The use of systems must be accompanied by strict controls and
segregation of certain functions like static data, trade input, client
account set-up, accounting and treasury functions.
Positions in derivatives represent exposures and the positions must
be reconciled to those held by the clearing house or agent broker or,
in the case of a client, their broker. As some products like futures are
not only marked to market each day but that MTM amount is also
settled; any incorrect position will result in problems agreeing the set-
tlement amount. We must also remember that some products go to
physical delivery and positions that remain open at the clearing
house can become subject to the delivery process. Therefore, main-
taining the correct net and gross positions through correct closeout of
longs and shorts is vital. So too is managing the tender, exercise and
assignment process as these will alter the open position which must
be amended accordingly.
We noted earlier in the book that if an option position is assigned
but the dealers are not informed and/or the position in our records
is not amended, the dealer is trading on an incorrect position and
this could cause a severe financial loss.
It is important to assign responsibility to people to manage the
processes of:
• position agreement to clearing house/broker and internal records;
• tendering and exercising for delivery and amending positions;
• checking for assignments (remember some options could be exer-
cised early) and notifying dealers as well as amending positions;
• reconciling settlement figures (premium, variations and initial mar-
gin) to internal records. This will highlight any position/price error.
The systems in the derivatives operations area will also provide key
regulatory reports and reporting information, either directly to the
regulator or to the compliance department; and therefore any lack of
control over the quality and timeliness of the data used could lead to
a potential breach of regulations.
Mapping operational risk in a derivatives operations
environment
What qualifies as operational risk?
One reason for the delay in recognising operational risk as a separate
category of risk is probably the difficulty in determining exactly what
operational risk is.
Operational risk 159
Some would argue that it is everything that affects a business, which
is not market or credit risk. Others argue that it is everything and any-
thing to do with the post-transaction clearing and settlement process.
Another key factor in this lack of recognition is that the subject of
risk is viewed primarily in terms of potential financial loss. As such
operational risk is frequently considered to be unlikely to cause a
severe financial loss, at least not in one hit. The logic here is that an
inappropriate or incorrect deal can result in substantial loss,
whereas a settlement problem with the transaction, whilst it may
incur costs, is not likely to generate a significant loss.
History would tend to suggest that the headline-making ‘disasters’
in the financial services industry are all mainly related to market
and/or credit risk, in the sense that they involve significant positions
in derivatives where the obligations could not be met.
However, delve a little deeper and it may be that associated opera-
tions issues contributed to the problem. The contribution may not
have been ‘physical’ in the sense of an error in processing transac-
tions but rather a failure to carry out the risk management role that
the operations team undoubtedly have.
Understanding the risk sources and the impact of that risk is called
risk mapping. This involves the analysis of the workflow and the critical
tasks through the clearing and settlement process. It is also prudent to
consider any risk sources that could occur prior to clearing and settle-
ment. These would include pre-trade checks on:
• Authorised products
• Deal limits
• Position and exposure limits
• Counterparty limits
• Liquidity limits.
In addition we can include product knowledge and static data in
the list.
Some other areas in the organisation like the Credit Team and
Compliance will monitor some of these.
However, the operations area is involved in some of this risk
management process as the information produced on positions, for
example, is critical to an accurate risk management process.
Key functions such as reconciliation and error resolution must be
effective; otherwise the dealing function is hampered, or the organisa-
tion may be put at risk by ‘hidden’ positions, unauthorised exposures,
etc. As these present not only an unacceptable risk but also a breach
of regulations, the consequences are clear.
160 Clearing and settlement of derivatives
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