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Exchange Equalisation Account: Accounts 1997-8

CONTENTS

Introduction

1. The Exchange Equalisation Account (EEA) holds the United Kingdom's reserves of gold, foreign currencies and International Monetary Fund (IMF) Special Drawing Rights (SDRs). These holdings, together with the United Kingdom's reserve tranche position⁽¹⁾ at the IMF, make up the United Kingdom's official reserves.

Origin and purpose

2. The EEA was established in 1932 to provide a fund which could be used for "checking undue fluctuations in the exchange value of sterling"⁽²⁾. Any UK Government intervention would therefore be conducted through the EEA⁽³⁾. Subsequent legislation extended the possible use of the fund; and, under the consolidating Exchange Equalisation Account Act 1979, it is now also used:

- to secure the conservation or disposition in the national interest of the means of making payments abroad; and

- for certain purposes arising from the United Kingdom's membership of the IMF, including the holding, purchase and sale of SDRs.

3. Under the Act the funds in the EEA may be invested in any assets denominated in the currency of any country; in the purchase of gold; or in the acquisition of SDRs.

Audit and Publication

4. There is no statutory requirement for financial statements to be prepared and published for the EEA. However, the Exchange Equalisation Account Act 1979 requires the Comptroller and Auditor General (C&AG) to certify to the House of Commons that the operations on, and transactions in connection with, the EEA have or have not been in accordance with the provisions of the Act. The financial statements for the EEA which the Treasury has prepared using returns supplied by the Bank of England have been audited by the National Audit Office (NAO) following a recommendation by the Committee of Public Accounts in its 8th Report of 1989-90. The NAO's audit opinion on the 1997-98 financial statements can be found on pages 28-29.

5. The EEA's financial statements are being published for the first time following the Chancellor's announcement of 22 September 1997 that he was "opening up the books" on the UK's reserves of foreign currency and gold. The financial statements do not include any comparative figures for 1996-97 as they would relate to a period under the previous administration which, by convention, remains confidential. The financial statements are produced in accordance with the Accounts Direction which is reproduced at page 34.

Statement of the Accounting Officer's Responsibilities

6. Treasury have appointed an Accounting Officer for the EEA. His relevant responsibilities as Accounting Officer, including the propriety and regularity of the public finances for which he is answerable and for the keeping of proper records, are set out in the Accounting Officers' Memorandum issued by the Treasury and published in "Government Accounting".

Administration and control

7. The EEA is under the control of the Treasury which has appointed the Bank of England to act as its agent. The Bank carries out the day-to-day dealing in foreign currencies and the investment of the reserves. The Bank's management costs are charged to the EEA.

8. The Treasury set the Bank an annual Remit for the management of the reserves. The Remit specifies:

• any change in the level of the reserves for the year,

• benchmarks for investing the reserves with limits to the Bank's discretion to take currency or interest rate positions relative to these benchmarks,

• the framework for controlling credit risk,

• it also specifies the National Loans Fund (NLF) foreign currency borrowing programme which is partly used to finance the reserves.

The Remit can be reviewed during the year at the Bank or the Treasury's request.

9. Every six months the Accounting Officer and the Bank's Executive Director for Financial Market Operations review the Bank's performance at managing the reserves. These are supplemented by monthly meetings between the Treasury's Debt and Reserves Management Team and the Bank's Foreign Exchange Division. The Bank provides the Treasury with a daily report on the level of the reserves.

10. The EEA's assets are held by a range of custodians. US treasury bonds and bills are held on our behalf by Chase Manhattan and the Federal Reserve in New York. Bunds (German government bonds) are held by Deutsche Bank. Most other European government bonds are held by Chase but some are held at Euroclear⁽⁴⁾. JGBs (Japanese government bonds) are held at the Bank of Japan. Canadian Government bonds are held by Royal Trust (part of the Royal Bank of Canada). Eurobonds and short term credit instruments such as certificates of deposit and commercial paper are held in Euroclear and Cedel. SDRs are entries in the IMF's books. Gold bars and gold coins are held by a number of central bank custodians.

Links to the National Loans Fund

11. Looked at in isolation the EEA gives an incomplete picture of the Treasury's overall foreign currency asset and liability position which also includes NLF foreign currency debt and the UK's reserve tranche at the IMF (an NLF asset). Table 1 below summarises the Treasury's total foreign currency assets and liabilities i.e. it combines the EEA and NLF foreign currency assets and liabilities. Assets and liabilities are valued in Table 1 at their market value at the balance sheet date.

