June 2015

Where geology meets operational risk: Post-trade risks... Settling the costs

As industry and regulators demand far greater levels of insight and awareness into trade execution and post-trade risks than ever before, as well as the effectiveness of the controls in place to reduce or mitigate these risks, Trax’s Camille McKelvey takes a look at the various post-trade challenges and what firms can do to avoid incorrect trade and settlement details.
 

Where geology meets operational risk

Foreword by Chris Smith, Head of Post-Trade Services at MarketAxess and Trax

Financial markets are far from simple. Investing in them, working in them, and regulating them have all become more complicated in the past 30 years. Deregulation, globalisation and a drive for improved investment returns has led to dramatic changes in market structure. However, the need for post-trade processes to improve efficiency and reduce operational risk remain constant.

In 1987, running a middle office operation for a large US investment manager, my goal was to prevent loss to our funds caused by failed trades. This was a simple measurement of operational risk. The world changed dramatically with the market crash of October 1987, and as a result, in 1989 the G30 published 9 recommendations aimed at improving the global financial markets. By 2004, under Basel II, global regulators had more broadly recognised operational risk, and the G30 themselves re-issued their 1989 report, now containing 20 recommendations. As a result of events in 2008 we were forced again to think about the effect of operational risk, its impact and management.

In responding to these disruptive events, market participants (and more recently regulators) have called for the implementation of new practices and sought greater amounts of transparency.

In fact, we can consider each major market event to represent a change in the post-trade era. Rather like the geology of our planet, post-trade has moved over the past 30 years through different eons:

It is clear that as firms, including service providers like Trax, involved in the increasingly complex financial markets, we have the responsibility to ensure that the processes and procedures we implement are aimed at reducing failed trades, improving the quality of reporting data and, most importantly of all, reducing cost and risk. Verification of data, of trades, and of processes is now an essential aspect of post-trade if we are to manage and control operational risk.

Introduction

The financial industry, and in particular its regulators, are demanding far greater levels of insight and awareness into trade execution and post-trade risks, as well as the effectiveness of the controls in place to reduce or mitigate these risks. Compliance regulations like the Basel Accords mandate a focus on operational risks which forces financial organisations to identify, measure, evaluate, control and demonstrate effective management in this area.

Core to these risks is the impact of incorrect trade and settlement details across the whole firm. Errors can result in much higher costs and risks in other parts of the business, however there is a disproportionate focus on the cost to the operational areas handling the settlement process.

Firms need accurate trade data on trade date. This isn’t just a settlement requirement; risk control, treasury, collateral management, management information, regulatory reporting, finance and other business functions are all dependent on trades being recorded correctly.

Errors need to be identified and corrected quickly. The longer this takes:

  • The greater the cost of fixing them across the firm

  • The greater the risk that a decision (or lack of a decision) results in a loss or regulatory breach

The bottom line is that, despite investment in post-trade middle office systems, in today’s world settlement processing doesn’t identify trade errors quickly enough. Batch processes and timing differences mean a minimum of several hours may lapse before issues are identified. In many cases it takes much longer – an average of 8% of trades are still unmatched on settlement date. How can managers know that the controls they are relying on are effective when they don’t have an agreed trade? How can they be confident they are going to hit the CSDR target of 99 .5% settlement, when currently we see around 97% in many of the liquid bond markets?

Drivers for Change

It stands to reason that the later a problem is identified and addressed, the higher the costs. For many years firms have been prepared to accept the costs and risks associated with late or delayed identification of errors in trade data as it was not considered material enough to justify management time and expense to address the causes. However, the markets are now waking up to the adverse implications (in terms of increased risk of regulatory breaches and adverse impact upon P&L) of any delay in identifying errors - whether that delay be on trade date or beyond. Firms now need to identify and correct trade data errors earlier in the trade life cycle.

Regulators expect that:

  • Firms will settle on time – CSDR introduces fines and mandatory buy-ins

  • The expected settlement rate under CSDR is 99.5% - however settlement rates are not currently at this level

  • T+2 is expected to become a global standard, with the US already working towards a timeframe for T+2 implementation

  • Firms will accurately report trades

  • Large fines have been levied on firms that failed to report trades accurately under MiFID I

  • SFTR and MiFID II introduce much more complex reporting requirements leading to much more data processing

  • Business managers will be individually accountable for the effectiveness of the controls upon which they rely to ensure compliance with regulatory standards for all or part of their business, and will be required to attest to the effectiveness of these controls

  • From the firm’s perspective, this increases the risk of enforcement action and penalties if a problem emerges

  • From the individual’s perspective, it means the risk of prosecution for knowingly or negligently providing incorrect or misleading information to the regulator

  • Regulatory breaches also carry the risk of significant damage to market reputation

In addition to fines, a further cost can also include the need to remediate using more expensive resources. The later exceptions are identified the more urgent they are. Accordingly, failure to address any issues with the trade data as soon as possible in the trade life cycle can often lead to unnecessary reliance on senior and more costly resources to address remediation. This isn’t just within settlements – this applies wherever the data needs to be amended.

