Front Office, Back Office and Middle Office

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The treasury department of a bank is divided into the front office, middle office and back office. The forex desk or the dealing room of a bank is a part of the front office of the treasury department. The forex market operations of a bank are not limited to the dealers buying and selling currencies for customers and for bank’s proprietary trading. The trade transactions that take place in the dealing room are just the starting point of the whole cycle of forex trading operations.

When the trade has been completed between the dealers of two banks, there are several other actions required on the part of these banks in order to successfully close the deal. Suppose Bank A purchases US dollar against euro from Bank B, the deal is completed only when Bank A is credited with US dollars against its payment to Bank B in euros. This process is not as simple as domestic money transfers between banks because of international nature transactions. This process of two-way transfer of funds as per the terms of the deal to the respective bank accounts is called settlement process.

Apart from the settlement process, several other functions are also involved in the forex trading life cycle. These include confirmation, matching, risk management, compliance with regulatory guidelines, reporting requirements, etc. All these activities cannot be performed in the dealing room itself. Therefore, the forex treasury operations are segregated into three departments – front office, back office and middle office. Dealing room is the most important part of the front office. As discussed, the front office is involved in actual trading in interbank forex markets through dedicated dealers. A sales staff may also be attached to the front office.

his sales force interacts with the clients directly. The back office takes care of the post-trade activities such as deal confirmation, matching, settlement, accounting and reconciliation. The middle office takes care of the risk management and maintains the Management Information System (MIS) for the forex desk. If the size of the forex operations is small, the treasury department may not have separate front, middle and back offices. Banks that have sizeable volume of forex operations maintain these three offices.

The heads of the front, middle and back offices along with the head of the risk management and research report to the head of the treasury department. The treasury head coordinates the activities of these three departments and the risk management department. Usually, the treasury head is also a part of the Asset Liability Committee (ALCO). In case, a bank has several desks meant for different markets, dealers for respective markets such as chief dealer (forex), chief dealer (money markets), etc., all report to the treasury head.

Role and Responsibilities of Each Office

Let us discuss the role and responsibilities of each office in detail.

Front Office

The primary responsibility of the front office is to manage investments and market risks in accordance with the bank’s policies. The bank’s risk management division and ALCO will provide relevant guidelines for performing the front office functions. The resulting required activities are carried out in the dealing room where dealers execute their strategies in the interbank markets.

The middle and back offices carry out the activities related to the rest of trade activities required for the completion of the forex trade. The dealers are responsible for trading, risk taking and risk management, and adhering to the bank’s policies with regard to risk management. This involves monitoring market movements, position keeping, monitoring control and exposure limits, etc. All these are necessary for the effective management of market risks.

Back Office

Before discussing the back office operations, it is necessary to understand the trade life cycle of forex trading. Figure shows the various stages in the life cycle of a trade:

Let us now discuss each step in the trade life cycle:

Trade Execution and Trade Capture (Front Office)

This step refers to actual trading done by dealers. The trade execution in the forex market happens through the OTC market either by telephone calls or electronic trading platforms. After this, the information related to the trade is required to be passed to the back office for further processing.

Since the dealers are not allowed to interfere in the back office operations, the trade data are usually captured in the dealing room and are passed to the back office for settlement. This process can be either automated or manual. Apart from these two steps, all other steps in the trade life cycle are handled in the back office.

Trade Capture, Enrichment and Validation

The back office activities start with the deal slip verification. In automated environments, the trade data is captured in the back office applications directly from the front office dealing applications. In non-automated environments, it may be required that the data of the forex transactions is fed manually into the back office applications. The trade data that comes from the front office will only have the essential data such as currencies, trade date, amount, exchange rate, etc.

All the associated data, such as nostro accounts applicable, counterparty details and settlement instructions required for executing the settlement are added to the trade data. This process is called trade enrichment and it can be automated based on the back office master database. Once the trade data is complete for processing, the validation of data is performed. This ensures that the data is consistent and accurate. For example, the value date applicable for a forex trade depends on the holiday calendar in respective financial centres. Such details need to be verified before processing them for settlement.

Trade Confirmation

Trade confirmation is the process of ensuring the validity of the trade. In the case of money market operations, the trade confirmation process would involve each counterparty sending trade confirmation messages to each other for every trade carried out between them, to ensure the authenticity of trade between them and the accuracy of the details. This can also happen automatically through the Straight Through Processing (STP) capable applications where the confirmation messages could be generated automatically after the trade data is captured in the back office application.

aSettlement Instructions and Trade Settlement

In this step, relevant settlement messages are generated and sent to the counterparties. This usually involves the use of secure electronic communication networks such as SWIFT, FIX, etc., for the settlement of financial transactions. The settlement instruction generated and sent by the bank informs its correspondent bank to debit the nostro account maintained with it and transfer the required amount to the counterparty bank’s account on the value date.

The trade settlement refers to the actual debit and credit in the respective nostro accounts of the counterparties.The application will also register the confirmation message coming from the counterparty and will match the data with the application data for trade agreement. In the case of forex transactions, deals may be verified on the basis of deal slips prepared by dealers and also by confirmation received from counterparties. The back office may also confirm the trade over phone with the counterparties for verifying the authenticity of the confirmation document.

Apart from the above, the back office is also responsible for the following activities:

  • Nostro reconciliation

  • Accounting of transactions in the bank’s general ledger

  • Generation of Management Information Systems (MIS) reports

  • Statutory reporting to RBI

  • Monitoring approved exposure and control limits

  • Monitoring the receipt of funds, settlement failures, nostro fund balances towards liquidity management

Middle Office

The middle office takes care of the risk measurement, risk monitoring and management reporting aspects of forex operations.

The various activities of the middle office are summarised as follows:

  • Setting various limits for the transaction and monitoring exposures

  • Coordinating with the risk management division for managing liquidity and market risks

  • Monitoring open currency positions in accordance with bank policies

  • Marking-to-market the open positions and record unrealised gains and losses

  • Calculating and reporting the Value-at-Risk (VaR) parameters

  • Providing research and strategic inputs regarding market movements, hedging strategies, risk-return analysis, etc.

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