(i) Treasury transactions are highly leveraged, for very low fund they can take large positions which results in higher risks.
(ii) Large size of transactions done at the sole discretion of the dealer. Value of single transactions can range from Rs 5 crore to Rs 50 crore and any error of judgment of the dealer can cause losses of such huge amounts.
(iii) Loss is materialized in very short span of time and often doesn’t give time to set right the position or cover the losses. Since function of treasury is to operate in various markets, it faces all the risks associated with those markets namely, market risk, funding risk, interest rate risk, liquidity risk, counter party risk etc.
These risks need to be managed by conventional tools and supervisory measures in the following ways:
(i) Organisational control: Treasury department is divided into three offices, front office or dealing room, back office and middle office. This is done to ensure checks and balances within the system.
(ii) Internal controls: Internal controls mean internal control imposed by the Bank on position limits and stop loss limits. What are positions?
Suppose a Bank for the sake of trading profits enter into a deal to buy 1 million USD, 1 month from now at Rs 60. Now if after 1 month USD is valued at Rs 65 bank will make profit of Rs 50 lakh since it can buy USD at Rs 60 while their market value is Rs 65.
However, if after 1 month USD is valued at Rs 55, Bank will lose Rs 50 lakh.
Here the deal to buy 1 million USD is known as position of the Bank.
When the deal is to buy it is called long position, when the deal is to sell it is called short position.
As already stated earlier the deals are made by single dealer and that too quickly based on his assessment and judgment, if a dealer is allowed to make any size of deal he can even make a deal of 1 billion USD in which case bank in scenario 2 of dollar at Rs 55 will suffer loss of Rs 500 crore.
Thus there is a need to put restrictions on the deal size which a dealer can make.
Case II : Suppose a bank enters into a deal to buy 100 dollars at Rs 60, and at the same time enter into a contract to sell 100 dollars at Rs 61.
The position here is called covered position as bank has matched the buy and sells position and at the end of day Bank will make profit of Rs 100.
However, if bank has bought 100 dollars and at the end of day there is no customer to whom it can sell, bank faces risk. First it has blocked its money in buying the dollars and secondly value of dollar may fall from Rs 60, resulting into loss to the bank. This position here where buy and sell orders are not matched is known as open position. Bank imposes limits on these open positions