International Monetary Fund · 1. Reserve Management Objectives, Scope, and Coordination 1.1...

Prepared by the Staff of theInternational Monetary Fund

International Monetary Fund Washington, DC

GUIDELINES FOR FOREIGN EXCHANGE RESERVE MANAGEMENT

© 2004 International Monetary Fund

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[Guidelines for foreign exchange reserve management]—Washington, D.C.: Inter-national Monetary Fund, 2004.

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1. Bank reserve. 2. Foreign exchange. I. International Monetary Fund.

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Preface v

I. What Is Reserve Management and Why Is It Important? 1

II. Purpose of the Guidelines 3

III. The Guidelines 4

1. Reserve Management Objectives, Scope, and Coordination 42. Transparency and Accountability 43. Institutional Framework 54. Risk Management Framework 55. Role of Efficient Markets 5

IV. Discussion of the Guidelines 6

1. Reserve Management Objectives, Scope, and Coordination 62. Transparency and Accountability 83. Institutional Framework 124. Risk Management Framework 145. Role of Efficient Markets 18

Glossary 20

Boxes

1. Foreign Reserves Disclosures Under IMF Standards and Codes 92. Adverse Reserve Management Experiences 153. Benchmark Portfolios and Risk Management 17

iii

Contents

The Guidelines for Foreign Exchange Reserve Management have been devel-oped as part of a broader work program undertaken by the IMF to help strengthenthe international financial architecture, to promote policies and practices that con-tribute to stability and transparency in the financial sector, and to reduce externalvulnerabilities of member countries. The Guidelines parallel those for Public DebtManagement that were developed by the IMF and the World Bank and released inMarch 2001.

In developing the Guidelines, IMF staff worked in close collaboration withreserve management entities from a broad group of member countries and inter-national institutions in a comprehensive outreach process. The outreach processincluded regional meetings in Abu Dhabi, Basel, Gaborone, Mexico City,Singapore, and Washington, DC, to discuss earlier versions of the Guidelines. Thepractitioners’ insight that this process brought to the Guidelines has enabled theenunciation of broadly applicable principles as well as institutional and operationalfoundations that have relevance for members with a wide range of institutionalstructures at different stages of development.

The staff acknowledges and greatly appreciates the efforts of all who con-tributed to the successful completion of this project.

v

Preface

Reserve management is a process that ensuresthat adequate official public sector foreign assetsare readily available to and controlled by theauthorities for meeting a defined range of objec-tives for a country or union.1 In this context, areserve management entity is normally maderesponsible for the management of reserves andassociated risks.2 Typically, official foreign ex-change reserves are held in support of a range ofobjectives,3 including to

• support and maintain confidence in the poli-cies for monetary and exchange rate man-

agement, including the capacity to intervenein support of the national or union currency;

• limit external vulnerability by maintainingforeign currency liquidity to absorb shocksduring times of crisis or when access to bor-rowing is curtailed, and in doing so

• provide a level of confidence to markets thata country can meet its external obligations;

• demonstrate the backing of domestic cur-rency by external assets;

• assist the government in meeting its foreignexchange needs and external debt obliga-tions; and

• maintain a reserve for national disasters oremergencies.

Sound reserve management practices areimportant because they can increase a country’s orregion’s overall resilience to shocks. Through theirinteraction with financial markets, reserve man-agers gain access to valuable information thatkeeps policymakers informed of market develop-ments and views on potential threats. The impor-tance of sound practices has also been highlightedby experiences where weak or risky reserve man-agement practices have restricted the ability of theauthorities to respond effectively to financial crises,which may have accentuated the severity of thesecrises. Moreover, weak or risky reserve manage-ment practices can also have significant financialand reputational costs. Several countries, for exam-ple, have incurred large losses that have had direct,

1

IWhat Is Reserve Management and Why Is It Important?

1The word union is used to represent monetary or exchangemanagement unions that also undertake reservemanagement.2Among countries, and among monetary or exchange man-agement unions, the entity responsible for reserve manage-ment may be a central bank or monetary authority actingeither as a principal or as an agent for another repository ofreserves such as an exchange fund. These entities may alsohave a range of policy responsibilities and functions thatextend beyond their reserve management responsibilities. Fordiscussion purposes, the term reserve management entity isused throughout this paper to refer to the entity that isresponsible for reserve management, and the term reservemanager is used to refer to the specific area within the entitythat performs the actual reserve management function.3A number of countries also maintain separate stabilization orsavings funds often related to nonrenewable resources. Suchfunds do not generally fall within the definition of reserveassets and are not specifically covered by these guidelines.They do, however, represent public sector assets that must bemanaged with due care and diligence. Accordingly, the princi-ples contained in the guidelines may also have potential rele-vance for the sound management and stewardship of suchforeign assets.

or indirect, fiscal consequences.4 Accordingly,appropriate portfolio management policies con-cerning the currency composition, choice ofinvestment instruments, and acceptable duration

of the reserves portfolio, and which reflect a coun-try’s specific policy settings and circumstancesserve to ensure that assets are safeguarded, readilyavailable, and support market confidence.

Sound reserve management policies and prac-tices can support, but not substitute for, soundmacroeconomic management. Moreover, inappro-priate economic policies (fiscal, monetary andexchange rate, and financial) can pose serious risksto the ability to manage reserves.

2 GUIDELINES FOR FOREIGN EXCHANGE RESERVE MANAGEMENT

4Such experiences are not discussed in detail in this paper, buthave been drawn upon in identifying risks to which countrieshave been exposed. Some further detail, however, is providedin Chapter 4.

The guidelines presented in this paper areintended to assist governments in strengtheningtheir policy frameworks for reserve managementso as to help increase their country’s resilience toshocks that may originate from global financialmarkets or within the domestic financial system.The aim is to help the authorities articulate appro-priate objectives and principles for reserve man-agement and build adequate institutional andoperational foundations for good reserve manage-ment practices.

The guidelines identify areas of broad agree-ment among practitioners on reserve managementprinciples and practices that are applicable to abroad range of countries at different stages ofdevelopment and with various institutional struc-tures for reserve management. In doing so, theguidelines serve to disseminate sound practicesmore widely, while recognizing that there is nounique set of reserve management practices orinstitutional arrangements that is best for all coun-tries or situations. In this respect, they should beregarded as nonmandatory and should not beviewed as a set of binding principles.

In their usage, the guidelines are intendedprimarily for voluntary application by members in strengthening their policies and practices.They could also play a useful role in the contextof technical assistance and, as warranted, as abasis for informed discussion between the author-ities and the Fund on reserve management issuesand practices.

Although institutional arrangements and gen-eral policy environments can differ, surveys ofactual practices indicate that there is increasingconvergence on what are considered soundreserve management practices that takentogether constitute a broad framework for reservemanagement. In the context of this paper, thesepractices are reflected in guidelines that encom-pass (1) clear objectives for the management ofreserves; (2) a framework of transparency thatensures accountability and clarity of reserve man-agement activities and results; (3) sound institu-tional and governance structures; (4) prudentmanagement of risks; and (5) the conduct ofreserve management operations in efficient andsound markets.

3

IIPurpose of the Guidelines

1. Reserve Management Objectives,Scope, and Coordination

1.1 Objectives

Reserve management should seek to ensurethat (1) adequate foreign exchange reserves areavailable for meeting a defined range of objectives;(2) liquidity, market, and credit risks are controlledin a prudent manner; and (3) subject to liquidityand other risk constraints, reasonable earnings aregenerated over the medium to long term on thefunds invested.

1.2 Scope

Reserves consist of official public sector for-eign assets that are readily available to and con-trolled by the monetary authorities.