Table 1: HM Treasury Foreign Currency Assets and Liabilities (£mns)

Note: The above Mark-to-Market balance sheet has been derived from the Bank's unaudited internal management information systems. It includes forwards and other off-balance sheet positions (the present value of these future cash flows is included in the asset lines). These are some of the reasons why there will be differences between the asset values shown above and in the EEA's statement of assets and liabilities on pages 17 and 18.

12. The EEA's exposures are managed alongside those of the NLF. For example, when the NLF borrows in a foreign currency it assumes the currency and interest rate risk as it sells the foreign currency to the EEA for sterling. Typically through its investments the EEA will take an offsetting currency and interest rate position so that the Treasury's exposures as a whole are controlled. This does, however, mean that the EEA's returns looked at in isolation give an incomplete picture of the Treasury's overall returns on its foreign currency assets and liabilities. The return information given below in paragraph 25 which has been extracted from the Bank's internal management information system combines the EEA and NLF foreign currency exposures.

Investment Policy

13. The foreign currency reserves held in the EEA to provide the wherewithal for intervention in the foreign exchange market need to be carefully managed to ensure their liquidity and to avoid exposing the public purse to unnecessary risk. Market risk (exposure to movements in either exchange rates or interest rates) is carefully controlled both in financing the EEA's reserves and in limiting the Bank's discretion to actively manage them. While the EEA was not set up to make a profit, achieving value for money means that the Treasury and the Bank seek to maximise returns on the foreign currency balance sheet, taking assets and liabilities together, subject to controlling risk and ensuring liquidity.

14. Largely financing the foreign currency reserves by borrowing in foreign currency limits the Treasury's exposure to fluctuations in sterling. When sterling appreciates, as it did during 1997-98, the value of the EEA's foreign currency assets falls in sterling terms but the value of the NLF's foreign currency debt also falls. As Table 1 illustrates, while the Treasury's reserves of foreign currency and gold totalled £22,448 million at the end of 1997-98, its exposure to currency movements (and the gold price) was largely limited to the net assets valued at £8,568 million as most of the currency exposure on the assets is hedged by the foreign currency liabilities valued at £13,880. There is, however, a net currency exposure and this needs to be controlled. Taking account of past patterns of risk and return the benchmark for net currency exposures in 1997-98 was 40% US Dollar, 40% deutsche mark and 20% Yen.⁽⁵⁾ This is reflected in the differences between the level of foreign currency assets and liabilities in the US dollar bloc, European bloc and in yen at the balance sheet dates. The overall currency composition is determined by the "40:40:20" benchmark for the net reserves combined with the composition of the NLF's foreign currency liabilities. As most of the foreign currency liabilities are denominated in US dollar or European bloc currencies, yen assets make up much less than 20% of total foreign currency assets although the yen share of net currency assets was 20% at the balance sheet dates.

15. Interest rate risk is controlled by matching the risk characteristics, for example the maturity, of the EEA's assets to the NLF's foreign currency liabilities. The net currency assets are invested in short term money market instruments to control the residual interest rate risk.

16. The 'benchmark' for investing the reserves during 1997-98, against which the actual return can be measured, was the return to keeping currency exposures split 40:40:20 between US dollar, deutsche mark and yen and limiting interest rate exposure to 1 month on the net currency reserves. The composition of the currency risk can vary from the benchmark or the Treasury can take on interest rate risk, as a result of decisions taken by the Treasury or the Bank. Any intervention to influence the level of sterling would change the level and possibly composition of the currency risk.

17. Decisions by the Treasury on advice from the Bank to set deviations from the 40:40:20 currency benchmark or the one month interest rate benchmark (denoted 'strategy positions') would only be taken if it was thought markets were showing a fundamental misalignment. This discretion is rarely used. No such 'strategy positions' were in place at the start of 1997-98 and no strategy positions were taken during 1997-98.

