The 3 R’s of Reconciliations

There are not three R’s in reconciliation, that of course would cause a break (sic). What reading, ‘riting and ‘rithmetic, or math for our friends from across the pond, are to children, the three types of reconciliation are to operations professional.  This week’s post is inspired both by a Goldman Sachs story and a Goldman Sachs experience.

Reconciliation is the daily diet of Operations. If you don’t like ticking and tying then you are as much in the wrong job as a soldier who does not like marching or being shot at or a English Premier League Referee who doesn’t like it when the crowds shout abuse.

Last week, there was press coverage of a loss of $118 million round at Goldman Sachs caused by a trader fraud (For more, see this article from Here is the City). Headlines on operational issues and Goldman Sachs tend to catch my attention. I was shocked at what I read. The story has some similarities to the UBS / Adoboli case currently before the courts, but only some. What caused me to be shocked was how the control folk at my alma mater missed this. The errant trader was, it seems, booking trades in e-mini futures into Goldman’s systems that did not exist in the real world on the futures exchange. All that was needed was a basic reconciliation (rec) between Goldman’s books and the outside world.

Before getting too detailed, a little theory and structure. The diagram illustrates the parts of a bank and the outside world involved in the trade life-cycle. This one is from the world of FX, which is not 100% the same as other asset classes, but will serve out purposes well enough. In any asset class, there are multiple internal systems involved, as well as the outside world. Keeping the books straight is essential and reconciliation is the only way to do it. In your own personal world, you might look at your bank statement each month and see if you recognise all the entries; that is a form of reconciliation, albeit crude. If you are in the US, you might use the wonderful Quicken software to do this for you. It is easy to imaging that if you are a bank you need to do two things: reconcile often and with system support.

This week well start with the first “R of Reconciliation”: FOFO or front-office to front office. Imagine a simple world of say equity orders on the NYSE. Imagine that every day there are 100 orders and at the end of them, 80 are filled. 20 are open because they are limit orders and the price has not been hit yet. At the end of day, you should have booked 80 trades and have 20 open orders.  A wise man would now want to check what is in the trading system vs. what is in the market. A typical way of doing this is to get a “trade blotter”, some form of summary recap of all orders booked and open. You need to reconcile the status, the economics and often, but not always, the counterpart details. In a derivatives environment, such as in FX , where there is clearing of NDF trades, you would want to match your trading records against the matching venue. In this case, you will have booked many trades with a settlement date sometime in the future, so the “open item” file may get quite large. You may also have trades not in “cleared” or “parked” status, because they are not accepted for clearing yet.

You can of course only do this if there is an external set of data to compare to. Sometimes, this data source may be referred to as a “drop copy”. The CME uses this expression to describe one of their trade recaps. Somewhat mistakenly, at least in my humble opinion, this has tool has been mooted as a control that would have prevented the meltdown at Knight Trading (Click Here). To my understanding, Knight’s software went beserk and put in too many orders, many of which were executed. A rec would not help here, because the front-office system sent the orders.  A so called “Kill Switch” might well have done; when the error was detected, such a switch would have allowed a single command to delete all open orders.

So, I would offer the opinion that in the Goldman case, the erroneous bookings ought to have been caught the same day with a FOFO rec. Of course, if I was there now, I would no doubt have the rather daunting task of hunting down all global instances where this ought to be done and checking if it was done and properly.

Some folks will be delighted that Goldman showed signs of being mortal and lost the money. Others might have some Schadenfreude; sad that money was lost, happy it happened to Goldman. I am just sad; this should not have happened, least of all there. A simple end-of-day comparison of executed trades ought to have caught this.

We will have more on the other two reconciliation points in the coming weeks. It would be remiss of me though not to thank a couple of great old troopers from the days of my youth who kept me on the straight and narrow when I was there. In Goldman, as there should be in every shop, there is a specialist department for controls; at GS it was called Operations Control. As a young Ops manager I had the same attitude with my Ops Control friends that Luis Suarez has with many a referee and argued a lot with them. I certainly under appreciated them at the time, however in my defence, I would offer that the discipline worked. Now that the banking world is a more complex place, that early training makes a difference. So, perhaps belatedly, but with real appreciation, a thank you must go to Mssrs. Mark Jacobowitz and Joe Bergen for a good grounding. I cannot imagine that the two of you would have been caught out in this e-mini futures debacle. I suspect that standards have slipped round at Goldman Sachs.

Lessons Learned: Good discipline. that was missing here. A good Ops manager will have a very clear and current view of what reconciliations ought be performed in her area. And, that will be backed by a decent procedure that makes sure it is done, daily.

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