Reserve management activities may alsoencompass the management of liabilities, othershort foreign exchange positions, and the use ofderivative financial instruments.

1.3 Reserve Management Strategy andCoordination

Reserve management strategies should be con-sistent with and supportive of a country’s orunion’s specific policy environment, in particularits monetary and exchange arrangements.

Evaluation of alternative reserve managementstrategies and their respective implications forreserve adequacy are likely to be facilitated by acost-benefit analysis of holding reserves.

Reserve management strategies may also needto take into account strategies for the managementof external debt for purposes of reducing externalvulnerability.

2. Transparency and Accountability

2.1 Clarity of Roles, Responsibilities, andObjectives of Financial AgenciesResponsible for Reserve Management

The allocation of reserve management respon-sibilities, including agency arrangements, betweenthe government, the reserve management entity,and other agencies should be publicly disclosedand explained.

The broad objectives of reserve managementshould be clearly defined and publicly disclosed,and the key elements of the adopted policyexplained.

2.2 Open Process for Reserve ManagementMarket Operations

The general principles governing the reservemanagement entity’s relationships with counter-parties should be publicly disclosed.

2.3 Public Availability of Information onForeign Exchange Reserves

Information on official foreign exchangereserves should be publicly disclosed on a pre-announced schedule.

4

IIIThe Guidelines

2.4 Accountability and Assurances of Integrityby Agencies Responsible for ReserveManagement

The conduct of reserve management activitiesshould be included in the annual audit of thereserve management entity’s financial statements.Independent external auditors should conduct theaudit and their opinions on the financial state-ments should be publicly disclosed.

General principles for internal governance usedto ensure the integrity of the reserve managemententity’s operations should be publicly disclosed.

3. Institutional Framework

3.1 Legal Foundation

Sound institutional and governance arrange-ments should be established through a legislativeframework that clearly establishes the reserve man-agement entity’s responsibilities and authority.

3.2 Internal Governance

The internal governance structure of thereserve management entity should be guided byand reflect the principles of clear allocation andseparation of responsibilities. Sound managementof internal operations and risks requires appropri-ately qualified and well-trained staff, followingsound business practices.

Effective monitoring of internal operationsand related risks should be supported by reliableinformation and reporting systems, and an inde-pendent audit function.

Staff involved in reserve management shouldbe subject to a code of conduct and conflict of

interest guidelines regarding the management oftheir personal affairs.

Effective recovery procedures should be inplace to mitigate the risk that reserve managementactivities might be severely disrupted by the failureof operating systems, or other catastrophic events.

4. Risk Management Framework

There should be a framework that identifiesand assesses the risks of reserve management oper-ations and that allows the management of riskswithin acceptable parameters and levels.

The risk management framework should applythe same principles and measures to externally man-aged funds as it does to those managed internally.

Risk exposures should be monitored continu-ously to determine whether exposures have beenextended beyond acceptable limits.

Reserve managers should be aware of and beable to account for potential financial losses andother consequences of the risk exposures they areprepared to accept.

The risk management framework should alsoaddress risks associated with derivative financialinstruments and other foreign currency operations.

To assess the risk and vulnerability of thereserve portfolio, the reserve management entityshould regularly conduct stress tests to ascertainthe potential effects of macroeconomic and finan-cial variables or shocks.

5. Role of Efficient Markets

Reserve management, and any related policyoperations, should be conducted in markets thathave sufficient depth and liquidity, and can processtransactions in a sound and efficient manner.

The Guidelines 5

1. Reserve Management Objectives,Scope, and Coordination

1.1 Objectives

Reserve management should seek to ensurethat (1) adequate foreign exchange reserves areavailable for meeting a defined range of objectives;(2) liquidity, market, and credit risks are controlledin a prudent manner; and (3) subject to liquidityand other risk constraints, reasonable earnings aregenerated over the medium to long term on thefunds invested. Reserve management forms a partof official economic policies, and specific circum-stances will impact on choices concerning bothreserve adequacy and reserve management objec-tives. In order to ensure the availability of reserves,and as part of setting appropriate investment pri-orities, the reserve manager needs to have anassessment of what constitutes an adequate level ofreserves. Such an assessment may be made by thereserve management entity, or it may involve con-sultation between the reserve management entityand other agencies. There are no universally appli-cable measures for assessing the adequacy ofreserves and the determination of reserve ade-quacy falls beyond the scope of these guidelines.Relevant factors have traditionally included a coun-try’s monetary and exchange rate arrangements,and the size, nature, and variability of its balance ofpayments and external position. More recently,financial risks associated with a country’s externaldebt position and the volatility of its capital flowshave received particular attention, especially for

economies with significant but not fully certainaccess to international markets. In the process,ensuring the availability of reserves will be influ-enced by the exchange rate system, and the partic-ular objectives for which they are held.5

To ensure that reserves are available at the timeswhen they are needed most, liquidity—which is theability to convert quickly reserve assets into foreignexchange—usually receives the highest priority,albeit with a cost that usually involves acceptinglower-yielding investment instruments. Closely fol-lowing is the need for the management and controlof risks to ensure that asset values are protected.Market and credit risks, for instance, can lead to sud-den losses and impair liquidity. Finally, earnings arean important outcome of the management ofreserve assets. For some countries, they play a role inoffsetting the costs associated with other centralbank policies and domestic monetary operations,which among other things fund the acquisition ofreserves. In other cases, such as where reserves areborrowed in foreign markets, earnings play animportant role in minimizing the carrying costs ofreserve assets. Accordingly, achieving an acceptablelevel of earnings should be a priority within clearlydefined liquidity and risk constraints.

In sum, the reserve management entity shouldseek to maximize the value of reserves, within the

6

IVDiscussion of the Guidelines

5A discussion of reserve adequacy can be found inInternational Monetary Fund, 2000, Debt- and Reserve-RelatedIndicators of External Vulnerability, which is available on theIMF’s website: http://www.imf.org/external/np/pdr/debtres/index.htm.

prudent risk limits that form the framework forreserve management, so that reserves are alwaysavailable when they are needed. As a consequence,reserve asset portfolios tend to be highly risk-averse, with a consequent priority for liquidity andsecurity before profit or carrying cost considera-tions. This necessarily involves making a trade-offbetween risk and return in the context of settingreserve management priorities.

1.2 Scope

Reserves consist of official public sector for-eign assets that are readily available to and con-trolled by the monetary authorities. Reserve assetportfolios usually have special characteristics thatdistinguish them from other foreign currency assets.First and foremost, official reserve assets normallyconsist of liquid or easily marketable foreign cur-rency assets that are under the effective control of,and readily available to, the reserve managemententity.6 Furthermore, to be liquid and freely usablefor settlements of international transactions, theyneed to be held in the form of convertible foreigncurrency claims of the authorities on nonresidents.7

Reserve management activities may alsoencompass the management of liabilities, othershort foreign exchange positions, and the use ofderivative financial instruments. Depending upona country’s or union’s specific policy objectives andsettings, the reserve management entity may alsobe involved in the borrowing of foreign exchange,or drawing against committed credit lines, as partof its responsibility for maintaining an adequatelevel of reserves. Managing reserves may also

involve liability positions that derive from repur-chase agreements, forward exchange and swapagreements, as well as positions arising from oper-ations involving futures and options. In the latterrespect, many countries now use derivative finan-cial instruments as an integral part of reserve man-agement operations to establish hedges againstcurrency and interest rate exposures.8

1.3 Reserve Management Strategy andCoordination

Reserve management strategies should be con-sistent with and supportive of a country’s orunion’s specific policy environment, in particularits monetary and exchange arrangements. Reservemanagement strategies will be shaped by the spe-cific reasons for which reserves are held. In thecontext of monetary and exchange arrangements,the exchange rate regime and the degree to whichexchange and capital controls have been liberal-ized are of particular relevance.