18. As part of its active management, the Bank can run currency or interest rate risk on the reserves within the following limits. On currencies, deviations from the 40:40:20 benchmark must be limited to the equivalent of $300mn for each currency . On interest rates, exposure to parallel shifts in each of the dollar, deutsche mark or yen yield curves had to be limited to a $200,000 profit/loss per 1 basis point shift during 1997-98. The Bank made little use of its discretion to take currency or interest rate risk during 1997-98. The maximum month-end currency divergence was long $6mn dollars and $10mn worth of yen and short $16mn worth of deutsche marks at the end of November. Maximum month-end interest rate divergences from the benchmark were (profit/loss per 1bp shift) $18,000 for the dollar yield curve at the end of July 1997 and minus $11,000 for the deutsche mark yield curve at the end of November 1997. Divergences were under $1,000 for the yen yield curve throughout the year. Overall interest rate exposures to parallel shifts in the yield curve at the end of March 1998 were (profit/loss per 1bp shift) under $1,000 for the dollar and yen yield curves and $13,000 for the deutsche mark yield curve.

19. Limits and measuring exposures to parallel shifts in yield curves does not tell the whole picture on interest rate exposures. During 1998-99 the Bank is introducing a new management information system that will enable value at risk (VAR) limits to be implemented. Value at Risk measures the aggregate market risk on a portfolio. Specifically the maximum potential change in the value of a portfolio with a given probability over a given time horizon. For example, "95% of the time losses will not exceed $10mn over a two week period". These value-at-risk estimates are based on the past volatility of returns on different asset classes and how the returns on each asset class are correlated with others held in the portfolio.

20. Investments need to be highly liquid so they can be made available quickly for intervention purposes if necessary and carry minimal credit risk. Essentially this means that the bulk of the assets are securities issued by the national governments of the United States, France, Germany and Japan and currency deposits with highly rated banks. During 1997-98 the EEA also made use of other financial instruments including:

• bonds issued by supra-national organisations and agencies guaranteed by national governments,

• foreign currency spot, forward and swap transactions,

• interest rate and currency swaps,

• bond and interest rate futures,

• sale and repurchase agreements,

• forward rate agreements,

• gold deposits, gold loco and gold quality swaps,

• special drawing rights (SDRs),

• and corporate commercial paper.

The EEA did not use options during 1997-98.

Credit Risk

21. The management of the reserves involves exposure to the credit-worthiness of commercial banks. Part of the Bank's reserve management function is to measure and manage these exposures based on an assessment of each bank's creditworthiness. Credit exposures to banks are monitored on a daily basis against set limits. On occasion it may be necessary to exceed limits for operational reasons but the control framework ensures that this is only done with the prior approval of Bank senior management. A report of any overall exposure limit excesses is sent to the Treasury each month.

22. Limits are set for each type of credit exposure in each country. For instance there are limits for foreign and domestic currency credit exposures for each sovereign issuer. In addition there are limits to reflect the overall exposure to each country's payment systems. Further limits have been established for holdings of commercial paper issued by AAA/Aaa rated corporates.

23. The bonds held by Chase, Deutsche and Royal Trust participate in their lending programmes. These programmes involve lending the bonds against collateral consisting of either other government bonds or cash. The custodians are permitted to invest cash collateral in money market instruments ranging from US government agency repo to bank deposits. The credit limits delegated to the custodians are deducted from the limits available to the Bank for its own EEA fund management activities. Any maturity mismatch of the collateral held and the corresponding investments is strictly limited. Daily reports are received to check compliance with the investment constraints.

Evaluation of the Bank's Management of the Reserves

24. The Bank's internal unaudited management accounting system is designed to calculate the sterling return earned by the Treasury on its reserves⁽⁶⁾. By convention these are split into the 'borrowed reserves' - the assets financed by borrowing in foreign currency - and the 'net currency reserves' - the remaining foreign currency assets (effectively financed by sterling borrowing and the EEA's net SDR liability) plus the forward book. The 'forward book' comprises outstanding commitments to buy or sell foreign currency for sterling. The overall return can be split into:

(a) the return on holding foreign currencies: this identifies the return from holding the ' net currency reserves' in the 'neutral' 40:40:20 benchmark. The sterling borrowing is assumed to be raised at 1 month sterling LIBOR less 25 basis points, while the 'neutral' benchmark is assumed to earn 1 month LIBOR less 25 basis points in US dollars, Deutschemarks and Yen; and

(b) the return to the hedges: the hedges are hypothetical portfolios identified by the Bank consisting of a set of assets which as closely as possible have the same risk characteristics as the liabilities that finance the 'borrowed reserves' (for the US Dollar portfolio a hedge would typically comprise US Treasuries with a similar maturity to the NLF's dollar liabilities). The hedges can be regarded as minimum risk portfolios. The returns to the hedges are the returns that would have occurred had the actual assets held been those of the hypothetical hedges.

