 

While a bank and its FCM have a distinct legal status (by separate

incorporation), the FCM could wrongly be considered part of the bank by the

business community. As a result, it is critical that the FCM employ

competent and appropriately trained personnel and that it complies with

applicable laws, rules, regulations, guidelines, conditions, policies, and

procedures. To protect the bank’s reputation, the FCM should implement

policies and procedures that address the issues of soliciting new customers,

analyzing customer creditworthiness, performing ongoing monitoring of

customer accounts, and handling customer complaints. 

A FCM should also institute procedures to ensure that customer transactions

are authorized and executed in accordance with applicable customer

specifications. For example, when a customer of the FCM places a “limit

order,” the FCM makes a best-effort commitment to bid or offer the

customer’s order at the specified market price or better. The FCM does not

have an obligation to fill the customer order in the case of limit orders. When
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a FCM customer places a “stop order,” however, the FCM has an obligation

to execute this order if market prices reach the pre-specified threshold. In

either case, the FCM should have procedures that describe mechanisms to

track orders according to specific limits or restrictions. Failure to handle

orders in a manner consistent with customer specifications may result in the

FCM expending capital to cover customer opportunity costs. 

Credit Risk

Credit risk is the risk to earnings or capital arising from an obligor's failure to

meet the terms of any contract with the bank or otherwise fail to perform as

agreed. Credit risk is found in all activities where success depends on

counterparty, issuer, or borrower performance. It arises any time bank funds

are extended, committed, invested, or otherwise exposed through actual or

implied contractual agreements, whether reflected on or off the balance

sheet.

The credit risk associated with futures and options on futures differs from that

associated with OTC derivatives because of the different institutional

environments in which the instruments are traded. While OTC instruments

are customized bilateral agreements, futures are standardized, fungible

contracts traded on organized exchanges. In order to trade futures, customers

must trade through intermediaries. 

As noted above, a FCM is an entity that is authorized to receive customers’

orders, take margin, and, if it is a member of an exchange, execute orders on

the floor of the exchange. If it is a clearing member, it may clear the trade as

well. Acting as financial intermediaries, FCMs are exposed to credit risk when

they perform these services. The exchanges have implemented certain

institutional arrangements which reduce counterparty risk through controls

designed to limit the effect of counterparty default. These arrangements

include margin requirements, daily marking-to-market of open positions,

daily price limits, and an organized clearinghouse. 

Margin Requirements

When a futures contract is bought or sold, the position has no value. 

Subsequent price changes affect the value of the position. Increases in value

are profitable for the longs (purchaser of a contract), and unprofitable for the

shorts (seller of a contract). With few exceptions, initial margin is required at

the initiation of a position. Initial margin serves as a good faith deposit to

offset any losses to the intermediary (or the clearinghouse) should the

customer default on the trade. To clarify the concept and role of initial

margin, it is useful to note that this “performance bond” does not involve any

extension of credit, but rather acts as collateral for adverse market movements

and subsequent defaults and losses. 
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Domestically, initial margins are established in relation to historical price

volatility, expected market volatility, and whether the transaction involves

speculative, hedging or spreading (the simultaneous purchase or sale of one

futures contract against the sale or purchase of another futures contract)

activities. For example, some domestic exchanges use the implied volatility

in the futures contract over the previous one, three, and six months, and

absolute dollar price changes, to establish a level of margin that covers

approximately the 95th percentile of absolute daily price changes. 

Different intermediaries set their margin requirements depending on the

function they perform in the marketplace. The futures clearinghouses set

levels of margin which their members are required to maintain for any open

positions. The exchanges set minimum levels of margin which a member

FCM must maintain for positions it carries for itself or for its customers. The

FCMs set levels of margin which they require of their customers. Since the

levels set by any individual FCM must be at least as large as those required by

exchange and/or clearinghouse rules, the ability and willingness to establish

higher margin requirements for customers are one way a FCM can control

credit exposures.

Daily Marking-to-Market

After the posting of initial margin, price movements may cause an open

future or options position to suffer a loss. A decline in the value of a contract

will result in the FCM issuing a margin call to the customer. If the initial

margin falls below the maintenance margin level, the customer will be

required to bring the margin back up to the initial margin level. Should the

customer default on the margin call, the FCM has the remaining margin to

cover the difference between the price at which the contract is currently

trading and its value at the close of the previous day. Because futures

contracts are marked-to-market daily, the margin serves to reduce the risk of

default from any price change. 

Daily Price Limits

Daily price limits are frequently used in domestic nonfinancial futures and

options markets to further reduce the risk of large losses. Price limits control

credit risk because they constrain the amount of price change in certain

contracts on any given day. For example, in crude oil futures trading, daily

price changes are limited to $1.50 per barrel. If the price of crude oil

contracts fell $1.50, the maximum daily loss for one contract (1,000 barrels)

would be $1,500. Similarly, if the price of crude oil contracts increased

$1.50, the maximum daily loss for a trader who was short one contract would

be $1,500.
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The Clearinghouse

One advantage of exchange-traded instruments over customized OTC

instruments is that the clearinghouse is interposed as the counterparty to all

transactions. When a FCM sends a customer’s order to the exchange floor

and that order is executed against the order of another FCM, the

clearinghouse stands between the two FCMs to guarantee the trade. Thus,

the buyer buys from the clearinghouse, and the seller sells to the

clearinghouse. The clearing member substitutes its credit for that of its

customers and, thereby, assumes the full risk of its customers’ defaults up

until the time of delivery on a matured contract. Clearing members make

margin deposits to the clearinghouse and assume full financial and

performance responsibility for every trade presented to the clearinghouse —

regardless of whether the position is carried for a customer’s account, the

account of another exchange member, or for the clearing member’s

proprietary account. 

Clearinghouses mitigate the risk of default through self-insurance programs

designed to cover losses should one or more of their members become

insolvent. Depending on the structure of the clearinghouse, members are

required either to contribute to a guarantee fund, or to purchase stock in a

clearing corporation. In the event of default of one of its members, the

clearinghouse would look first to the margins and other assets of the

defaulting member to satisfy net margin payable to other clearing members. 

If this is insufficient, the clearinghouse would draw on the guarantee fund or

on the capital of the clearing corporation. It is in this sense that the risk is

shared or spread among the clearing members.

Some clearinghouses use a net margin system in which the clearing FCM’s

margin obligation is determined by the net of its long and short positions. 

Other clearing associations use a gross margin system which requires clearing

members to post full margin for each long and each short position. Gross

margin systems provide greater stability to the clearinghouse since the

required margin level is higher than under a net margin system. Net

margining reduces the aggregate margin balance held at the clearinghouse

and may place greater reliance on the guarantee fund.