Under a free float, a public commitment by theauthorities not to operate in the foreign exchangemarket gives the reserve manager greater latitudein structuring the duration and liquidity of theportfolio. In practice, however, the authorities mayseek to maintain a capacity to ensure orderly mar-kets during times of very sharp adjustments of theexchange rate or market pressures, or more gener-ally to be able to counter unforeseen internal orexternal shocks.

In countries with fixed exchange rates, includ-ing those that operate currency boards, the author-ities may need to operate often in the foreignexchange market and will therefore need reservesthat can be readily converted into foreignexchange.9 Especially in these cases, reserves areneeded to provide confidence in the currency pegand deter speculation. For these purposes, reserves

Discussion of the Guidelines 7

6In general, control is assured when reserve assets are ownedby the reserve management entity. However, external assetsheld by another authority may also be considered as reserveassets when such assets are under the direct and effective con-trol of the reserve management entity. Comprehensive guid-ance on definitional and other aspects of reserves andliquidity can be found in International Monetary Fund,Statistics Department, 1999, “Data Template on InternationalReserves and Foreign Currency Liquidity—OperationalGuidelines,” October.7Official foreign exchange reserves may also include holdingsof gold. Such holdings would need to be held by the authori-ties as monetary gold so as to ensure ready availability for saleand delivery on world bullion markets.

8Examples of instruments used include swap, futures, andoptions contracts involving foreign currencies or interest rates.Risk aspects associated with these operations are discussed inSection 4.9A currency board arrangement may also have a direct impli-cation for the currency composition of reserves, if there is arequirement for base money to be backed wholly, or predomi-nantly, by the currency to which the local currency is pegged.

tend to be invested in a form that facilitates theirready availability.

Intermediate exchange rate regimes, such asmanaged float or peg arrangements,10 require theauthorities to operate in support of the arrange-ment. This may call for more or less active opera-tions depending on market evolution andconditions with consequences for the choice ofthe appropriate level of liquidity that would needto be maintained.

Evaluation of alternative reserve managementstrategies and their respective implications forreserve adequacy are likely to be facilitated by acost-benefit analysis of holding reserves. Suchanalysis would aim to place values on the costs andbenefits of holding more or less reserves, for exam-ple, by weighing the costs of raising and holdingadditional reserves against expected benefits of lessvolatile capital flows, increased foreign investorconfidence, and reduced risk of contagion.

Reserve management strategies may also needto take into account strategies for the managementof external debt for purposes of reducing externalvulnerability. Mutually consistent and supportingpolicies for debt and reserve management can beimportant elements of crisis prevention. At thepublic sector level, this might involve a coordi-nated approach that considers the assets and liabil-ities of several official institutions including, whererelevant, positions of subnational authorities. Theaim in these circumstances is to determine whethera country’s official “whole of government” balancesheet has an adequate level of reserves to provideliquidity as needed, and to allow time to absorbshocks in situations where access to borrowing iscurtailed or very costly. In some economies, short-term external private debt may also be an addi-tional factor in determining reserve adequacy.

In countries where reserve management anddebt management responsibilities are entrusted tothe same authority, consistent strategies can beachieved through a well-coordinated asset-liability

risk management approach. Where reserve manage-ment and debt management responsibilities aresplit between authorities, however, the respectivepolicy objectives may differ. In situations where, forexample, the reserve management entity has a pri-mary responsibility for monetary policy, care shouldbe taken to ensure that coordination efforts are notseen as compromising the separation between mon-etary policy and debt management. In such situa-tions, coordination might also seek to ensure thatthe authorities’ respective actions send out clear sig-nals and avoid contradictory messages.11

2. Transparency and Accountability

The main issues of transparency in the contextof good governance and accountability in reservemanagement are addressed in the IMF’s Code ofGood Practices on Transparency in Monetary andFinancial Policies: Declaration of Principles, September1999 (MFP Transparency Code) and illustrated inthe Supporting Document to the Code. The MFPTransparency Code aims at promoting trans-parency practices for central banks in their con-duct of monetary policy, and for central banks andother financial agencies in their conduct of finan-cial policies (Box 1). In doing so, it contains severalelements of good transparency practices relating toforeign exchange policies, reserve management,and related foreign exchange market operations.In addition to identifying a range of general dis-closures concerning foreign exchange policies andinstitutional responsibilities for reserve manage-ment, the MFP Transparency Code aims to pro-mote transparency through accountability. Thesubsections of this chapter follow the respectiveheadings of the Code that relate to reserve man-agement. It should be noted that within the spe-cific sections of these guidelines, references to thelevel of disclosure by a reserve management entityreflect those levels implied by the relevant sectionof the MFP Transparency Code, and where appli-cable, other relevant standards.


10Arrangements in this regard would include conventionalfixed pegs, crawling pegs, horizontal bands, and crawlingbands. Further details on these arrangements can be found inthe IMF’s Annual Report 2001 (Appendix II, pp. 141–43),which is available on the Fund’s website: http://www.imf.org/external/pubs/ft/ar/2001/eng/index.htm.

11This may involve, for example, a policy coordination bodysuch as a separate treasury council that oversees external debtmanagement and coordinates borrowing programs havingregard to advice from the reserve management entity on thedesired level of reserves.

2.1 Clarity of Roles, Responsibilities, andObjectives of Financial AgenciesResponsible for Reserve Management

The allocation of reserve management respon-sibilities, including agency arrangements, betweenthe government, the reserve management entity,and other agencies should be publicly disclosed andexplained.12 A reserve management entity may per-form its functions in a number of ways, acting, forexample, either as principal or in an agency capac-

ity. In each case, it is important, therefore, that theownership of reserves be clearly established. Varyinginstitutional responsibilities for foreign exchangepolicy may also have implications for reserve man-agement responsibilities. Accordingly, the specificinstitutional responsibilities for foreign exchangepolicy and reserve management should also be dis-closed. These disclosures help financial markets andthe general public understand how exchange ratepolicy decisions are made, their impact on reservemanagement objectives, and the accountabilityframework for reserve management decisions andoutcomes.


Box 1. Foreign Reserves Disclosures Under IMF Standards and Codes

Code of Good Practices on Transparency inMonetary and Financial Policies (MFP Transparency Code)

The MFP Transparency Code, adopted by theInterim Committee in September 1999, requires spe-cific public disclosures covering (1) the institutionwith responsibility for foreign exchange policy, para-graph 1.1.4; (2) the responsibilities of the centralbank, if any, for foreign exchange reserves, paragraph1.3.1; (3) rules and procedures for the central bank’srelationships with counterparties in markets where itoperates, paragraph 2.1.2, as well as regulations forthe operation of organized financial markets (includ-ing those for issuers of traded financial instruments),paragraph 6.1.3; (4) information about the country’sforeign exchange reserve assets, liabilities, and com-mitments by the monetary authorities, according to apreannounced schedule, paragraph 3.2.4; and (5)release of the central bank balance sheet on a prean-nounced schedule, and selected information on itsmarket transactions, paragraph 3.2. Further detail onthe specific disclosure requirements relating to for-eign reserves can also be found in Section 1.3.1 of theSupporting Document.

Other more general disclosure requirements thatwould incorporate information on reserve manage-ment include (1) release of summary central bankbalance sheets on a frequent and preannouncedschedule; (2) preparation of detailed central bankbalance sheets in accordance with appropriate andpublicly documented accounting standards, para-graph 3.2.1; (3) public disclosure of financial state-

ments on a preannounced schedule, paragraph 4.2,and that have been audited by an independent audi-tor, paragraph 4.2.1; and (4) internal governanceprocedures necessary to ensure integrity of opera-tions, including internal audit arrangements, para-graph 4.2.