(c) returns to active management: this is the overall return on the reserves less the 'return on holding foreign currencies' and less the 'returns to the hedges'.

Returns in 1997-98

25. The management information system disclosed a total sterling return on all of the Treasury's reserves of -£271 million, made up as follows:

£ million

26. The negative return on holding foreign currencies reflected the appreciation of sterling during 1997-98.

Gold

27. The EEA continued its practice of lending part of its gold holdings to market participants. 70 tonnes was available for lending during the year. Interest received during 1997-98 amounted to £7 million.

28. The market value of the EEA's holdings of 23 million ounces fell from £4,920 mn to £4,142 mn over the year. This includes the gold pledged to the EMI (see paragraph 38) which is not included in the assets and liabilities statement set out on pages 17 and 18. Also note that in the financial statements gold is valued at a discount to its market value (Accounting policy 1 (c) on page 19).

Review of Activities during 1997-98

Intervention

29. There was no intervention in the foreign exchange market during 1997-98 to influence the level of sterling.

Provision of foreign currency services to Departments.

30. The EEA continued to provide foreign currency services to various Government Departments and agencies i.e. sales of foreign currency to departments with foreign currency obligations and purchases of foreign currency from Departments with foreign currency receipts. Over the year these purchases and sales were offset by transactions with the market.

Loans to the IMF

31. At various times during the year the IMF called on the UK's quota at the Fund. This resulted in an increase in the UK's reserve tranche position at the Fund from the SDR equivalent of £1,363mn at end-March 1997 to the SDR equivalent of £1,752mn by end-March 1998. To avoid the Treasury's foreign currency exposures increasing when the IMF calls for funding (which is provided in sterling but results in an increased SDR asset), the EEA bought the sterling back from the IMF using some of the currency reserves.

Foreign currency borrowing programme

32. The foreign currency borrowing programme comprises NLF foreign currency liabilities. The foreign currency receipts are sold to the EEA (for sterling) and partly finance the reserves. The Treasury continued with its regular auction programme in ECU bills and maintained the total outstanding at ECU 3.5bn. ECU 2bn of ECU Notes were issued to refinance the 1998 ECU Note which matured in January 1998. The UK Government's deutsche mark bond maturing in October 1997 was not refinanced.

Level of the Reserves

33. Overall there was a fall in the level of reserves in sterling terms as the deutsche mark bond was not refinanced, sterling strengthened and the gold price fell.

Financial Statements

34. The financial statements of the EEA comprise a Receipts and Payments Account, a Statement of Assets and Liabilities and supporting notes. The Receipts and Payments Account is a cash account which measures the level of the EEA's turnover for the year. The Statement of Assets and Liabilities records the EEA's (but not the NLF's) assets and liabilities including its sterling balance at the Paymaster General. Assets are valued at their weighted average historic cost in their original currency of issue but for balance sheet purposes this historic cost is converted to a sterling equivalent using year end exchange rates.

35. Before drawing any inferences from the attached financial statements the reader should remember that they only cover the EEA's assets and liabilities. As explained above the EEA's exposures are managed together with the NLF's. Currency or interest rate movements that generate a gain or loss to the EEA may well therefore have an equal and offsetting impact on the NLF. The management accounting data presented above combines the EEA and NLF's foreign currency assets and liabilities. Furthermore the EEA's financial statements are currently constructed on a cash rather than an accruals basis and assets are valued using a modified historic cost basis rather than at their open market values. For example, this means that the financial statements make no allowance for variations in the prices of bonds the EEA holds until such time as they are sold and no allowance is made for any 'mark-to-market' gains or losses on uncompleted contracts such as forward commitments to purchase foreign currency.

36. The Bank is hoping to introduce a new accounting system by the end of 1999-00 based on UK GAAP accounting methodology. As well as reporting the EEA's returns on a UK GAAP basis, we plan in future to publish a proforma set of financial statements using UK GAAP accounting which combines the NLF and EEA foreign currency assets and liabilities. This should generate meaningful profit/loss figures for the Treasury's foreign currency exposures as a whole which can be audited by the NAO. For more information about the NLF see the 'Consolidated Fund and National Loans Fund Accounts 1997-98 Supplementary Statements' published December 1998 by The Stationery Office.