Credit Risk Management Practices

Clearinghouses manage credit risk by:

C Establishing minimum capital requirements for the clearing members.

C Assuring that clearing members’ post initial and variation margin

promptly.
15

C Monitoring the financial condition of its members. 

C Overseeing members’ positions on a daily basis. 

Clearinghouses also manage their exposure by monitoring members’

accounts on a daily basis, by conducting exchange audits, and by performing

other compliance functions. 

FCMs rely on margin requirements and credit administration practices to

protect themselves from credit losses. With respect to margin, a FCM should

have policies that direct the timely liquidation or close out of under-margined

positions. Credit administration practices should be guided by policies that

address customer selection, account documentation, and the determination of

creditworthiness. FCMs can use the customer selection process to reduce the

likelihood of loss from customer default. For example, they may agree to

deal only with those bank customers assigned the highest internal credit

ratings. 

Proper documentation of customer authority is also critical for controlling

credit risk exposures. The FCM should ensure that sufficient authorization

has been obtained from the customer prior to execution of futures or options

transactions and that transactions are consistent with any restrictions or

limitations included in such authorization.

Initial determination of creditworthiness and ongoing credit evaluations are

also tools available to the FCM to control credit risk exposures. Credit limits

should take into consideration other exposures arising at the parent bank or

affiliates and any correlation risks which might arise if the customer transacts

futures and options on multiple exchanges. The FCM may rely on the bank’s

ongoing credit evaluation process to ensure that customers have the financial

capacity and liquidity to meet margin requirements both in normal market

conditions and during periods of unusual or stressed market conditions.

Although the FCM does not need to duplicate bank credit files, it should

retain sufficient information to support the determination of creditworthiness.

If the FCM is a clearing member, it may elect to provide clearing services to

other FCMs. The account of the non-clearing FCM can either be fully

disclosed (in which case the clearing FCM knows the actual customer’s

identity, position, and margin status) or omnibus (in which case such

customer information is not disclosed to the clearing FCM). If a FCM elects

to accept omnibus accounts, it should have appropriate procedures in place

to ensure that the originating FCM selects creditworthy customers and

collects margin according to exchange rules. 

Some customers may need or wish to execute through other brokers, known

as “give-up brokers.” Common reasons for executing through several brokers

are to disguise the size of a position or hide the identity of the principal to the
16

transaction. This practice, however, may expose a clearing FCM to risks that

are difficult to control. For example, if the customer chooses to execute

through other brokers, the clearing FCM may not have the opportunity to

reject trades prior to presentation for clearing. If the FCM both executes and

clears transactions, however, it would be in a position to evaluate

transactions relative to customer account limits. For example, if the customer

placed unusual orders or if a series of transactions appeared to pose undue

risk, the FCM could question the purpose of such transactions. If necessary,

the FCM could refuse to accept the customer's order. For these reasons,

some FCMs may prohibit "clearing only" accounts. If the FCM chooses to

clear trades executed by others, it may wish to place higher credit

qualifications on the customer. Restricting the volume and type of "clearing

only" trades, requesting prior notice of "clearing only" trades, or otherwise

reducing the exposure to trades that the FCM is unaware of prior to

presentation for clearing are other ways in which a FCM can control credit

risk.

When considering whether or not to apply for clearing membership, a FCM

must assess an exchange and its clearinghouse. Among the factors the FCM

should consider are the number, and financial strength, of the clearing

members, the type of guarantee provided to clearing members, the degree of

protection afforded by margins (gross versus net), the frequency and cause of

member defaults in the past, the quality of supervision over executing and

clearing members, and the reliability of accounting statements for the

clearinghouse and its members.

Examiners need to recognize that the guarantees between the clearinghouse

and its members do not extend to customers. To protect customers from the

risk of loss resulting from the failure or default of a FCM, exchanges have

adopted customer protection rules. Exchanges require strict segregation of

customer funds from FCM funds. This rule will not help customers if their

margin must be used to cover the default of another customer of the same

FCM, however. For example, in 1985, Volume Investors (a FCM and clearing

member of the Commodity Exchange, Inc.) defaulted because of the failure of

a large customer (the customer could not meet a margin call after a significant

change in the price of gold futures). The clearinghouse only guaranteed the

trades between Volume and other clearing members. The margin of some

non-defaulting Volume customers was used by the clearinghouse to meet the

financial requirements of this guarantee. 

A FCM is exposed to this risk if it elects not to be a clearing member of an

exchange, but instead decides to utilize the services of a clearing member. 

The FCM is then “just another customer,” with its margin at the clearing FCM

subject to possible use for covering losses resulting from the default of

another customer of the clearing FCM.

Furthermore, examiners should understand that exchange minimum margins
17

and daily price limits do not eliminate credit risk. Intra-day price movements

may occur so rapidly that the FCM cannot call and receive sufficient variation

margin. Additionally, successive daily price moves may eventually cause

losses so extensive that a customer is unable to meet obligations and,

consequently, defaults. FCMs must take additional controls to reduce these

risks. A first step is the careful selection of customers who understand the

risks of futures and options on futures trading and have the financial strength

to fulfill their contracts. Secondly, FCMs should establish customer credit

limits that are appropriate for the account. Bank subsidiary FCMs commonly

restrict their customer base to large corporations, other financial institutions,

and fund managers. If the FCM accepts customer accounts from entities that

are not existing bank customers, the FCM and/or its parent bank should

develop well-defined credit standards. The customer selection criteria should

specify whether the FCM would accept accounts from corporate clients,

hedge funds, trusts, or individuals.

Liquidity Risk

Liquidity risk is the risk to earnings or capital arising from a bank’s inability to

meet its obligations when they come due without incurring unacceptable

losses. Liquidity risk includes the inability to manage unplanned decreases or

changes in funding sources. Liquidity risk also arises from the bank’s failure

to recognize or address changes in market conditions that affect the ability to

liquidate assets quickly and with minimal loss in value.

Cash Flow Liquidity

Cash flow liquidity involves the ability to fund the operating needs of the

FCM at a reasonable cost. As noted previously, a primary source and use of

funds for a FCM is the receipt and payment of margin. As FCM customers

place futures orders, they are required to provide a margin to the FCM which

becomes a source of cash flow. As the FCM places the order at the

exchange, however, the clearinghouse will require margin of the FCM, which

then becomes a use of cash flow for the FCM. 