Special Data Dissemination Standard

The Special Data Dissemination Standard (SDDS)was established in 1996 to guide IMF member countriesthat have, or that might seek, access to internationalcapital markets in the provision of their economic andfinancial data to the public. Subscription to SDDS is voluntary, but it carries a commitment by a subscribingmember to observe the standard, including thereserves data template, as approved by the IMF’sExecutive Board on March 23, 1999.

The reserves data template is designed to provideinformation on the amount and composition ofreserve assets, other foreign currency assets held bythe central bank and the government, short-term for-eign liabilities, and related activities that can lead todemand on reserves (such as financial derivativespositions and guarantees extended by the govern-ment for private borrowing).

The template consists of four sections: (1) officialreserves and other foreign currency assets; (2) prede-termined short-term drains on foreign currencyassets; (3) contingent short-term net drains on for-eign currency assets; and (4) memorandum items.Dissemination of the 55 data categories included inthe template is mandatory for SDDS subscribers.

12See MFP Transparency Code, 1.1.4 and 1.3.1.

Where the reserve management entity acts asthe government’s agent in performing reservemanagement functions, its role and powers shouldalso be clearly defined, such as in the entity’senabling legislation, in addition to being publiclydisclosed and explained.13 Defining clearly theentity’s agency role and powers avoids confusionover who has the ultimate responsibility for settingand implementing reserve management policy.Public disclosure enables the public to understandthe extent of the reserve management entity’sresponsibilities and to hold the reserve manage-ment entity and government accountable for theirrespective responsibilities and actions.

The broad objectives of reserve managementshould be clearly defined, publicly disclosed, andthe key elements of the adopted policy explained.14

Public disclosure enhances the credibility of reservemanagement policies, goals, and results and is usu-ally contained in the annual reports of reserve man-agement entities. Information provided concerning,for example, the currency composition of bench-marks or the classes of assets would generally becouched in broad terms rather than by the provisionof specific details of underlying assets and opera-tions, which in some circumstances could be desta-bilizing. Some reserve management entities alsoinclude in their annual reports, and in broad terms,information relating to investment performance rel-ative to the benchmarks adopted. Specific disclosurepractices vary and may depend on country circum-stances, including the stage of market development.Nonetheless, disclosure practices should strive to beconsistent with the intent of the MFP TransparencyCode.

2.2 Open Process for Reserve ManagementMarket Operations

The general principles governing the reservemanagement entity’s relationships with counterpar-ties should be publicly disclosed.15 Disclosure, inthis context, serves to assure the public that reservemanagement dealings are based on objective crite-

ria and are fair and impartial. Examples of particu-lar disclosures could include the criteria used todetermine eligible market counterparties, thatreserve management dealings are undertaken atmarket-determined prices, and that market partici-pants observe recognized codes of conduct.Confidentiality considerations are important, how-ever, and public disclosure should not extend tooperational details that may weaken the reservemanagement entity’s ability to operate effectivelyin markets. Public disclosure would also not extendto providing specific details concerning relation-ships with individual counterparties.

2.3 Public Availability of Information onForeign Exchange Reserves

Information on official foreign exchangereserves should be publicly disclosed on a prean-nounced schedule.16 Public disclosure of a coun-try’s international reserve position and foreignexchange liquidity on a timely and accurate basishelps promote informed decision making in thepublic and private sectors, in both domestic andglobal financial markets. Experience also suggeststhat timely disclosure of such information mayallow for a more gradual market adjustment.

The Fund’s Special Data DisseminationStandard (SDDS), and its associated data templateon international reserves and foreign currency li-quidity (the data template), provides a compre-hensive benchmark standard for the content andtiming of public disclosures on foreign reservesand other activities of potential relevance (Box 1).The data template integrates balance sheet andoff–balance sheet data of the international finan-cial activities of the country’s authorities,17 andaims to provide a comprehensive account of for-eign currency assets and drains on such resourcesarising from various foreign currency liabilities andcommitments. The data template is also used as the


13See MFP Transparency Code, 1.3.1.14See MFP Transparency Code, 1.1 and 5.1.15See MFP Transparency Code, 2.1.2.

16See MFP Transparency Code, 3.1 and 3.2.4.17It should be noted that this approach differs from more tra-ditional entity-specific reporting regimes, in that it integratesthe activities of all public authorities, including the reservemanagement entity, which may be responsible for, or involvedin, responding to currency crises.

basis for the reporting of data to the Fund for pur-poses of monitoring a Fund program.18

In many countries, public disclosure of infor-mation on foreign exchange reserves is also madethrough periodic releases, such as statistical releaseson international liquidity and summary balancesheets, as well as in the annual reports of reservemanagement entities. Such disclosures are gener-ally timed so that their release would not interferewith market operations, or that changes to reservemanagement strategies or priorities would not bepublicized ahead of their implementation.

2.4 Accountability and Assurances of Integrityby Agencies Responsible for ReserveManagement

The conduct of reserve management activitiesshould be included in the annual audit of thereserve management entity’s financial statements.Independent external auditors should conduct theaudit and their opinion on the financial statementsshould be publicly disclosed.19 External audits,when performed in accordance with internation-ally recognized auditing standards, provide anindependent opinion on the truth and fairness ofdisclosures contained in the financial statementsand, accordingly, the underlying financial recordsin respect to reserve management activities andresults. An independent external audit of theannual financial statements of the reserve manage-ment entity would normally include an examina-tion of the accounting records and controlsassociated with reserve management activities andalso check for consistency between disclosures con-tained within the financial statements, and thoseelsewhere in the annual report. Publication of theaudit opinion along with the financial statementsshould also be an integral part of the accountabil-ity framework.

Achieving a true and fair opinion requires thatthe financial information and other disclosures

contained in the financial statements adhere tointernationally recognized accounting standards,such as International Accounting Standards(IAS).20 The adoption of high-quality accountingstandards is an essential element in facilitatingmarket understanding of the role and risks of areserve management entity, and that its financialposition and performance have been measured ona consistent and comparable basis. In recent years,a particular focus of IAS has been on standards cov-ering principles for the recognition, valuation, andmanagement of risks associated with financialassets and liabilities.21 Valuation issues addressed inthese standards relate closely to the widely adoptedreserve management practice of “marking to mar-ket,” by requiring that securities held for ready saleare properly reported at their fair or market valuein the reserve management entity’s financial state-ments.22 To the extent that market-based valuationgains may be included in net profits, some reservemanagement entities may require supporting rulesto avoid premature distribution of such profits.

General principles for internal governanceused to ensure that the integrity of the reserve man-


18Further information on the SDDS and the data template,including data periodicity and timeliness, can be obtainedfrom the Dissemination Standards Bulletin Board athttp://dsbb.imf.org/sddsindex.htm.19See MFP Transparency Code, 4.2.1 and 8.2.1.