37. The high level of reported turnover on the Receipts and Payments account reflects the current accounting methodology. In the case of a deposit in dollars for example, the initial placement of a deposit is scored as a sale of dollars (cash) and a purchase of dollars (deposit). When the deposit matures another sale and receipt is scored. Each of these transactions are converted into sterling at the market exchange rate ruling at the time of the transaction. Rolling over short term deposits contributes to the level of turnover. For example an overnight deposit of $100mn rolled over throughout the year would contribute $50billion (plus interest) to the turnover. The use of swaps for liquidity management and for rolling the forward book is also significant.

38. As a member of the European Monetary System the UK swapped 20 per cent of its gold holdings and 20 per cent of its gross dollar reserves with the European Monetary Institute (EMI) during 1997-98 in return for an equivalent value of official ECUs. Each swap was for three months, at the end of which the swap was unwound and a new swap entered into. The swaps reduced the level of gold and dollars on the EEA's statement of assets and liabilities and increased the holdings of ECUs.

39. 'Payments' of interest represent the accrued interest element of bonds purchased by the EEA in the year. Recorded purchases of gold exceeding sales reflects fluctuations in the sterling price of gold between the dates gold was placed on deposit and when the deposit matured combined with changes to the maturity profile of the EEA's gold deposits.

G O'Donnell H M Treasury

Accounting Officer 1999

ACCOUNT OF RECEIPTS AND PAYMENTS IN THE YEAR ENDED 31 MARCH 1998

G O'Donnell
H M Treasury Accounting Officer 1999

STATEMENT OF ASSETS AND LIABILITIES

G O'Donnell
HM Treasury Accounting Officer 1999

NOTES TO THE FINANCIAL STATEMENTS FOR THE YEAR ENDED 31 MARCH 1998

1. Accounting Policies

(a) The financial statements are prepared on a cash basis with all transactions being accounted for on settlement. Purchases and sales of securities and currencies include purchases of foreign currencies with sterling but they also include inter alia;

- purchases of foreign currency with another foreign currency;

- placing (purchasing) foreign currency deposits with foreign currency and the maturity of foreign currency deposits for foreign currency;

- purchases of securities denominated in foreign currency with foreign currency and the sale of such securities for foreign currency.

(b) Transactions in foreign currency, ECU, Gold and IMF SDRs are translated at the market price or exchange rate ruling at the date of the transactions.

(c) Stocks of gold held at the year end are valued at 75 per cent of the average of the daily final London fixing price over the three months to the balance sheet date. This policy has resulted in gold balances at 31 March 1998 being valued at £134.019 per troy oz.

Foreign currency, ECU and IMF Special Drawing Rights deposits are translated into sterling at the year end using market exchange rates ruling on the last working day in March.

(d) Investments are not revalued at the balance sheet date, but are carried at their average historic cost unless determined to have suffered a permanent loss of value in which case they are written off. No write-offs occurred during 1997-98. Holdings of foreign currencies are primarily invested in securities.

2. Transfers of sterling between the EEA and the National Loans Fund

The sterling balance in the EEA is held in cash at the Paymaster General. When the sterling balance falls it can always be increased by a fresh issue of capital from the NLF under the terms of section 7 of the National Loans Act 1968. This in turn creates a liability on the EEA to the NLF. No interest is charged on these liabilities. Conversely, when foreign currency is sold for sterling with the result that the sterling balance is in excess of the EEA's requirement, the Treasury can decide that some reduction should be made by a transfer from the EEA to the NLF. This reduces any outstanding liability of the EEA to the NLF. If there is no outstanding liability the sterling transfer is a 'capital repayment'.

Sterling transfers during the year were as follows:

The liability to the NLF was repaid during the year. Additionally a capital repayment of £3,000mn was made to the NLF (Note 3). Therefore total transfers to the NLF were £6,450 million.

3. Retained Surplus

The retained surplus represents the difference between the EEA's total assets and liabilities. The movement in that surplus during the year was as follows:

4. Unrealised valuation gains(losses) during the year

Unrealised valuation gains and losses result from movements in sterling against the associated foreign currencies in which the bulk of the EEA's assets and liabilities are denominated. Such gains and losses result from movements in exchange rates between the date of the original transaction and the balance sheet date.

5. Uncompleted contracts

At 31 March 1998 there were outstanding commitments valued at £990 m for sale of holdings, resulting from forward sales and unsettled spot transactions.

