Chapter 2 Automating Trade and Order Flow

2.1 Introduction

Investment firms and broker-dealers have developed their own trading processes honed over time. Input from auditors, regulators, experience, and management have all had an influence in shaping the landscape for trade flow. Securities clearance and settlements also play a major component. It is important to balance risk, soundness, efficiency, and acceptable cost to link the process together. Technology solutions in the front and back office must be run in tandem, in terms of development rate and integration.

The financial industry has been proactively involved with the automation of trade processing. The processing environment is segregated among three subsets: pre-trade, trade, and post-trade (see Exhibit 2.1). In the post-trade sector, a vast number of nonprofessional staff are needed to process repetitive, data-intensive trade information. The personnel expense alone justifies the move to automation. Pre-trade activities have benefited immensely from the introduction of technology. Complex analytical work performed by asset managers and traders today was very difficult prior to the introduction of cost-efficient databases and high-speed computational capacity.

When a trade is traditionally executed in an exchange or in an OTC market, a number of stages must be followed in order to achieve an effective transfer of securities versus payment between counterparties. Close cooperation must exist between the front and back office to prevent mistakes. The segregation between front- and back-office duties minimizes legal violations, such as fraud and embezzlement, or violation of regulations. Operational integrity is maintained through the independent processing of trades, trade confirmations, and settlements. The back office serves several vital functions. It records and confirms trades transacted and provides internal control mechanisms segregating duties. A properly functioning back office will help ensure the integrity of the financial institution and minimize operations, settlement, and legal risks.

The links between front- and back-office operations may range from totally manual to fully computerized systems. The complexity of linking systems should be related to the volume of trading activities undertaken. Operational risk is the risk that information systems or internal controls result in unexpected loss. It can be monitored through examining a series of plausible scenarios. It can be assessed through reviews of procedures, data processing systems, and other operating practices.

2.2 Internal Controls

Formal written procedures should be in place for purchase, sales, processing, accounting, clearance, and activities related to transactions. These procedures should be designed to ensure that financial contracts are properly recorded and senior management is aware of exposure, gains, or losses resulting from trading activities. Desirable controls include1

1. written documentation indicating the range of permissible products, trading authorities, and permissible counterparties;
2. written position limits for each type of contract or risk type;
3. a market risk management system to monitor the organization’s exposure to market risk, and written procedures for authorizing trades and excess of position limits;
4. a credit risk management system to monitor the organization’s exposure to customers and broker dealers;
5. separation of duties and supervision to ensure that persons executing transactions are not involved in approving the accounting methodology or entries;
6. a clearly defined flow of order tickets and confirmations designed to verify accuracy and enable reconciliations throughout the system and to enable the reconcilement of trader’s position reports to those positions maintained by an operating unit;
7. procedures for promptly resolving failures to receive or deliver securities on the date securities are settled;
8. guidelines for the appropriate behavior of dealing and controlling staff and training of competent personnel to follow written policies and guidelines.

2.3 Trade Cycle

Once a transaction has been executed by the front office, the trade-processing responsibility rests with various back-office personnel. The back office is responsible for processing all payments and delivery or receipt of securities, commodities, and written contracts. They are responsible for verifying the amounts and direction of payments that are made under a range of netting agreements.

Trade processing involves entering a trade agreement on the correct form or into an automated system. After the front office has inputted the trade, verification of transaction data should be performed. Copies of the trade agreement are used for bookkeeping entries and settlements. It is appropriate to evaluate whether an institution’s automated trade-processing system provides adequate support for its processing functions.

CONFIRMATIONS

When a transaction is agreed upon, a confirmation is sent to the counterparty. The back office should then initiate, follow up, and control counterparty confirmations. A strictly controlled confirmation process helps to prevent fraudulent trades. For example, a trader may enter into a fraudulent deal, or a trader could enter into a contract, send the original confirmation, and then destroy copies. This may allow the trader to build up positions without the knowledge of management. The trader when closing out the position would make up a ticket for the originally destroyed contract and pass it on together with the offsetting contract so that the position is netted off. Receipt and verification of incoming confirmations by an independent department would immediately uncover this type of activity.

SETTLEMENT PROCESS

After a purchase or sale has been made, the transaction must be cleared through back-office interaction with a clearing agent. On the settlement date, payments or instruments are exchanged and general ledger entries are updated. Settlement is completed when the buyer or buyer’s agent has received or delivered securities and the seller has been paid. Brokers may assign these tasks to a separate organization such as a clearinghouse, but remain responsible to their customers for ensuring the transactions were handled properly. Losses may be incurred if the counterparty fails to make delivery. In some cases, the clearing agent and broker are liable for any problems that occur in completing the transaction. Settlement risk should be controlled through the continuous monitoring of movement of the institution’s money and securities by the establishment of counterparty limits by the credit department.

RECONCILIATION

The back office should perform timely reconciliation with the policies and procedures of the institution. The individual responsible for performing the reconcilement of accounts should be independent of the person responsible for the input of transaction data. Reconciliation should determine positions held by the front office, as well as provide an audit trail for regulatory reporting. The typical reports that need to be reconciled include trader positions, regulatory reports, broker statements, and income statements.

THE EVOLUTION OF TRADE FLOW

Today’s front office has focused primarily on automation and technology. Trade confirmation and matching have seriously lagged behind. Firms have leveraged technology to remain competitive in the face of rising costs, tighter margins, greater regulation, and compliance. The rise of electronic and algorithmic trading is the clearest representation of this through the influence of complex technology and trading strategies. Regulation has increased pressure on costs. Market conditions, increased competition, and more educated investors have all put pressure on the securities industry to focus on the bottom line and cope with squeezes in margin. As a result of these changes, the back office has lagged behind. There are a number of trends, however, that are helping the back office come up to speed. First, is the adoption of back-office outsourcing, by both traditional investment managers to banks and hedge funds. Outsourcing trends are allowing investment firms to concentrate on their core business, while improving operational efficiency.

2.4 Straight-Through Processing and Trade Automation

The advancement of back-office automation and the use of computer technology to analyze and record trade history have led to the evolution of pre-trade analytics and processes. An increasing amount of market information became available. Bloomberg was a pioneer in this area, merging market data with security information and analytics. These advances allowed information management opportunities to arise between the back and front office. Firms began to devise a means to integrate data flow between two previously distinct sectors of an organization, yielding advances toward straight-through processing (STP).

Efforts have been under way to redirect capital investment toward advances in liquidity, efficiency, and market transparency through the application of technology. The equity and foreign exchange markets have benefited most to date. Open access to historical trade information has been emphasized by the Securities and Exchange Commission (SEC). Institutional money managers continue to control growing proportions of the world’s financial assets. This has caused greater pressure on traditional market structures to provide open, equal access to trading venues for all market participants....