30 NovThe 3rd of the 3 R’s of Reconciliations.

BOBO. Back-Office to Back-Office reconciliation. This is the last of the three reconciliation areas. There are three types of rec that I would place in this group; d open trades, confirmations and positions. Both are essential and both are a vital, daily controls.

Before we delver into any detail, a word of apology. This week’s post is a tad late and quite long. Reconciliations are important, irrespective of product. Having a complete set of thoughts on this seemed the right thing to do.

Open Trades: Things do not always work as planned. A typical bank will be sending multiple instructions out to its depots and agents. There are good reasons to compare what you have pending with an outside source.

Failed Trades: particularly in the securities business, trades fail, in other words they do not settle on the planned value date. Agents or depots will have local rules on how long they manage or hold on to open trades. Beyond them, the CSD’s, the Central Securities Depository, may have its own rules. For example, it used to be the case that in Switzerland the CSD would simply delete aged and unsettled instructions after some 30 or 60 days. At the point, the trade cannot settle.

Future Value Dates: particularly in the derivatives world, transactions can be live, or open, for a very long time. In the FX world, you might compare the open items at a CCP such as ForexClear.

Comparing ensures that there is nothing you expect to happen that will not happen in the real world.

Matching: This is different from an Open Trade rec. The Open Trade rec just ensures that what you have on your books exists in the outside world too. Over and above that, you want to know two things: does the counterpart know the trade, which requires a trade date rec and secondly is the instruction matched for settlement in the outside world? The latter has to be based on value date. You have to do both recs.

Positions: This is about what has settled. When a transaction settles, the firm’s systems should record that position as being in an external location and, if there is an associated cash movement, there should be a movement in the opposite direction in that cash position. That “location” will vary depending on the instrument; a purchase of Euro Government bonds would result in an increase in the position at an external Depot, probably Euroclear, and a decrease in cash at Euroclear. When an FX NDF trade settles, if you are paying out on a losing trade  then there is a decrease in cash at the Nostro, which in accounting terms is an increase in the liability.

There is a little bit of accounting to bear in mind here; if you buy something, there is an asset which appears as a debit position in the location. Think of it like the location owing the firm something. On the other side, the cash is shown as a credit position, which you should think of as the firm owing something to the bank.

As a rule, whilst you can have a negative cash position, because you are using an overdraft from the bank, you cannot have a negative balance in a securities account. This is because you cannot deliver out securities you do not have. You can deliver out securities you borrow, but that is a separate topic.

So at the end of any business day, your firm’s ledger will have balances in the Depots and Nostros. These need to be compared to a statement from the Depot or Nostro. Both are normally sent in SWIFT format and via SWIFT to the firm. MT950 format is used by the Nostro, MT535/6 by the Depots. The statements will normally have opening balance, movements and closing balance. These are fed into a reconciliation engine such as SmartStream or IntelliMatch. The ledger side is fed as an end-of-day batch. Each of the individual elements need to be compared and accounted for, not just the end balance. Breaks can and do happen; a couple of things are important in terms of handling them. Firstly, independent checking by an operations control function. The key part here is independent. The people checking should not be involved in daily business. I have seen the reporting line be into the CFO line or into the Global Head of Operations. Generally I am more in favour of the former than the latter, simply because the line folk doing the daily work will report into the Head of Operations and by separating out the control function, there is better segregation of duties and avoidance of any conflict of interest. Key though is the quality of the reporting. Secondly, cumulative reporting; breaks not fixed from yesterday should still be there today. Thirdly, aging and escalation. Having a few breaks is part of the business and should be accepted, having the same breaks for a long-time is not acceptable and should not be accepted. The reporting must clearly segregate breaks by age. There should be a summary and the detail. Some escalation process ought to be in place on both sides: in the line, once breaks are more than 2 days old, somebody other than the person fixing the break should sign-off they have seen the break and are resolving. Inside the Operations Control function, somebody other than then person preparing the rec and doing the day-to-day chasing of the line ought to sign off on breaks over say 7 days.