Trade Confirmation Isn’t Just About Settlement

As time passes, trade data is processed by more business units and further commercial decisions are taken. Decisions based on incorrect data are likely to have both a material impact on risk levels (e.g. internal or counterparty risk monitoring) and cost (e.g. treasury, collateral management and stock lending). Identifying, communicating, and then unwinding these errors followed by taking the necessary corrective action is likely to be time-consuming and highly disruptive to the units affected. The longer the time lapse, the greater the disruption.

Settlement, including accuracy of standard settlement instructions (SSI’s), is very important. Firms can realise significant cost and risk reductions in this part of the business if they and their counterparties have the correct economic and settlement details. Settlement is not the only benefit of early trade confirmation, it also helps to manage risk monitoring, reporting etc.

Trax Trade Confirmation is a Key Control

Trax Match provides firms with the necessary automated and standardised matching process to identify and resolve cash and repo trade discrepancies in near real-time. Trax has a large post-trade cash fixed income community and has a growing percentage of the repo fixed income market. Trax Match provides an easy entry point for new firms looking for a solution.

Getting trades confirmed quickly depends on both counterparties having:

  • An accurate and immediate view of their full trade population;

  • A standard means of communicating and comparing all trades;

  • A process for investigating and resolving all differences.

Firms depend on their counterparties. If they are trading with entities that can’t provide all the necessary trade information in the required timeframes, using an agreed standard mechanism, then they are not going to be able to identify and resolve differences quickly enough to avoid unnecessary costs and risks.

Trax’s long-standing role in delivering industry infrastructure solutions has been built on its ability to work effectively with its clients, both individually and through its broader client forums. It has an agreed code of practice which, in conjunction with its clients, it continually develops to reflect changing market requirements. It provides firms with the support they need to modify or expand the use of the service within their firm. Trax can improve overall matching performance for the benefit of the whole community.

Quantifying Cost Savings

The focus on settlement impact alone and the difficulty in realising potential monetary savings in this area has historically deterred firms from looking to improve the efficiency of the post-trade correction process. Back office processing and control services are often outsourced or supplied as part of a fixed, long-term or firm-wide asset servicing arrangement. At times, securing budget to realise a saving that can’t be attributed to one particular area is also a challenge. Whilst savings are clearly realisable, it is often hard to monetise the benefits through lower operating costs until the relevant Service Level Agreement is reviewed.

However, there are other costs that firms can measure, especially in areas outside the settlement function, and these include:

Before Intended Settlement Date:

  • Lower costs for data remediation by other business functions (risk, regulatory reporting, treasury, collateral management, finance, etc)

  • Lower messaging and transaction costs from fewer amendments

  • Opportunities to use lower cost resources to resolve issues (less senior and in lower cost locations)

  • Lower borrowing costs (avoiding expensive auto-borrow costs)

  • Lower funding costs 

After Intended Settlement Date:

  • Internal and external reconciliations needed to indentify and address differences between actual and expected settlement

  • Avoiding buy-in costs

  • Avoiding regulatory capital charges

Firms are working hard to achieve reductions in operational risk. Although difficult to quantify, they include the risks associated with processes not operating correctly as a result of incorrect trade data, and cover:

  • Trade and/or transaction reporting errors resulting in significant fines

  • External counterparty risk monitoring errors resulting in credit losses

  • Internal risk monitoring errors resulting in losses

  • Regulatory breaches arising from incorrect Management Information and other data that may result in fines and other potential sanctions

  • Market fines from failing trades, and the market risk from having to close out a failing position in the market

  • The reputational impact of these events

Summary

Failing trades represent a significant direct and indirect cost to the financial services industry. The longer it takes to identify and address trade errors, the greater the costs and associated risks. Operations Management will strive in the coming years to satisfy their risk and control obligations by reviewing failing trades, and by doing so, ensuring compliance with regulatory timeframes. Effective management of underlying data, together with comprehensive community tools to ensure firms are matching and agreeing to the full details, including place of settlement within 15 minutes of trade time, is an essential aspect of cutting overall operational risk. What price do you place on incorrect risk and counterparty exposure figures? What is the cost to the management of your business in working with incorrect Management Information?