The timing of clearinghouse cash flow requirements is not under the control

of the FCM because exchanges mark-to-market daily and require that margins

be maintained on a daily basis. Since FCMs have a clear obligation to collect

margin from their customers, however, the FCM has some flexibility with

respect to the timing of such cash flows. Subject to CFTC and exchange

grace period restrictions and capital requirements, a FCM may deviate from

the practice of domestic exchanges that require daily mark-to-market and

margin calls. Cash flow may become a liquidity issue, however, if a FCM

customer fails to meet a margin call, requiring the FCM to fund the

customer’s position until margin can be made or the position closed out.

 
18

Product Liquidity

Product liquidity involves the ability to trade an asset quickly at a price that is

fair and reasonable in light of underlying demand and supply conditions. In

other words, trading at fair prices. 

When an exchange proposes to trade a futures contract, it must first submit it

to the CFTC for review. One important criterion that enters into the review is

the potential demand for the product. The concern is that if the demand is

not sufficient, the market will not be liquid. When a contract fails to attract

sufficient trading interest, it is said to “fail.” Liquidity requires a significant

number of market participants who see economic use in the contract. In an

illiquid market, it may take time to unwind a position, or the trader may only

be able to do so at a high cost. Additionally, in an illiquid market, the market

price may be hard to determine. 

Liquidity risk is generally lower in the futures markets than it is in the OTC

derivatives market where a market and a market price for an exotic

instrument may not exist. In periods of market stress, however, all markets

may be illiquid. On October 19, 1987, for example, enormous sell pressure

in the futures, cash, and securities markets took place. One of the reasons for

the steep market drop was that there were no buyers. If one side of the

market is absent, no market exists — or it is essentially illiquid. 

Liquidity Risk Management

Cash flow liquidity is a primary risk to FCM operations and can best be

managed through the implementation of procedures that are designed to

minimize unexpected mismatched payments and settlements. Additionally,

concentration limits that reduce the reliance on any individual or related

entities also serves to control the FCM’s exposure to liquidity risk. 

One way to limit liquidity risk is through a customer margin collection

practice which parallels the daily mark-to-market practice of the

clearinghouse. If customer margins are collected on a daily basis, it is

unlikely that the FCM will find itself in a position where it has advanced

margin to the clearinghouse before collecting margin from a customer. A

FCM that does not adopt margin collection practices which parallel those of

the exchange should be prepared to demonstrate, to examiners, controls

addressing this potential cash flow liquidity exposure.

Concentration limits may also be used to control the vulnerability of FCMs to

cash flow imbalances. If the composition of the FCM customer base is such

that an interruption in the cash flow of any individual customer is

insignificant relative to the total cash flows of the FCM, liquidity risk should

be reduced. Furthermore, if the futures contracts acquired for FCM customers 
19

are well diversified, it is less likely that a market event will affect the cash

flow abilities of each of the customers in the same manner.

Finally, product liquidity can be controlled with policies and procedures that

specify approved contract types and tenors. Such policies should consider

factors such as contract “open interest” (the total number of futures contracts

that have not been eliminated by either an offsetting trade or by delivery) and

the market “depth” (the number of market participants buying and selling

contracts).

Transaction Risk

Transaction risk is the risk to earnings or capital arising from problems with

service or product delivery. This risk is a function of internal controls,

information systems, employee integrity, and operating processes. 

Transaction risk exists in all products and services.

An important aspect of FCM activities involves the executing and clearing of

trades. Whether the FCM performs these functions for its own account, the

account of affiliates, or for customers, the FCM must process transactions

accurately and quickly, at a reasonable cost. 

Transaction Flow

When a customer decides to enter an order, the customer calls either a FCM

or an introducing broker to take the order. Since an introducing broker will

merely transmit the order to a FCM for handling, this discussion will focus on

the activity of FCMs. The person who takes the order generally will be an

associated person or merely an order entry clerk. (In certain cases, the FCM

may allow the customer to call directly to the floor trader.) The order will be

time-stamped and have the customer’s name and account number attached. 

Unless called to the floor trader directly, the order will then be phoned or

otherwise transmitted to the FCM’s office on the trading floor. Runners then

communicate the order to a floor broker in the pit who is employed by the

FCM. Often this “communication” of the order takes place by hand signals. 

The broker will loudly bid or offer the order to the pit (or accept the bid or

offer of another trader). 

Once the order is filled, the broker records the price, number of contracts,

time bracket (the trading day is divided into half-hour time brackets), and

opposite broker on a trading card. The broker subsequently signals to the

runner that the order is filled, and the runner goes back to the FCM’s booth,

where confirmation is sent to the customer. The whole process may take less

than one minute as the pits are active, especially in the near contract month. 

(The exchange has separately made a record of the price and time of trade as

recorded by the price reporter stationed on the trading floor.) Finally, the
20

FCM and clearinghouse use the trade cards to reconcile trades and retain an

audit trail of transactions. 

Transaction Risk Management Practices

A bank FCM should have comprehensive written policies, procedures, and

systems covering transaction risk. Policies and procedures should cover the

receipt of orders, the execution of orders, trade capture, pay/receive,

safekeeping of cash and margin collateral, accounting practices, and the

reconcilement process.

Since the quality of operational support depends on the quality of staff, the

FCM should address the need to attract and develop capable employees. 

Compensation plans should be designed to retain experienced, competent

operations staff.

CFTC and exchange regulations are designed to promote sound operational

practices. For example, CFTC regulations require FCMs to execute trades for

customers in a fair and equitable manner. Procedures should ensure that

customer order transactions are transmitted and executed fairly, generally in

the order received. When executing orders for the FCM's own account or for

the account of affiliated entities, procedures should ensure that customer

orders for the same contract, executable at or near market prices, are given

priority. As such, prompt trade order entry, recording, and tracking are

necessary to ensure customer orders executable at or near market prices are

transmitted and executed prior to orders for the same contract for the FCM's

own account or the account of affiliated entities. For example, regulations

require that orders must be time-stamped when received, when transmitted

for execution, and when reported out as executed. Controls such as

prenumbered tickets or automated tracking systems help to ensure that

incoming trade orders are recorded and tracked. 

Accounting controls, required by the CFTC and exchange regulations, help to

ensure that the FCM keeps current ledgers or accounts showing each transaction

affecting assets, liabilities, income, expense, and capital of the firm. For

example, where accounts or balances are due to or from other entities

(safekeeping agents, payment agents, clearinghouse balances, etc.), the FCM

should have accounting procedures that require prompt reconcilements and

reports to management of any exceptions. If the FCM executes orders for

customers, accounting controls must require prompt recording of orders in

customer ledgers and transaction journals and recording of all customer funds or

property received from customers. Controls over customer property must

ensure proper segregation, identify the location of assets, revalue assets at fair

market value, and provide for reconcilements. If the FCM invests customer

funds, accounting records must show the amount, type, date of receipt, and

earnings on such funds, and such investments must be limited to the types of

investments permitted under the CEA and CFTC rules.
21

Operational controls also should ensure that each transaction is promptly

confirmed with the floor broker or trader on the other side of the transaction. 