20IAS are promulgated by the International AccountingStandards Board, London. The publication of annual financialstatements that are prepared in accordance with such stan-dards, or equivalent national standards, and are indepen-dently audited, is also a key element of the Fund’s SafeguardsAssessment framework. This framework has been adopted toensure that central banks responsible for managing resourcesobtained from the Fund have adequate control, accounting,reporting, and auditing systems in place to manage funds andto ensure the integrity of operations. The SupportingDocument of the MFP Transparency Code also suggests anapproach to good accountability practices based on the adop-tion of internationally recognized accounting and auditingstandards.21While IAS do not contain any prescriptions relating specifi-cally to international reserves, disclosures by a reserve man-agement entity, on its reserve-related assets and liabilities,would likely form a large part of the more general annualfinancial statement disclosures required by IAS. Two relevantstandards in this regard are IAS 32, Financial Instruments:Disclosure and Presentation, and IAS 39, Financial Instruments:Recognition and Measurement. These standards require, interalia, financial statement disclosures relating to exposures tointerest rate and credit risks, and the fair or market-based val-uation of financial assets.22The “mark to market” process of valuing all marketableinvestments at their current market price is a specific featureof the fair value measures defined in IAS 32 and IAS 39.

agement entity’s operations be publicly disclosed.23

Disclosure in this context is an important elementin satisfying the general public and markets as tothe competence and performance of the reservemanagement entity in discharging its responsibili-ties for reserve management activities, as well as forother functions the entity may perform. The disclo-sures may be made as part of the entity’s annualfinancial statements, or they can be made in an offi-cial register or in other publications, as well as onthe entity’s website. In addition to the risk manage-ment disclosures, required by accounting stan-dards, they could extend to a broad discussion ofthe role of the Governing Board and InvestmentCommittee in setting reserve management policiesand parameters, internal audit, the role of an auditcommittee, and external audit arrangements.

3. Institutional Framework

3.1 Legal Foundation

Sound institutional and governance arrange-ments should be established through a legislativeframework that clearly establishes the reserve man-agement entity’s responsibilities and authority. Aninstitutional framework that contains a clear identi-fication of responsibilities helps ensure good gover-nance and accountability, as well as ensuring thatreserves are managed effectively and efficiently in amanner appropriate to a country’s needs. Legalassignment of institutional responsibilities, sup-ported by delegation of appropriate authority to areserve management entity, is particularly impor-tant for ensuring effective coordination and perfor-mance where reserve management responsibilitiesand functions are allocated across more than oneinstitution.24 Clearly establishing the reserve man-agement entity’s authority in legislation and appro-priate documentation such as secondary legislationor regulations, coupled with public disclosure,enhances transparency and accountability, and also

assures counterparties of the reserve managemententity’s mandate.25

3.2 Internal Governance

The internal governance structure of thereserve management entity should be guided byand reflect the principles of clear allocation andseparation of responsibilities. A well-defined orga-nizational structure from the very top to opera-tional levels of the reserve management entityestablishes a clear separation of responsibilitiesand authority. In doing so, this creates a decision-making hierarchy that limits risks by ensuring theintegrity of, and effective control over, reservemanagement activities. A supporting system of well-articulated, and formally documented, delegationsand limits of authority works to ensure that personsinvolved in reserve management clearly under-stand their individual responsibilities and limits ofauthority, that risks are to be managed in a prudentand transparent manner, and that only authorizedoperations occur.

At the very top level of the reserve managemententity, decisions are of a strategic nature and areusually made by the governing board or similarbody, or the governor. Their role is to define and setthe overall parameters for reserve managementoperations and the control of risk, including thepreferred trade-off between the different risks facedand the entity’s tolerance for loss in, say, any oneyear. The board’s overall monitoring responsibilitieswould also see a requirement for the regular reviewof investment activity and performance. Such areview should occur at least annually but can also bemore frequent, such as semiannually or quarterly.

Decisions concerning implementation ofboard strategies are usually the responsibility of aninvestment committee. The committee typically ischaired by the board member with responsibilityfor reserve management. It is responsible for set-ting the operational framework for reserve man-agement activities, including the investmentstrategy and portfolio benchmarks, and for review-ing operations and performance on a regular basis.The committee would also have a responsibility for


23See MFP Transparency Code, 4.2.2 and 8.2.2.24Responsibilities in this regard are usually allocated amongthe ministry of finance, central bank, or a central repositorysuch as an exchange fund. 25Following, for example, Guideline 2.1.

approving the inclusion of new types of investmentoperations and instruments. Such approval wouldalso encompass the policies and procedures forassessing new investment proposals, particularly interms of their risks and the ability of existing staffand systems to handle the operations proposed.

At the operational level, decision making andresponsibility for day-to-day reserve managementoperations are usually separated between thosewho initiate reserve management transactions(front office); those who control and ensure thatrisk limits are observed, assess performance, andprovide reports for management (middle office);those who arrange settlement of transactions (backoffice); and those who maintain the financialaccounting records that form the basis of publicdisclosures (accounting department). Within thisoperational framework, many reserve managemententities have established a separate risk manage-ment unit to monitor day-to-day operations andcontrols including, for example, breaches of dele-gated authorities and limits, errors and operationalfailures, and risk management measures such asValue-at-Risk (VaR),26 duration, portfolio perfor-mance, and deviation from benchmarks.

Sound management of internal operations andrisks requires appropriately qualified and well-trained staff, following sound business practices.All aspects of reserve management operationsrequire well-trained staff. First and foremost, staffshould have a firm grounding in market practicesand instruments to undertake respective reservemanagement activities. Supporting this, the proce-dures that staff follow for settlement and, wherenecessary, resolution of disputes or differencesshould be based on sound business practices. Staffshould also fully understand the risks and the con-trol environment in which they operate. Failure ofstaff to observe controls, as well as failure of thecontrol environment, can lead to significant finan-cial losses and may tarnish the reputation of thereserve management entity. An added complexityfor many reserve managers is the difficulty of

retaining high-quality staff in a highly mobile for-eign exchange and investment market environ-ment. Some reserve management entities mightseek to provide adequate additional remunerationor financial incentives to match market offers. Thismay not always be an option, however, and othernonfinancial options such as providing a challeng-ing work environment, including increased levelsof responsibility commensurate with skill and expe-rience, and a well-structured staff training pro-gram, may assist in retaining qualified staff and indeveloping resources to cover the unexpecteddeparture of a key member of staff.

Effective monitoring of internal operationsand related risks should be supported by reliableinformation and reporting systems, and an inde-pendent audit function. Inadequate control overoperational aspects can threaten the ongoing per-formance of reserve management operations andthe ability of the reserve management entity tosafeguard the assets under its control. Reservemanagers need to be aware of the main opera-tional risks they face in day-to-day operations andthe appropriate procedures to control such risks.27

Equally important, they need to be sure that thecontrol measures adopted are being observed. Inthis context, reserve managers require access toreliable information and reporting that enablesthem to monitor risks and performance, as well asany breaches of controls. Ideally, transaction pro-cessing and information systems should be fullyintegrated to reduce the risk of error and toimprove the speed at which management informa-tion is available. Establishing such systems can,however, involve a significant investment in theoperating infrastructure of a reserve manager.Evaluation of particular systems may need to haveregard to the size and complexity of the reservemanagement entity’s operations, and the skills ofstaff, to ensure an appropriate balance between thecosts and benefits of the chosen system.


26VaR methodologies can be a useful tool and component ofrisk management systems for the measurement of exposure torisks emanating from movements in market prices. Nonetheless,VaR has limitations and requires careful attention to the devel-opment, application, and analysis of results.

27Particular operational risks that might need to be addressedin the context of reserve management activities include con-trol system failures associated with (1) dealing risks; (2) settle-ment risk; (3) custodial risk; (4) legal risk; (5) informationtechnology risk; and (6) financial error or misstatement risk.Further details on each of these risks are contained in theglossary to these guidelines.

An effective and independent audit unit playsan important role in providing independent assur-ance to the senior levels of the reserve managemententity (such as the audit committee, or the govern-ing board) that reserve management operationsand internal control and reporting systems are oper-ating properly to safeguard reserve and otherassets.28 The role of internal audit now tends tofocus on a risk-based approach in assessing that theoperating framework is adequate, and that controlprocedures have no gaps in addressing key reservemanagement and operational risks. Particularaspects of reserve management operations on whichinternal audit review might focus include (1) thedegree of success in achieving reserve managementobjectives; (2) determining whether all relevantrisks have been identified; (3) the adequacy of thesystem of internal controls in addressing risks andmonitoring compliance with procedures and con-trols; (4) the existence of proper safeguards to pro-tect assets; (5) the reliability, security, and integrityof Electronic Data Processing (EDP) communica-tion and other information systems; and (6) theaccuracy of accounting records and processes.