6. Exchange cover scheme

The EEA reserves have been partly financed through the Exchange Cover Scheme (ECS). Under the ECS Local Authorities and Public corporations borrowed in foreign currency and sold the foreign currency to the EEA for sterling. The EEA is committed to sell back to the Local Authorities the foreign currency that they require to repay their borrowing at the same rate of exchange at which the initial borrowing took place.

For this "exchange cover" the EEA receives as premium all or a greater part of the difference between the rate of interest charged on the foreign currency borrowing and the rate which would have been charged on normal borrowing from the NLF by the body concerned. Until 1987, borrowers received a percentage of the interest rate difference as a benefit. If the foreign currency was borrowed at a floating rate of interest, and the rate at any time exceeds the appropriate NLF rate, the EEA pays the difference to the borrower. No foreign currency borrowing has received exchange cover since 1987 and none is planned.

7. Administration Costs

The following table sets out the administrative costs of EEA management.

* Total EEA assets at 31 March 1998 as shown in the EEA annual statement of account.

8. SDRs

The EEA has a liability to pay the IMF for those SDRs which were allocated to the UK when the UK became a participant in the Special Drawing Rights Agreement. Payment would be required at current exchange rates if the UK withdrew from participation or the Agreement were wound up. This liability was valued at £1,521 million at 31 March 1998.

9. Post Balance Sheet Events

On 7 May 1999 the Treasury announced a restructuring of the United Kingdom's official reserves, which involves a programme of gold auctions. Over the medium term HM Treasury has stated that it is planning to reduce the gold holdings to around 300 tonnes. In 1999 - 2000 the Bank of England, on behalf of HM Treasury, intends to sell approximately 125 tonnes of gold from the account in a programme of five auctions of 25 tonnes each. Detailed plans for sales in the year 2000-01 and later years will be announced nearer the time.

The introduction of the euro on 1 January 1999 changed the denomination of the EEA's foreign currency holdings in respect of those countries that joined the single currency.

GLOSSARY

AAA/Aaa rated the highest rating that can be assigned by the credit rating agencies. It rates the issuer's capacity to pay interest and repay principal extremely strongly.

Active Management is the difference between actual returns and the returns which would have been achieved from a passive investment strategy.

Basis Point (bp) is equal to 100^th of a percentage point, e.g. 0.5% is equal to 50bp.

Benchmark is a neutral or passive investment strategy which can be easily monitored to compare against actual performance.

Corporate Commercial Paper short term debt issued by companies.

Credit risk is the risk of financial loss arising from a counterparty to a transaction defaulting on its financial obligations under that transaction.

Currency Risk is the risk of financial loss arising from fluctuations in exchange rates.

ECU was the European Currency Unit, a weighted basket of EU currencies such as Sterling, Deutschmark and French Franc (now replaced by the euro).

ECU Notes three year marketable debt denominated in ECU issued by HM Treasury (now redenominated into euro).

Eurosystem is the area of 11 nations which adopted the Euro as a single currency on 1^st January 1999, and which will start using Euro notes and coins three years later

European Bloc Eurosystem currencies plus the Danish krone, the Swedish krona, the Norwegian krone and the Swiss franc.

Forward Book is the difference between aggregate forward commitments to sell sterling for foreign currency and forward commitments to buy sterling with foreign currency.

Forward Rate Agreement is a contract obligating two parties to exchange the difference between two interest rates at some future date, one rate being fixed now and the other being a future floating rate (e.g. LIBOR)

Forward transaction is an agreement to pay a specific amount at a specific time in the future for a currency or financial instrument.

Futures a contract to buy or sell a specified asset at a fixed price at some future time. Futures differ from forward contracts in that they are traded on a futures exchange. Initial and variation margin is also paid or received to eliminate any counterparty credit risk.

Gold loco swap exchange of gold in one location for gold in another location with a commitment to reverse the exchange at some specified future date.

Gold quality swap exchange of gold of one delivery standard (purity) for gold of another delivery standard with a commitment to reverse the exchange at some specified future date.

Hedge is an asset or derivative whose market risk offsets the risk in another asset held or liability.

Interest Rate Risk is the risk of financial loss arising from fluctuations in interest rates.

Intervention is the purchase or sale of domestic currency by central banks or governments with the intention of influencing the exchange rate.

Liquidity risk is the risk of financial loss that could occur should the reserves require restructuring. Liquidity is the ease with which one financial claim can be exchanged for another as a result of the willingness of third parties to transact in these assets.