Records should include a log of orders received, filled, unfilled, or canceled. 

Unmatched trades should be promptly investigated. Transactions for

customers, including orders for affiliates or associated persons, should be

promptly confirmed in writing. Control systems require separation of the

following duties: account acceptance, order receipt, execution, confirmation

preparation and comparison, margin receipt/delivery, and accounting entries.

Additionally, the FCM should have operational procedures to ensure that

trades are fairly allocated when orders are bundled. Under CFTC rules, each

order sent to the exchange for execution is required to be linked to a

particular account. To accommodate FCMs and CTAs who manage multiple

accounts with similar investment goals, an exception to the rule was given for

managed accounts. Orders can be “bundled” or grouped together. Once the

total bundle is filled in a sequence of transactions, the fills are allocated to

individual accounts. The assignment uses one of two methods: a

predetermined allocation scheme, or the determination of a volume-weighted

average price. The accounts in the bundle have to be specified before the

orders are sent to the exchange, and the allocation scheme must remain on

file with the member FCM.

Sound controls also include systems to track errors and discrepancies. 

Customer complaints should be thoroughly investigated by persons

independent of those who received and executed the order. The FCM should

have systems to track disputes with customers, other brokers, as well as

exchanges and clearinghouses. The resolution of such disputes should be

summarized and reported to management.

Compliance Risk

Compliance risk is the risk to earnings or capital arising from violations of, or

non-conformance with, laws, rules, regulations, prescribed practices, or

ethical standards. Compliance risk also arises in situations where the laws or

rules governing certain bank products or activities of the bank’s clients may

be ambiguous or untested. This risk exposes the institution to fines, civil

money penalties, payment of damages, and the voiding of contracts. 

Compliance risk can lead to a diminished reputation, reduced franchise

value, limited business opportunities, lessened expansion potential, and lack

of contract enforceability.

National banks engaged in FCM activities through operating subsidiaries may

be subject to increased compliance risk because of the bank's obligation to

ensure compliance with laws and regulations issued by the OCC and the

CFTC, in addition to rules of the NFA and the futures exchanges. The failure
22

of a FCM to comply with applicable laws and regulations could result in

enforcement action by one or more of these regulatory bodies. 

Noncompliance with applicable laws could also result in customer litigation

with the FCM or the bank.

Domestic FCMs must comply with the CEA and regulations issued by the

CFTC. The CFTC has delegated registration authority to the NFA, a selfregulatory organization which all domestic FCMs must join. Exchange

member FCMs are also subject to any examination and reporting

requirements imposed by the rules of a particular exchange and annual

examinations by the NFA or a relevant futures exchange.

Some trade practice rules are meant to reduce the possibility of customer

fraud. These include prohibitions on trades that are not clearly linked with

an order (or a pre-specified bundled order), prohibitions on dual trading

(unless some strict audit trail standards can be met by an exchange), and

record-keeping rules (which are addressed below). During the open outcry,

traders in the pits are actively bidding or offering orders which they hold. 

Where dual trading is allowed, these orders can be either for customers or for

the floor broker’s proprietary account. A prohibition of dual trading means

that members trading for their own accounts cannot also bid and offer

customers’ orders on the same day. 

Price manipulation is yet another issue addressed by trade practice rules. 

Under the CEA, price discovery is explicitly recognized as an important

function of the futures markets. Therefore, any change in the auction rules is

assessed relative to its impact on the accuracy of price discovery and the

possibility for price manipulation.

Compliance Risk Management Practices

To ensure compliance with OCC guidance and other rules and regulations,

the FCM should have a well-defined compliance program. FCMs should

adopt sound policies and procedures including compliance manuals or other

written documentation governing compliance matters. Procedures should

also be adopted to ensure that manuals are updated periodically.

At a minimum, the FCM should have a designated compliance officer who is

responsible for compliance with customer protection rules. Similar to the

audit function, compliance officers should report independently of FCM

management and demonstrate the necessary expertise to ensure compliance

with rules and regulations governing FCM activities. Within the compliance

function, management should designate an individual to handle customer

complaints and inquiries. Management should set standards for disclosure of

risks to customers that fully comply with exchange rules and adequately

protect the FCM from charges of unfair treatment. In particular, the 
23

compliance system should ensure that the firm has a mechanism to assure

that employees are familiar with applicable CFTC regulations and exchange

rules. 

Specifically, compliance should ensure that:

C Each customer account is reviewed on a periodic basis.

C Customer complaints are tracked and responded to. 

C Customers receive required risk disclosure statements. 

C All transactions and payments occurring in customer accounts are

appropriate and authorized by the customer. 

 Finally, employees should receive ethics training that stresses honest, fair

dealing practices which are in the best interest of the customer. 

To further reduce compliance risk, bank management should ensure that

bank subsidiary FCM activities are conducted in accordance with any

conditions imposed by the OCC in its approval letter and in conformity with

relevant OCC guidelines. At a minimum, this includes procedural controls,

position or limits, and accounting methods consistent with those discussed in

OCC Banking Circular 277, with appropriate tests to evaluate them on an

ongoing basis.

A FCM should maintain capital sufficient to support customer and affiliate

commitments, in addition to its own. The CFTC has established minimum

financial requirements for FCMs, which require maintenance of adjusted net

capital at certain identified levels. Exchanges may also impose minimum

capitalization requirements. (The rules and regulations governing activity on

foreign exchanges may differ substantially from domestic exchange rules. 

Management should be aware of these different rules and understand their

impact on its ability to control risk.)
24

Futures Commission

Merchant Activities Examination Objectives

1. To evaluate the adequacy of board and senior management oversight of

FCM activities.

2. To identify the levels of strategic, reputation, credit, liquidity,

transaction, and compliance risk.

3. As applicable, to identify the level of price risk arising from proprietary

trading activities. (Refer to the booklet entitled “Risk Management of

Financial Derivatives” of the Comptroller's Handbook).

4. To communicate findings to the board and management and, as

applicable, to obtain necessary commitments.

5. To ensure the supervisory strategy is appropriate.
25

Futures Commission 

Merchant Activities Examination Procedures

Examination Planning

 

1. Based upon the OCC supervisory strategy approved for the bank,

establish the scope of the FCM examination and determine necessary

resources.

2. Obtain the following: 

Q Bank documents. (See appendix entitled “Sample FCM Request

Letter.”)

Q OCC documents:

— OCC approvals.

— FCM filings.

— Previous examination reports.

— Overall summary comments.

— Workpapers from previous examinations.