Staff involved in reserve management shouldbe subject to a code of conduct and conflict ofinterest guidelines regarding the management oftheir personal affairs.29 Such codes help to allayconcerns that staff’s actions or personal financialinterests may subvert reserve management prac-tices. These arrangements should also include arequirement that staff adopt and comply with pro-fessional codes of conduct that apply in the mar-kets in which reserve management operations areundertaken. Similar arrangements might also beextended to staff of external managers through thecontractual arrangements with such managers.

Effective recovery procedures should be inplace to mitigate the risk that reserve managementactivities might be severely disrupted by the failureof operating systems, or other catastrophic events.

Reserve management systems now typically dependupon the continuous operation of efficient andsecure EDP and communications systems. Such sys-tems require controls that protect against majorinterruptions to business from events such asequipment or power failure, unauthorized access,natural disaster, or other external acts. These con-trols should also include comprehensive businessrecovery procedures including backup systems andcontingency plans to ensure that operations can beresumed with a minimum of delay should a catas-trophic event occur.

4. Risk Management Framework

There should be a framework that identifies andassesses the risks of reserve management operationsand that allows the management of risks withinacceptable parameters and levels. Reserve manage-ment involves a number of financial and operationalrisks. A summary of external market-based and oper-ational risks, which have been faced by reserve man-agement entities, is provided in Box 2. A riskmanagement framework seeks to identify the possi-ble risks that may impact portfolio values and tomanage these risks through the measurement ofexposures and, where necessary, supporting proce-dures to mitigate the potential effects of these risks.

Although there is no set formula that suits allsituations, in practice, many reserve managemententities draw upon generally accepted portfoliomanagement principles in determining the strat-egy for asset selection and allocation to controlexposures to external risks. Typically this involvesestablishing parameters for (1) the currency hold-ing and mix necessary to maintain the ready avail-ability of convertible currencies, and also tomaintain cross-rate exposures within acceptablelimits; (2) the permissible range of investmentinstruments that meet liquidity and securityrequirements; and (3) maturity or durationrequirements for limiting exposure to interest rateor market price risks. Regarding the second point,risk parameters should include the minimumacceptable credit ratings for the issuers of thoseinstruments.

The strategic asset allocation is typically embod-ied in a benchmark portfolio that represents the best


28Typically a separate area, such as the internal audit unit,within the reserve management entity performs this function.In some cases, particularly those involving smaller entities witha limited resource base, consideration might also be given tocontracting out internal audit work associated with specializedoperations such as reserve management.29See MFP Transparency Code, 4.4 and 8.4.

or optimal portfolio given the reserve managementobjectives and risk constraints (Box 3). In order toguide investment operations, the benchmark portfo-lio needs to be well defined,30 including in terms of

the notional size, security composition, and rebal-ancing rules. Considerations in the selection of thecurrency mix within the benchmark portfolioinclude liquidity as well as currency risk. The reservemanagement entity may, for example, wish to holdsome additional liquidity in the main intervention


30The definition of a benchmark portfolio may be based on,or similar to, recognized investment “industry” benchmarkssuch as those used and published by major investment houses.Many reserve managers, while drawing on such industry mea-sures, choose to define and construct their benchmarks with

more specific regard for the objectives, operations, and risksof the reserve management entity.

Box 2. Adverse Reserve Management Experiences

External Market-Based Risks

Liquidity risks. The pledging of reserves as collateralwith foreign financial institutions as support for loansto either domestic entities or foreign subsidiaries ofthe reserve management entity has rendered reservesilliquid until the loans have been repaid. Liquidityrisks have also arisen from the direct lending ofreserves to such institutions when shocks to thedomestic economy led to the borrowers’ inability torepay their liabilities, and impairment of the liquidityof the reserve assets.

Credit risk. Losses have arisen from the investment ofreserves in high-yielding assets that were made withoutdue regard to the credit risk associated with the issuerof the asset. Lending of reserves to domestic banks,and overseas subsidiaries of reserve management enti-ties, has also exposed reserve management entities tocredit risk.

Currency risk. Some elements of currency risk maybe unavoidable with reserve asset portfolios. Therehave, however, been instances where large positionswere taken in other countries’ currencies in anticipa-tion of favorable future changes in major cross-rates,but where subsequent adverse exchange rate move-ments led to large losses.

Interest rate risks. Losses have arisen on reserveassets from increases in market yields that reducedthe value of marketable investments below theiracquisition cost. Losses have also arisen from opera-tions involving derivative financial instruments,including the taking of large positions, which have been subject to the effects of sharp and largeadverse movements in market yields. In someinstances, reserve managers may have had an inadequate understanding of all the characteristicsand risks of the instruments used, and may also

have lacked the technical skills required to manageexposures.

Operational Risks

Control system failure risks. There have been a fewcases of outright fraud, money laundering, and theftof reserve assets that were made possible by weak ormissing control procedures, inadequate skills, poorseparation of duties, and collusion among reservemanagement staff members.

Financial error risk. Incorrect measurement of the netforeign currency position has exposed reserve man-agement entities to large and unintended exchangerate risks, and led to large losses when exchange ratechanges have been adverse. This has also occurredwhen risk has been measured only by reference to thecurrency composition of reserves directly under man-agement by the reserve management unit, and has notincluded other foreign-currency-denominated assetsand liabilities on and off the reserve managemententity’s balance sheet.

Financial misstatement risk. In measuring and report-ing official foreign exchange reserves, some authori-ties have incorrectly included funds that have beenlent to domestic banks, or the foreign branches ofdomestic banks. Similarly, placements with a reservemanagement entity’s own foreign subsidiaries havealso been incorrectly reported as reserve assets.

Loss of potential income. A failure to reinvest fundsaccumulating in clearing (nostro) accounts with for-eign banks in a timely manner has given rise to theloss of significant amounts of potential revenue. Thisproblem arises from inadequate procedures for mon-itoring and managing settlements and other cashflows, and for reconciling statements from counter-parts with internal records.

currency, or in specific currencies to facilitate debtservicing. It may also wish to consider whether othermajor liquid currencies should be held for purposesof hedging currency risk in the portfolio vis-à-visother liabilities.

A number of reserve management entities alsosubdivide their reserves portfolio into “tranches”according to liquidity and investment objectivesand policy requirements. A “liquidity tranche”would reflect transaction and/or interventionneeds based on the assessment of potential needfor liquidity on demand. Such portfolios are typi-cally invested in the most liquid and risk-averseinstruments. For reserves that are held to providean additional cushion, but are less likely to bedrawn upon, an “investment tranche” may be cre-ated where greater emphasis is placed on return aswell as safety and liquidity. The relative size of eachtranche may be determined as part of an assess-ment of reserves adequacy, and each tranchewould have a separate benchmark reflecting thedifferent objectives. In some countries, tranching isalso used to immunize market and foreignexchange risks on the reserve balance sheet, byestablishing characteristics for a particular assetportfolio that match those of a group of counter-part foreign liabilities.