There is room for what I call “interesting philosophical debate” on the exact aging and the exact hierarchy. I say philosophical, because there is no one right answer, however, what you should be unequivocal about is the checks & balances. Having oversight and hierarchy are important; a four eyes principal both in the line function and the control one are key controls and those functions have to perform their functions properly.

The FSA report into the rogue trader loss at UBS makes a couple of good points on this, as well as numerous good ones on a number of other points. “Aged Breaks” were a feature in two ways; although reporting existed, both at the level of operations for unmatched trades and in product control for unexplained P&L, in both areas, breaks were allowed to age without sufficient challenge. The folks at UBS also missed matching to the outside settlement world. Adoboli booked a lot of trades with settlement dates way in the future. A simple matching rec would have caught the fact that there were many trades that the counterparts did not know.

There are numerous possible reasons for breaks, some more likely ones are below, with some suggested remedies. The list is not exhaustive.

Securities or Depot Related Breaks

As a rule securities ledger postings are made on the day that a trade actually settles. This is referred to as “actual settlement”. The following are reasons that things happen, however, I have to stress that when looking at breaks you need a sense of what is normal; it is unlikely that the cause or explanation is the same each time, there should not be abnormal volumes of activity and you must watch that things do not age.

 

Type of Break Explanation / Handling
Too few securities at depot This means a debit or a delivery out has been processed externally, but not internally. This is serious, because in the worst case somebody has bypassed operations and made an instruction directly to the bank. To solve this type of break:

Look at the open item reconciliation. If you have an item open internally that is not open at the custodian, then that would suggest that a settlement message was not applied properly. For a DVP trade, you would expect to also have a break on the cash rec.

Another possible explanation is that this is a securities lending instruction of some kind.

Corproate actions are a possible source of the break: an exercised put option will lead to securities leaving the depot. Or conceivably, your bank might issue call warrants or options allowing the holder to buy shares at a fixed price.

Too many securities Free delivery from a client; if you have a private client business it is possible that securities are delivered so called “free of charge”, so not against payment, without the client notifying you. If the delivery identifies that receiver by name and with account number, then happy days. However, if they are client securities then the RM should be posting the entries

Securities borrowing: it is possible that the Stock Loan desk have borrowed stock and not made the entries.

Corporate Action or Asset Servicing event: There are several types of corporate action events that might affect the securities position: exercised rights or an exercised warrant or call option, a stock split or a stock dividend

 

Cash Reconciliation Breaks

These will happen almost every day. As with securities breaks, the same warning about understanding what is normal and watching aged items is the key control. There are some typical reasons for breaks:

 

Type of Break Explanation / Handling
Statement Credit, No ledger debit This is an unexpected credit. Might happen if you have a private client or retail business where somebody sends money from an account held elsewhere to the account with you.

If the name and the account number to credit are on the account, then the Relationship Manager should be informed and asked to make an adjusting entry

Statement Credit does not match ledger debit Possibly a “shape problem”. You were expecting 10 and received 6 & 4. These can be paired-off. If the same thing repeatedly happens with the same parties involved, you will want to push back on the person causing the problem
Ledger credit with no statement credit This is a very typical break. It means you have passed an entry expecting cash, most likely from an FX trade or a Money Market one and it has not been received. Most of these entries are auto-posted, which means that the process is assuming the money comes in. Three considerations about these items:

Chase them: Get on the job and chase the money

Consider the interest lost: If you were expecting the money, you will likely have gone overdrawn. You should consider an interest claim. There are often local conventions on the rate that may be charged, for example LIBOR plus 200 bps and on the minimum amount

Balance sheet / risk adjustment: you have passed an entry assuming money comes in. As it has not, you now have a receivable, most likely an unsecured one. At that moment in time, the balance sheet is inaccurate. Normal practice is that the adjustment to the B/S should be on the third day.

Statement Debit, No ledger credit Very often these will be charges made by the Nostro provider for fees or for interest charges. Ideally, your Network Management team will be pre-advised of the charges and you should push back on them if fee entries are always resulting in breaks

 

Collateral lodged with CCP’s and counterparts is a related topic, but one for another day.

Lessons Learned: Recs. The daily diet. Make sure you have them all in place, make sure they are done and make sure that you are clear on what is aged.

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