3. Using the information obtained in procedures 1-2:

C Assess the nature of the FCM’s activities. Determine whether the

FCM functions as a:

— Non-member FCM (executes and clears through other FCMs).

— Non-clearing exchange member FCM (executes transactions

but is not a clearinghouse member).

— Clearing member (executes transactions and is a

clearinghouse member).

C Assess the nature of the FCM’s customer base. Determine whether

the FCM generally:

— Takes orders, executes and/or clears for bank customers only.

— Takes orders, executes and/or clears for customers with no

banking relationship.

— Takes orders, executes and/or clears for affiliates.

— Takes orders, executes and/or clears for its own proprietary

account(s).
26

C Identify significant changes since the previous examination with

respect to:

— Management.

— Products and activities.

— Customer base.

— Exchange membership.

— Risk measurement.

— Back office operations and systems.

— Policies and procedures.

— Staffing.

— Audit. 

4. Prioritize issues for follow-up during the examination. Identify key

weaknesses noted by audit, compliance, risk control, or previous

examination reports concerning:

C Oversight.

C Risk measurement.

C Risk control.

C Risk limits.

C Earnings and capital.

C Compliance.

C Operations and internal controls.

5. Where applicable, adjust the scope of the examination to build upon the

supervisory work performed by other regulatory bodies. Document

which OCC procedures have not been performed because another

futures or options supervisory authority recently performed similar work. 

Board and Senior Management Oversight

6. Determine whether significant policies directing the activities of FCM

management are approved by the parent bank’s board. Determine

whether FCM policies and procedures promote consistency with the

parent bank’s stated risk appetite. At a minimum, determine whether

such policies and procedures address:

C Approved products.

C Authorized activities.

C Sales, marketing, and advertising.

C Training.

C Transactions with affiliates.

C New product or activity approval.

C Risk measurement methodologies.
27

C Risk limits (credit, liquidity, transaction, etc.).

C Limit exception approval.

C Validation of risk measurement tools.

C Stress testing of positions.

C Internal controls.

C Compliance and risk control.

7. Review the risk control function and staffing. Determine whether it:

C Reports independently of individuals directly responsible for

executing trades.

C Is adequately staffed with qualified individuals.

C Is fully supported by the board and senior management and has

sufficient stature within the organization to be effective.

C Has been provided with the technical and financial resources,

corporate visibility, and authority to ensure effective oversight.

8. Assess the quality and stability of earnings. Consider:

C Primary revenue sources.

C Significant expenses.

C Reimbursements or settlements made to customer accounts.

C Fines or assessments by exchanges.

C Unusual or extraordinary items.

C Board approved risk/return objectives.

C Existing and proposed levels of risk (credit, liquidity, operations,

etc.).

9. Assess the quality of capital management. Consider:

C Compliance with net capital requirements (exchange rules).

C Activities/condition of affiliates.

C Board stated objectives.

C Adequacy of risk control, compliance and audit functions.

C Concentrations.

C Lines of credit (drawn upon and unused).

C Debt/equity ratio.

10. Evaluate the quality of key personnel. Determine whether management

is technically qualified and capable of properly engaging in the activity

transacted by the FCM. Consider:

C Management and staff education/experience.

C Personnel turnover.

C Job descriptions.

C Adequacy of existing and projected support staff, considering

projected volumes and types of transactions.
28

C Workload for operations personnel, considering use of overtime and

level of transaction processing or reconciling errors.

11. Review management information systems (MIS) used to report to board

members of the FCM and parent bank. Determine whether:

C Systems support timely reporting of risk and return information.

C Information reported to senior management and the board is

accurate.

C Management has taken raw risk measurement data and successfully

transformed it into reports to the board that convey meaningful

information about risk.

12. Determine whether the FCM has contingency plans that describe actions

to be taken in times of market disruptions. Determine whether such

plans address, at a minimum:

C Management responsibilities.

C Cash flow liquidity.

C The deterioration of customer credit quality.

13. Evaluate transactions with affiliates and confirm that such transactions

are conducted consistent with board-approved policies.

14. Review the audit scope for frequency and completeness. Determine

whether the audit function includes the following checks:

C Periodic review of FCM policies, limits, internal controls, and

procedures.

C Testing of operations functions including:

— Transaction and confirmation controls.

— Verification of balances held with clearinghouses, settlement

agents, etc.

— Verification of segregated funds held for customers.

— Review of receipt and payment controls.

— Accuracy of management reporting.

C Review of brokerage costs and commissions, testing for accuracy.

C Independent verification of the accuracy of pricing models and risk

measurement methodologies.

C Evaluation of internal controls and segregation of duties.

15. Determine the adequacy and qualifications of the audit staff size. 

Consider:
29

C Product complexity.

C Technical skills.

C Systems resources.

16. Assess the effectiveness of the audit process in ensuring internal controls

are maintained and systems remain reliable. Consider:

C Material criticisms or deficiencies.

C Timely implementation of corrective actions.

C Meaningful reporting to FCM senior management and the bank’s

board.

17. Determine whether the bank's board adequately holds management

accountable for performance. Consider:

C The consistency of performance against strategic and financial

objectives over time.

C Internal and external audit results. 

C The level of compliance with policies, procedures, and limits.

C The quality and timeliness of communication to the board.

Strategic Risk

18. Evaluate the strategic and tactical business plans for the FCM. Consider:

C The reasonableness of assumptions.

C Any inconsistencies with board stated plans and risk tolerances.

C The ability of existing resources to support planned expansion of

activities.

C Any potential changes in risk profile that may result from the

implementation and/or achievement of planned strategies.

Reputation Risk

19. Review compensation plans, especially incentive compensation

plans. Ensure that such plans:

C Are designed to attract and retain appropriate talent.

C Do not encourage employees to take unacceptable levels of financial

risk (credit, price, liquidity).

C Are consistent with the long-term strategic goals of the parent bank.

C Do not encourage sales or transaction processing practices that

might damage the reputation of the FCM or parent bank.

20. Determine that the FCM has procedures that address handling customer

orders with specific restrictions (e.g., limits orders, stop orders, etc.).
30

21. Evaluate the potential loss posed by outstanding customer complaints,

regulatory investigations, and pending litigation.

22. Determine whether sales and marketing practices are consistent with

risk/return objectives set forth by the board. Consider:

C Targeted customers.

C Products/services promoted.

C Training provided to sales and operations personnel.

Credit Risk

23. Review the organization structure to determine whether there is proper

segregation between the credit function and marketing, execution, and

margin payment/receipt functions.

 

24. Evaluate whether credit risk staff demonstrates knowledge of the

products brokered by the FCM and possess an understanding of current

and potential credit exposures.