The risk management framework should applythe same principles and measures to externallymanaged funds as it does to those managed inter-nally. Many reserve management entities allocatepart of their reserves to one or several externalinstitutions for management. External managersmay have skills that the reserve management entitylacks, or they may provide a level of safety to foreignoperations that the entity is unable to achieve. Theymay, for example, have skills and established sys-tems for undertaking investment activities in spe-cialized instruments and markets for which thereserve manager does not wish to develop a capa-bility. Alternatively, they might provide access tonew markets and activities or new investment strate-gies in which the reserve management entity isseeking to expand its operations. Finally, they mayalso assist smaller reserve management entities inmanaging or reducing the costs of maintaining areserve management operation in a particular mar-ket or instrument.

Sound risk management of externally man-aged funds begins with the careful selection of rep-utable external managers, and a clear mandate forthe managers to follow, together with agreedunderstandings of expected performance andtracking error. These arrangements should be setout clearly in separate written contracts with eachappointed manager to ensure accountability. It isalso important that appointment of an externalmanager not result in the reserve managemententity accepting operations and risks that wouldnot normally be considered, or are not fully under-stood. Appointment of external managers can alsohave implications for the reserve manager’s choiceof a custodian for its foreign securities. Generally,there should be a clear “firewall” separationbetween any external management and custodialfunctions performed by any one entity.

In principle, and in practice, there should beno difference between the risk management andperformance-monitoring framework that is appliedto externally and internally managed portfolios.Most likely it will, however, be necessary to establisha separate unit, or assign a position within the mid-dle office, to enable the reserve management entityto fully monitor the activities of the external man-ager and custodians.

Risk exposures should be monitored continu-ously to determine whether exposures have beenextended beyond acceptable limits. Monitoring isessential in identifying and limiting any cumulativelosses associated with either deviations from thebenchmark, any underperformance of the portfo-lio vis-à-vis the benchmark, and increases in expo-sures associated with the benchmark itself due tomarket developments or structural changes. Sincerisk is inherent in both benchmark31 and actualportfolios, monitoring should occur regardless ofwhether “passive” or “active” reserve managementapproaches are adopted.32 VaR or other simulation


31All benchmark portfolios, for example, reflect tolerance for risk that can, and will, vary among reserve managemententities.32Reserve management strategies can reflect varying choicesbetween approaches that are generally described as either activeor passive management. These terms, however, can be under-stood in different ways. Sometimes, a buy-and-hold-only strategyis viewed as passive management. The more generally accepted

methodologies may also form an integral part ofthe risk management and monitoring framework.

Reserve managers should be aware of and beable to account for potential financial losses andother consequences of the risk exposures they areprepared to accept. Active management based onexpectation of movements in interest rates orexchange rates, or a choice by the reserve manage-ment entity to accept a higher risk tolerance in its

benchmark portfolios, requires that management isable to monitor and control any cumulative finan-cial losses. Implicit in such an environment is theneed for specific and monitorable risk limits on theextent to which managers can deviate from thebenchmark, and a reliable and timely accountingsystem for measuring and reporting exposures andlosses. In addition to possible financial losses, otherconsequences can occur, such as the risk of adversesignaling to participants with respect to monetaryand exchange policies, damage to the reputation ofthe reserve management entity, and, possibly, abreach of a country’s obligations in terms of theFund’s Articles of Agreement. In this latter context,reserve management entities need to be aware oftheir country’s obligations to collaborate with theFund and other member countries to ensureorderly exchange arrangements (Article IV.1) andconsistency of policies on reserve assets in promot-


Box 3. Benchmark Portfolios and Risk Management

Senior management needs to specify a strategiclong-term portfolio that represents the best availabletrade-off between the different risks that the reservemanagement entity is facing. This is the entity’s invest-ment benchmark, which is made operational throughthe construction of actual benchmark portfolios thatinclude the chosen currencies with desired weights,investment instruments with appropriate credit char-acteristics, and duration that reflects the desired levelof interest rate risk. The benchmarks should notinclude transient factors or reflect short-term marketexpectations, but their appropriateness should bereviewed regularly. Changes to the benchmark wouldbe triggered by changes in market structure or char-acteristics that alter the investment environment. Theadoption of investment benchmarks is a sound prac-tice that brings discipline to the investment process.

There are various approaches to measuring riskand controlling exposures as a result of deviationsfrom the benchmark. Typically, such exposure is lim-ited by the setting of quantitative limits on the size ofany deviation from the benchmark in terms of cur-rency, duration, or credit that may be permitted bythose responsible for the investment of reserves.Currency risk is usually managed through quantita-tive limits on how much each individual currency, or

all currencies in the benchmark taken together, maydeviate from the benchmark structure. Interest raterisk can be managed by establishing benchmarks witha given duration and by limiting the actual portfolio’sdeviation both in terms of duration and yield curvemismatches. Credit (default) risk has traditionallybeen managed by placing limits on eligible issuers orcounterparties based on their capital and ratings. VaRmethodologies can also be used to provide a quanti-fied estimate of the maximum potential loss, with agiven probability and time horizon, resulting fromdeviations from the benchmark portfolio.

Investment benchmarks are an important tool forassessing performance and enforcing the account-ability of reserve managers. Where managers are per-mitted to deviate from the benchmark portfolio,performance assessment and accountability will occurthrough the comparison of performance of the actualportfolio with that which could have been generatedby holding the benchmark portfolio. Where portfoliomanagers seek to replicate the benchmark, assess-ment of performance would also be based on com-parison of actual performance versus the benchmark.In both cases, the benchmark establishes the refer-ence point for the reserve management entity’saccountability in terms of its choice of risk tolerance.

view of passive management is one where the risk characteristicsof the portfolio replicate those of the benchmark. In this case,portfolio managers take no view on the direction of the market(i.e., the rate of return provided by the benchmark isaccepted). However, over time, transactions would be necessaryto maintain the alignment of the portfolio with the predeter-mined benchmark. This is the kind of passive management dis-cussed here. Active management implies that the actualportfolio deviates from the benchmark as managers take viewson the direction of the market or some of its components.

ing better international surveillance of interna-tional liquidity (Article VIII.7). Accordingly, gover-nance arrangements to avoid such instances mightinclude the requirement for investment committeeapproval of changes to benchmark parameters orportfolio allocation policies.

The risk management framework should alsoaddress risks associated with derivative financialinstruments and other foreign currency opera-tions. As noted earlier, derivative instruments maybe used as part of reserve management operations,particularly in reducing risk exposures. Effectiverisk management requires that the reserve man-agement entity is aware of and understands therisks and benefits of these instruments, and thatstaff has a sound knowledge of the underlying risksand the modalities of particular instruments used.It also requires reserve management systems thatare sufficiently developed to properly measure thevalues and exposures associated with operations. Asthe use of derivatives and other structured finan-cial instruments grows, legal risk issues becomeparticularly relevant. In this regard, risk mitigationcould involve the use of standardized legal docu-mentation and the performance of periodicreviews of documentation.

Beyond their reserve management operations,some reserve management entities also have otherfunctions that involve foreign-currency-denomi-nated assets and liabilities both on and off balancesheet.33 While such operations do not fall withinthe definition of reserve management operations,per se, they may, nonetheless, represent an impor-tant part of a reserve management entity’s broadermandate and involve policy choices in the utiliza-tion of the country’s foreign exchange resources.

The reserve management entity, therefore,may be exposed to a range of additional risks thatneed to be managed in a coordinated and consis-

tent manner. In this regard, a comprehensive assetand liability risk management framework could beused to address the overall risk exposure of thereserve management entity’s entire balance sheetand, in doing so, reduce the risk of loss or impair-ment of reserves.

To assess the risk and vulnerability of thereserve portfolio, the reserve management entityshould regularly conduct stress tests to ascertainthe potential effects of macroeconomic and finan-cial variables or shocks. Stress testing can have sev-eral objectives and is often conducted usingfinancial models ranging from simple scenario-based models to more complex models involvingsophisticated statistical and simulation techniques.One objective typically is to determine the expo-sure of the portfolio to changes in market factors,such as changes in exchange rates or interest rates,often by using VaR models.