Long is to buy an asset on the expectation that its price will rise. In the case of bonds this implies an expectation that interest rates will fall.

Market Risk is the risk of financial loss arising from movements in interest rates or currencies.

National Loans Fund (NLF) is the account used for most of the Government's borrowing transactions, payments of debt interest and some domestic lending transactions.

Operational risk is the risk of financial loss arising from the transaction, settlement and resource management processes associated with reserves and debt management. This broad definition includes risks such as fraud risk, settlement risk, IT risks, legal risk, accounting risk, personnel risk and reputational risk.

Reserve Tranche Position (RTP) is the difference between the IMF's holdings of sterling and the UK's subscription (or quota) to the IMF. In effect the amount of the UK's subscription the IMF has called. The RTP is a reserve asset as in the event of need the UK could exchange sterling for useable foreign currencies up to the value of its RTP.

Sale and Repurchase Agreements (repo) is the sale of an asset with an obligation to repurchase it at a fixed price at some future date. Essentially secured borrowing.

Short is to sell on the expectation that the price of the asset will drop below its prevailing market price. In the case of bonds this implies an expectation that interest rates will rise.

Special Drawing Rights (SDRs) is an international reserve asset created by the IMF. It is valued in terms of a weighted basket of four currencies (US dollar, yen, sterling and euro).

Spot transaction is an agreement to pay the prevailing market price for a currency or financial instrument for immediate delivery which for example means two days time for most major currencies.

Swap is a financial transaction in which two counterparties agree to exchange streams of payments occurring over time according to predetermined rules. Swaps are used to change the currency or interest rate exposure associated with investments.

US Dollar bloc US and Canadian dollar holdings.

US Government Agencies US entities carrying out public policy functions in the US which issue their own debt e.g. Fannie Mae. Typically their debt is not formally guaranteed by the US Government but they are usually considered to be very credit worthy.

Value at Risk (VAR) measures the aggregate market risk on a portfolio. VAR is an estimate of the maximum potential change in the value of a portfolio with a given probability over a defined time horizon given the historic pattern of movements in financial markets. For example, "95% of the time losses will not exceed $10mn over a two week period".

Yield curve plots the relationship between bonds' maturity and their yield.

[Audit certificate for 1997-98 account]

THE EXCHANGE EQUALISATION ACCOUNT

ACCOUNTS DIRECTION GIVEN BY HM TREASURY

1. The Treasury shall prepare accounts for the Exchange Equalisation Account ("the Account") for the financial year ended 31 March 1998 and subsequent financial years comprising:

(a) a foreword, which inter alia, incorporates a statement of the Accounting Officer's responsibilities and provides information on the origins and purpose of the Account, the audit and publication requirements, administration and control, links to the National Loans Fund, investment policy, credit risk, an evaluation of the Bank of England's management of the Account and a review of activities during the financial year;

(b) a receipts and payments account;

(c) a statement of assets and liabilities; and

(d) notes which set out the accounting policies for the Account and provide details of transfers between the Account and the National Loans Fund; returns on surpluses; unrealised valuation of gains/losses during the year resulting from movements in sterling against the associated foreign currencies in which the bulk of the Account's assets and liabilities are denominated; uncompleted contracts; the Exchange Cover Scheme (ECS); administrative costs; Special Drawing Rights (SDRs) and any other details as may be necessary.

2. The accounts shall properly present the receipts and payments for the period and the assets and liabilities of the Account as at the end of the financial year.

3. The foreword, the Account and the assets and liabilities statement shall be signed by the Accounting Officer and dated.

4. The accounts direction shall be reproduced as an annex to the Account.

Jamie Mortimer

Treasury Officer of Accounts

24 March 1999

1. The Glossary explains this and other terms.

2. Section 24 of the Finance Act 1932.

3. As set out in the Chancellor's letter of 6 May 1997 to the Governor of the Bank of England, the Bank of England can intervene in support of its monetary policy objective using the Bank's own resources rather than those of the EEA.

4. Euroclear and Cedel are depositories which hold securities on others' behalf and operate a clearing system for the purchase or sale of bonds.

5. This benchmark applied to currency exposures excluding the EEA's holdings of Gold and SDRs and the NLF's reserve tranche position at the IMF (because they are not "actively managed").

6. All EEA and NLF foreign currency assets and liabilities except for the gold and the reserve tranche at the IMF.

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