25. Evaluate the adequacy of credit risk management policies and

procedures. Determine whether the credit policies:

C Establish limits for credit risk (credit quality, concentrations, tenors,

etc.)

C Require periodic credit reviews, risk ratings, credit exposure

reporting, and limit exception notification.

C Define the method used to calculate credit risk exposure and require

periodic validation of the method.

C Establish a process for limit exception approval and reporting.

26. Determine the adequacy of margin policies approved by the FCM. 

Consider:

C The adequacy and compliance with exchange rules of initial margin

requirements.

C The amount and frequency of maintenance margin calls.

C Types of acceptable margin.

C Net versus gross margins.

C Affiliate accounts.

C Customer accounts with significant margins.

27. Verify that the FCM performs a review of the credit and operating risk of

each exchange and clearing organization before it seeks membership

therein.
31

28. Discuss with management the credit standards employed by the FCM in

its customer selection process. Determine whether the standards

address, at a minimum, a determination of a customer’s:

C Financial strength and liquidity.

C Risk management objectives (speculating versus hedging, income

stabilization versus capital preservation, etc.).

C Knowledge and ability to understand the risks of sophisticated 

transactions.

29. If the FCM provides investment advisory services, determine whether the

FCM obtains customer information as needed or as would reasonably be

expected to be relevant to enable the FCM to evaluate the

appropriateness of its advice to the customer.

30. If the FCM clears omnibus accounts, determine whether the FCM has

credit standards that require the originating FCM to maintain sufficient

liquidity and capital. (Sufficient liquidity and capital should protect the

clearing FCM from a failure of the originating FCM which was caused by

the default of one or more of the customers included in the omnibus

account.)

31. If the FCM permits customers to use give-up brokers, determine whether 

the FCM has alternative controls to compensate for the inability of the

FCM to review orders before execution.

32. If the FCM clears its trades through another FCM, determine whether the

bank subsidiary FCM has established credit standards for approval of

clearing FCMs. (These standards should protect the bank subsidiary

FCM from losses arising from the use of its margin held by the clearing

FCM to cover defaults by other customers of the clearing FCM.)

33. Determine whether the FCM sets credit limits for each customer and, at

a minimum, whether the limits address:

C The financial capacity (liquidity and net worth) of the customer.

C Initial and maintenance margin levels.

C Type of margin accepted.

C Type, volume, and tenor of instruments executed or cleared.

34. Determine whether FCM credit policies address credit limit allocation

(suballocation) and credit exposure aggregation for customers who

execute trades on different exchanges or within different jurisdictions. 

Determine whether policies address:

C The legal risks associated with executing transactions governed by

foreign law.
32

C The potential lack of transparency.

C The correlation, or lack thereof, of market movements among

various exchanges or jurisdictions.

35. Determine how FCM account officers verify credit exposure when

orders are received. Consider issues such as:

C Whether line approvals have product and tenor restrictions.

C How transactions are approved for customers lacking a pre-approved

line.

C How credit exceptions are approved.

36. Review the credit risk measurement method used to estimate credit

exposure to determine whether it adequately assesses current and

potential credit exposure. Assess whether:

C The system recalculates variation margin as frequently as necessary

to control risk. 

C The system is designed to protect the FCM from credit losses

resulting from price moves so rapid that the FCM cannot obtain

additional margin in a timely manner.

C The frequency and process of collateral valuation is adequate.

C The model has been reviewed and validated by an independent

party.

C Credit exposure calculations are performed or verified by an

independent person or unit.

C Credit exposure reports are updated and changed on the system on a

timely basis.

37. If the FCM permits corporate customers to phone orders directly to the

trading floor, determine whether the FCM has alternative controls to

monitor risk such as conducting frequent transaction reviews or

maintaining higher credit standards for such customers.

38. Verify that the FCM maintains credit reserves to cover expected losses.

 

39. Determine how FCM management identifies, monitors, and resolves

accounts experiencing credit deterioration.

40. Draw a sample of customers. Review credit files for: 

C Evidence that the FCM made all required disclosures.

C Instances of additional disclosures provided to give customers

comprehensive and timely information for making informed

decisions.

C Documentation that supports an adequate assessment of the 

appropriateness of the decision.
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C Accurate and timely risk ratings.

C Reasonable customer limits.

41. Ascertain whether credit practices require:

C Independent monitoring of aggregate credit exposure for each

customer (including all credit exposure arising in other business

lines) and comparison with limits.

C An annual appropriateness review of account positions and

transactions to ensure activity is consistent with account objectives.

C Procedures to monitor:

— Cumulative losses.

— Daily trading volume relative to the balance of collateral in

the account.

— Naked short options.

— Pre-screening orders from customers if necessary due to the

style or trading or the creditworthiness of the customer.

42. Review reports received by senior management pertaining to credit risk. 

Determine whether the reports are:

C Provided to the appropriate levels of management and the board.

C Cover these issues in a comprehensive manner:

— Portfolio credit quality information.

— Concentrations.

— Significant exposures.

— Trend information (credit quality, tenor, etc.).

— Normal market conditions versus stressed market conditions.

C Accurate in terms of data integrity and address the impact of risk

measurement assumptions or data aggregations.

 

Liquidity Risk

43. Evaluate the adequacy of liquidity risk policies and procedures. 

Determine whether the policies:

C Establish liquidity limits (e.g., products, tenors, concentrations,

activities, cash flow mismatches, open interest).

C Require periodic reviews of liquidity risk exposures.

C Require periodic cash flow analyses.

C Establish processes for limit exception approvals and reporting.

C Establish guidelines for parent bank and affiliate transactions.
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44. Determine whether limits and reported exposures are derived

consistently.

45. Determine the effectiveness of controls and the monitoring of risk limits. 

Liquidity controls should include:

C The preparation and distribution of reliable liquidity reports

containing accurate information.

C Timely notification of actual or probable limit exceptions.

C Prompt approval of all limit exceptions.

C Monitoring and tracking of limit breaks and exception approvals.

 

46. Evaluate trends in cash flow liquidity over time. Consider management’s

ability to manage the inflow of margin received from customers as

compared to the outflow of margin requirements to a clearing FCM or

clearinghouse association. Focus evaluation on mismatched payments

and settlements, and concentrations (e.g., customer, contract, exchange)

and periods of market volatility.

Transaction Risk

47. If not included in information received from the request letter, gather the

following items:

C Flow charts of processing and reporting flows.

C Systems policies and procedures.

C Operations exceptions reports such as out-trades, uncollected

fees/commissions, outstanding items, suspense items, miscellaneous

losses, aging of margin calls.

C Position reconcilements (customer aggregate-to-firm totals,

clearinghouse totals).