A second objective concerns assessing the pos-sible impact on the level of official foreignexchange reserves of external shocks, contingentobligations that might materialize with suchshocks, and sudden calls on reserves that mayresult from a reversal of short-term capital flows orclosing out of the open foreign exchange positionof the commercial banking system. Stress testing inthis context is qualitatively different from measur-ing changes in the market value of the portfolio,and can be particularly useful in the formulation ofasset and liability management and strategic assetallocation policies to ensure reserve availabilityduring times of external stress.

5. Role of Efficient Markets

Reserve management, and any related policyoperations, should be conducted in markets thathave sufficient depth and liquidity and can pro-cess transactions in a sound and efficient manner.Reserve managers need to be certain that reservescan be liquidated in a prompt and efficient man-ner to provide the necessary foreign exchange forthe implementation of policy objectives relatingto, for example, market intervention, meetingbalance of payments or debt-servicing needs, orlimiting external vulnerability. Policy actions, onthe other hand, can also involve the purchase of


33Examples of other foreign currency activities include theissue of foreign-currency-denominated securities to fund lend-ing to domestic entities, facilities to support exporter access topre- and post-shipment finance, placement of deposits withforeign subsidiaries of the reserve management entity, guaran-tees, and letter of credit facilities. In some cases, commitmentshave also been given to foreign supervisory authorities to sup-port the capital and liquidity of the reserve managemententity’s foreign subsidiaries.

foreign exchange that should be placed promptlyinto investment portfolios. In these situations,undertaking the relevant investment transactionsin deep and liquid markets serves to ensure thatthey can be easily absorbed by these markets andwithout undue impact on investment pricesreceived, or paid, by the reserve manager. Policyactions invariably, however, involve transactionsinitiated in the reserve management entity’sdomestic foreign exchange market, and that havea consequential implication for the reserve man-ager. In these circumstances, the effectiveness ofthe policy action will be dependent upon the effi-

ciency and soundness of the domestic market.Furthermore, and of particular relevance forreserve levels, any failings or operating weak-nesses in that market can directly impact eitherthe amount of reserves required to support thepolicy action or the amount of foreign exchangeadded to reserve holdings.

Undertaking transactions in deep and well-established markets ensures that reserve-relatedtransactions can be easily absorbed at market-determined prices without undue distortions oradverse impacts on the level and availability of for-eign exchange reserves.


Asset liability management. The management ofbusiness and financial risks by matching the finan-cial characteristics (on and off balance sheet) of anentity’s assets to those of its liabilities.

Back office. The area of reserve managementoperations responsible for confirmation, settle-ment, and, in many cases, reconciliation of reservemanagement transactions.

Benchmark. The mix of currencies, investmentinstruments, and duration that reflect the reservemanager’s tolerance for exposure to liquidity,credit, and market risks.

Credit risk. The risk of nonperformance or defaultby borrowers on loans or other financial assets, orby a counterparty on financial contracts.

Currency risk. The risk of adverse movements inforeign currency cross-exchange rates that reducethe domestic currency value of internationalreserves. Currency risk also arises with an apprecia-tion of the domestic currency.

Custodial risk. The failure of a foreign agent orcustodian to deliver securities held on behalf of thereserve manager.

Dealing risk. Dealers exceed their authority indealing with counterparties or instruments, orincorrectly process a transaction.

Duration. A measure of the sensitivity of a portfolioto movements in market yields by determining thetime-weighted average of the present values of allfuture cash flows of a security or a portfolio, dis-counted at current interest rates.

Financial error or misstatement risk. The failure ofthe accounting system and related controls toproperly record all transactions and accountingadjustments.

Front office. The area responsible for initiatinginvestment transactions in accordance withapproved delegations, limits, and benchmarks andthe prompt and accurate entry of transactions intothe investment management system.

Information technology risk. The failure of criticalelectronic data processing and communicationand information systems, thereby causing severedisruption to reserve management functions.

Interest rate risk. Sometimes also referred to as anelement of market risk, interest rate risk involvesthe adverse effects of increases in market yieldsthat reduce the present value of fixed interestinvestments in the reserve portfolio. Interest raterisk increases, ceteris paribus, with the duration ofa portfolio.

Internal audit. An independent source of assur-ance about the management of risks and the oper-ation of the control system that assists managementof an organization in the effective discharge of itsresponsibilities.

Legal risk. The possibility of losses from contractsthat are not legally enforceable or not properlydocumented.

Liquidity risk. Liquidity risk refers to the possibledifficulties in selling (liquidating) large amounts ofassets quickly, possibly in a situation where market

20

Glossary

conditions are also unfavorable, resulting inadverse price movements.

Market risk. Risks associated with changes in mar-ket prices, such as interest rates and exchangerates. Changes in interest rates affect market pricesof fixed-interest securities. Hence, shorter durationsecurities are less at risk than long-term, fixed-ratesecurities.

Middle office. Located between the front andback offices, the middle office’s role is to monitorthat all transactions have been performed prop-erly, that risks are being monitored and limitsobserved, and that relevant information is avail-able for management.

Official foreign exchange reserves. Those exter-nal assets that are readily available to and con-trolled by monetary authorities for directfinancing of payments imbalances, for indirectlyregulating the magnitudes of such imbalancesthrough intervention in exchange markets toaffect the currency exchange rate, and/or forother purposes.34 To meet this definition, reserveassets need to be liquid or marketable foreign cur-rency assets that are under the effective controlof, or “usable” by, the reserve manager and heldin the form of convertible foreign currency claimsof the authorities on nonresidents. To be recog-nized as part of official foreign exchange reserves,gold must be held by the monetary authorities asmonetary gold.

Operational risk. A range of different types of risks,arising from inadequacies, failures, or nonobser-vance of internal controls and procedures thatthreaten the integrity and operation of businesssystems.

Public debt management. The process of establish-ing a strategy for managing the government’s debtin order to raise the required amount of funding,

achieve its risk and cost objectives, and meet anyother sovereign debt management goals the gov-ernment may have set.

Reputation risk. A reserve manager’s reputationand credibility may be called into question as aresult of inappropriate reserve managementactions or unauthorized release of information.

Reserve assets. See official foreign exchangereserves.

Reserve management. The process by which publicsector assets are managed in a manner that pro-vides for the ready availability of funds, the pru-dent management of risks, and the generation of areasonable return on the funds invested.

Risk. The possibility of financial or other lossesarising from an entity’s financial exposures and/orthe failure of its internal control systems.

Safeguards Assessment. A two-stage evaluation of amember country’s central bank control, account-ing, reporting, and auditing systems to ensure thatresources, including those provided by the Fund,are adequately monitored and controlled. The firststage will determine whether there are clear vul-nerabilities in these systems, based on informationprovided by central banks. If weaknesses in inter-nal procedures are suspected, a second stage willcomprise on-site evaluations and recommenda-tions for improvements. Safeguards Assessmentsfor all new users of Fund resources began in mid-2000.

Settlement risk. The potential loss as a result of fail-ure to settle, for whatever reason other thandefault, by the counterparty.

Sovereign risk. The risk that a foreign sovereigngovernment will restrict the ability of holders togain access to their assets or the proceeds from thesale of such assets. Sovereign risk is an inevitablefeature of reserve management since assets arenecessarily held in foreign countries, often insovereign government securities of major invest-ment currencies, and for which there are no betterinvestment alternatives available.

Glossary 21

34Source: International Monetary Fund, 1998, Balance ofPayments Manual, 5th ed. (Washington: IMF), paragraph 424.

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