C Brokerage statements showing commissions, fees, give-ups, etc.

C Disaster recovery plan.

48. Determine whether management has established comprehensive

policies and procedures that set forth appropriate internal controls

including:

C Segregation of duties.

C Trade entry and transaction documentation.

C Confirmation.

C Margin calculation.

C Account statement.

C Accounting treatment.

C Management reporting.
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49. Review the trade entry and processing environment to make sure the

FCM has systems that:

C Limit access to trading systems.

C Ensure that all trades are promptly captured through the use of:

— Pre-numbered tickets or sequential numbering systems.

— Recorded telephone conversations.

— Chronological records of telex/SWIFT messages.

— Chronological records of margin calls.

C Ensure that sufficient transactional documentation supports limit

reporting and a proper audit trail by determining that records of the

original entry capture sufficient contract details, including:

— Date and time the order was received (to the nearest minute).

— Date and time the order was executed (to the nearest minute).

— Name of the party executing the transaction.

— Name of the party entering the transaction data.

— Type of instrument, its price, and the amount.

— Settlement or effective date.

— Payment or settlement instructions.

— Brokers' fees or commissions and other expenses.

C Reduce the likelihood of errors by reconciling individual positions to

aggregate positions daily:

— Front office to back office.

— Aggregate position by instrument.

— Customer and affiliate account records.

— Aggregate account positions to clearinghouse records.

C Safeguard assets by establishing controls over the movement of cash,

collateral, or other assets.

C Facilitate the tracking and correction of errors through the use of

management information systems that monitor errors by the:

— Party accepting the trade.

— Party executing the trade.

— Party entering the trade.

— Settlement agent.

50. Determine whether the confirmation process requires that:

C Outgoing confirmations contain all relevant contract details.

C Outgoing confirmations are initiated no later than one business day

after the transaction date, upon expiry or option exercise.
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C The method of confirmation used provides a documentation trail —

such as recorded telephone lines, paper confirmation, or

telex/SWIFT messages — that supports the FCM's position in the

event of disputes.

C Incoming confirmations are handled by persons independent of the

employees who execute trades.

C All discrepancies requiring corrective action are promptly identified

and acted upon.

C All discrepancies are tracked, aged, and reported to management

and trends by type are identified and addressed.

51. Review margin calculations to assure the FCM records comply with

exchange rules. If the FCM acts as clearing member, check that daily

margin calculations agree with clearinghouse records.

52. Review reconcilements of deposits with clearing organizations and the

valuation of assets on deposit.

53. Determine that the FCM has procedures to monitor, analyze, and resolve

out-trades.

54. Obtain a list of suspense items due from/to customers. Investigate stale

items and trends in these accounts.

55. Verify that the FCM has the following controls and procedures with

respect to customer funds:

C Assets placed on deposit with banks, trust companies, clearing

organizations, and other FCMs are:

— Carried in accounts clearly identified as funds segregated for

customers and, 

— The FCM has received an acknowledgment to that effect from

each such depository.

C Total funds on deposit are reconciled on a daily basis.

C A daily calculation of total funds required by rule or regulation to be

on deposit is performed.

C Customer statements are prepared listing:

— Contracts with current price. 

— Unrealized profit and loss on open contracts.

— The amount of any customers funds held.

— A listing of transactions.

— A detailed accounting of all charges and credits.

56. Determine that the FCM has procedures that ensure that customer funds

are invested only as permitted by account authorization, law, rule, or
37

regulation.

57. Select a sample of customer account statements (including accounts with

large positions, zero balances, and high volume). Trace positions, cash

and margin to FCM account records to confirm that:

C Customer purchase/sale transactions are recorded accurately.

C Customer funds are properly segregated.

C Information concerning customer funds are properly disclosed.

58. Review exchange trade registers and confirmations from clearing brokers

to account for trades executed.

59. Review the revaluation of securities posted as margin. Determine that

key pricing parameters are obtained from, or verified by, a source

independent of the traders and are representative of the market.

60. Obtain a flow chart of reporting and systems flows and identify

important risk points:

C Review the policies and procedures governing MIS.

C Determine the adequacy of segregation of duties.

61. Review the personal computer policy for the institution, including

controls over spreadsheet applications. Ensure that: 

C Brokers cannot make changes to key spreadsheets for valuation or

risk management purposes.

C Data and applications are protected.

62. Review current systems capabilities and planned upgrades or

enhancements. Ensure that:

C Front office risk management requirements are properly considered.

C Systems planning and implementation schedules are consistent with

transaction growth and the current and planned level of business

activity.

C Security controls prevent unauthorized access to systems

information.

C Contingency planning is acceptable.

63. Review functional applications of MIS such as credit administration,

trade settlement, accounting, and risk control. Determine whether:

C The information is timely.

C The format supports management of risk.

C The information is accurate.
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64. For reports to senior management, determine that they:

C Permit the FCM to track errors and miscellaneous losses in sufficient

detail to identify the source of errors.

C Are prepared by individuals independent of traders. 

C Reflect the current status and trends for the following items:

— Aging of documentation exceptions.

— Position reconcilements.

— Outstanding general ledger reconciling items.

— Uncollected funds due.

— Unmatched trades.

— Aging of unconfirmed trades.

— Suspense items payable/receivable.

— Brokerage payments.

— Miscellaneous losses.

Compliance Risk

The following examination procedures highlight significant rules and

regulations required by domestic futures and options regulatory authorities. 

The examiner may use these procedures, as applicable, to supplement

examination work performed by the CFTC, SRO or exchange authorities.

65. Ensure the FCM has systems and controls that permit it to comply with

regulations and rules governing its activities. Rules and regulations vary

among exchanges and jurisdictions. Generally, rules will include the

following requirements:

C Periodic computation of minimum financial requirements. (For

example, see CFTC Rule 1.17, 17 CFR 1.17).

C Daily computation of customer segregation requirements. (For

example, see CEA 4d(2) and CFTC Rule 1.20, 17 CFR 1.20).

C Daily computation of cash, securities, or other customer assets used

to satisfy obligations to foreign futures and foreign options

exchanges. (For example, see CFTC Rule 30.7, 17 CFR 30.7).

C Reporting requirements, audited regulatory reports, and other

required filings. (For example, see Form 1-FR, CFTC Rule 1.10, 17

CFR 1.10).

C Segregation requirements of foreign regulators.

66. Determine that the FCM provides for accountants’ reports as required by

regulations and rules governing its activities. (For example, see CFTC

Rule 1.16, 17 CFR 1.16). Accountant's reports should include a

description of any material inadequacies as to accounting systems,
39

accounting controls, and procedures for the safeguarding of customer

assets. Review the audit letter, financials, and accompanying notes. 

Review reports on meetings between the accountants and FCM

management regarding internal controls.

67. Determine whether the FCM has adopted procedures that ensure:

C Confidentiality of customer account information.

C Fair treatment of customers:

— If the FCM acts in a dual capacity (executing for customers as

well as for its own account or for the account of affiliates),

determine that the interest of customers, including the use of

or access to information, and their transactions, have priority

over the interests of the FCM and its affiliates. (For example,

see CFTC Rule 155, 17 CFR 155).

— Among customers, each account is treated impartially with

equal access to information and priority of execution.

68. Ensure that the FCM has designated a compliance officer who is

responsible for handling and responding to customer complaints and

inquiries. Determine that the firm has controls or procedures to assure

that:

C Account officers cannot intercept customer complaints or inquiries

and that all complaints or inquiries are routed to the compliance

officer.

C Compliance officers periodically review tape recordings of

conversations between customers and associated persons, or order

clerks, if made.

69. Determine whether the firm maintains a compliance procedures manual

or other written documentation outlining compliance matters.

70. Verify that the FCM has a process for informing appropriate personnel of

changes to regulations and exchange rules.

71. Determine whether the FCM has procedures to ensure that each

customer account is reviewed periodically to check that:

C All transactions have been authorized by the customer before

execution.

C If applicable, the approval of customers authorizing the FCM to

execute transactions without prior specific approval is documented

in writing.

C All required risk disclosures are made.
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C Account statements accurately reflect the current status of the

account and reflect all transactions. 

72. Determine whether the compliance officer or other supervisory

personnel reviews the propriety of commission payments.

73. Determine whether the compliance officer or other supervisory officer

reviews all promotional material before it is first used.

74. If the bank subsidiary FCM carries accounts for employees of other

FCMs, determine whether:

C The bank subsidiary FCM obtains written authorization from

appropriate parties at such other FCMs. 

C Copies of customer statements are forwarded to such other FCM.

(See CFTC Rule 155.3(c).)

75. If the FCM allows its employees to maintain accounts with other firms,

determine whether the FCM has procedures to authorize and monitor

such activity, including conducting a review of the employees' account

statement and order tickets. (See CFTC Rule 155.3(d)).

Conclusions

76. Use the information and analysis prepared throughout the examination

to draw conclusions about the levels of strategic, reputation, credit,

liquidity, transaction, and compliance risks.

77. Use the information and analysis prepared throughout the examination

to draw conclusions about the adequacy of board and senior

management oversight of strategic, reputation, credit, liquidity,

transaction, and compliance risks.

78. Discuss findings with senior management and board members at exit

meetings. As applicable, obtain necessary commitments for corrective

action.

79. Prepare report comments and internal analysis comments, as

appropriate.

80. Update the bank's supervisory strategy.
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Futures Commission Internal Control

Merchant Activities Questionnaire

 Yes No

1. Does the board and senior management provide adequate oversight of

FCM activities?

2. Has the board approved policies and procedures that are consistent with

stated risk tolerances?

3. Do risk measurement systems identify and accurately reflect levels of

strategic, reputation, credit, liquidity, transaction, and compliance risks?

4. Do existing management information systems provide the board and

senior management with accurate and timely information?

5. Are control deficiencies that have been identified by audit, compliance,

or other regulatory bodies promptly addressed and resolved?

6. Do margin policies and practices adequately protect the FCM from

unwarranted credit or liquidity risk?

7. Do internal controls and systems used in FCM operations limit

exposures that might negatively affect the bank's financial condition

and/or reputation?
42

Futures Commission 

Merchant Activities Appendix

Sample FCM Request Letter

The following provides guidance to the examiner preparing for an onsite

examination of a FCM operating subsidiary. Consistent with OCC policy, the

examiner should use existing bank management reports whenever possible

and keep to a minimum reports that bank management must prepare

specifically for the examiner. Additionally, examiners should only request

items in this list applicable to the risks to be evaluated during the

examination. For example, if examiners will rely on work performed by

another regulatory body to evaluate compliance risk, they may not need to

request item 11.

NOTE: Copies need not be made of items marked by an asterisk. Examiners

will review originals and return them to bank management during the

examination.

_____ *1. Registration data filed with the NFA, OCC.

_____ 2. Summary of FCM activities (non-member, executing

member, clearing member, etc.).

_____ 3. List of types of futures and options on futures contracts

transacted by the FCM.

_____ 4. As applicable, list of clearing FCMs through which the FCM

executes or clears trades.

_____ 5. As applicable, list of exchanges on which the FCM executes

or clears trades.

_____ 6. As applicable, list of clearinghouses of which the FCM is a

member.

_____ 7. Summary information reflecting how much of FCM’s business

is conducted for:

C Affiliate bank(s).

C Nonbank affiliates.

C Third-party customers.

C The FCM’s own account.
43

_____ 8. FCM organization chart.

_____ *9. Bank board or executive committee minutes reflecting FCM

activities.

_____ *10. FCM board minutes or executive committee minutes. 

_____ 11. FCM compliance program policies, procedures, and annual

schedule.

_____ 12. Risk control function policies, procedures, and annual

schedule.

_____ *13. Reports prepared by internal audit, external audit,

compliance, the independent risk management unit, or the

designated self-regulatory organization (SRO) since the last

OCC examination.

_____ *14. Correspondence between the FCM and SRO since the last

OCC examination.

_____ 15. FCM strategic plans and budgets.

_____ *16. Resumes for FCM senior management.

_____ 17. Job descriptions for FCM senior management positions.

_____ 18. List of related organizations doing business with the FCM.

_____ *19. Service agreements, as applicable, for services provided by

the bank or other related entities.

_____ 20. FCM policies and procedures for managing risk (credit,

liquidity, operations, etc.).

_____ 21. Description of FCM limits for managing risk (credit, liquidity,

operations, etc.).

_____ 22. Description of risk measurement system used for quantifying

liquidity risk.

_____ 23. Description of risk measurement system used for quantifying

credit risk.

_____ *24. Credit risk reports for the last twelve months: limit

monitoring, exceptions, watch list.
44

_____ 25. Summary of compensation programs.

_____ *26. Actual compensation paid to senior managers and line

officers for the last fiscal period.

_____ 27. FCM volume of activity reports since the last OCC

examination.

_____ 28. FCM revenue and expense reports since the last OCC

examination.

_____ *29. Key marketing presentations, sales documents, advertising

materials.

_____ *30. Sales training information (manuals, etc.).

_____ *31. Reports used by management to monitor margin accounts.

_____ 32. List of any reimbursement or settlement made to customer

accounts since the last OCC examination.

_____ *33. The FCM’s net capital computations for the last 12 months.