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The Bankers’ Plumber’s Handbook How to do Operations in an investment bank properly, or not! Olaf Ransome
Copyright 2014 Olaf Ransome All rights reserved. No part of this book may be reproduced in any form or by any electronic or mechanical means, including information storage and retrieval systems, without written permission from the author, except in the case of a reviewer, who may quote brief passages embodied in critical articles or in a review. Trademarked names appear throughout this book. Rather than use a trademark symbol with every occurrence of a trademarked name, names are used in an editorial fashion, with no intention of infringement of the respective owner’s trademark. The information in this book is distributed on an “as is” basis, without warranty. Although every precaution has been taken in the preparation of this work, neither the author nor the publisher shall have any liability to any person or entity with respect to any loss or damage caused or alleged to be caused directly or indirectly by the information contained in this book.
August 2014 Version 2.2
Table of Contents
1 GLOSSARY 10
2 ABOUT OPERATIONS 44
2.1 INVESTMENT BANKING DEFINED 44 2.2 HOW DOES OPERATIONS FIT INTO AN INVESTMENT BANK? 45 2.3 WHAT DOES OPERATIONS DO? 46 2.3.1 PRODUCT ALIGNED FUNCTIONS 46 2.3.2 SHARED SERVICES 48
3 OPERATIONS IS PROCESS MANAGEMENT 51
3.1 OF POLICIES, PROCEDURES & CHECKLISTS 55 3.1.1 POLICY VS. PROCEDURE VS. CHECKLIST 56 3.1.2 PROCEDURE 57 3.2 CREATING THE BEST POLICIES, PROCEDURES & CHECKLISTS 67 3.2.1 POLICIES 67 3.2.2 PROCEDURES & CHECKLISTS 68 3.3 THE DIVISION OF FAULT AND RESPONSIBILITY 71 3.4 SYSTEMS 73 3.4.1 THE BASIC STUFF 73 3.4.2 THE ADVANCED CLASS 75 3.5 SIZE MATTERS -‐ NORMAL -‐ DO YOU HAVE A FEEL FOR YOUR BUSINESS? 78 3.5.1 TRADERS NOT ON THE UP AND UP MORE INSIGHT INTO UNDERSTANDING WHAT IS NORMAL IN YOUR BUSINESS 80 3.6 THE DRONES OF BIG BUSINESS -‐ E-‐MAIL SCANNERS 82
4 REFERENCE DATA -‐ A BANK’S MAP 84
4.1 BOOKS 85 4.1.1 TRADING VS. BANKING BOOK 86 4.1.2 BOOKS -‐ CONTROL POINTS 87 4.2 PRODUCTS / INSTRUMENTS 88 4.2.1 RULES FOR YOUR “INSTRUMENT MASTER SYSTEM” 90 4.2.2 NIRVANA FOR BANKS – A SINGLE GOLDEN SOURCE OF PRODUCT DATA 91 4.3 ACCOUNTS 91 4.3.1 INTERNALLY OWNED ACCOUNTS 92 4.3.1.1 Key Points of Control 95 4.3.2 EXTERNALLY OWNED ACCOUNTS 96 4.3.3 ACCOUNT OPENING AKA CLIENT ON BOARDING (COB) 97 4.3.3.1 AML 97 4.3.3.2 KYC 98 4.3.4 STANDING SETTLEMENT INSTRUCTIONS (SSI’S) 100 4.3.5 DERIVATIVES -‐ ISDA’S AND CSA’S 101 4.3.5.1 Collateral 102 4.3.5.2 Collateral Management 103 4.3.6 LEGAL ENTITIES (LE) 108 4.4 PRIVATE CLIENT INVESTMENT BUSINESS & INVESTMENT MANAGEMENT 109
4.4.1 RISK ASSESSMENT 110 4.4.1.1 Suitability / Appropriateness 110 4.4.1.2 Discretionary Mandates 112 4.4.1.3 Asset Management 112 4.5 THE COST OF POOR QUALITY 112
5 THE LIFECYCLE 115
5.1 THE 3 R’S OF RECONCILIATIONS -‐ CONTROLLING THE FLOW OF TRADES 116 5.1.1 THE FIRST R OF RECONCILIATION: FOFO OR FRONT-‐OFFICE TO FRONT-‐OFFICE. 117 5.1.2 THE SECOND R OF RECONCILIATION: FOBO OR FRONT TO BACK 119 5.1.3 BOBO. BACK-‐OFFICE TO BACK-‐OFFICE RECONCILIATION 119 5.1.3.1 About SWIFT 121 5.1.3.2 Keeping Control of Breaks 121 5.1.3.3 Securities or Depot Related Breaks 122 5.1.3.4 Cash Reconciliation Breaks 123 5.2 PRIVATE CLIENT INVESTMENT BUSINESS & INVESTMENT MANAGEMENT 123 5.3 ASSET MANAGEMENT 124 5.4 LESSONS FROM UBS’S $2.3 BILLION LOSS 124
6 ABOUT TRADING 129
7 RISK MANAGEMENT 132
7.1 WHO DOES WHAT? 132 7.1.1 MARKET RISK 132 7.1.2 CREDIT RISK 132 7.1.3 OPERATIONAL RISK 132 7.2 WHERE DOES IT ALL GO WRONG? 132 7.2.1 FAT FINGER SYNDROME 133 7.2.1.1 Mis-‐Executing a client order 133 7.2.1.2 Traders or the bank getting it wrong 133 7.2.2 TRADERS WITH DANGEROUS IDEAS 134 7.2.3 CANCEL / CORRECTS 135 7.2.4 INTER-‐COMPANY AND INTRA-‐COMPANY 136 7.2.4.1 Intra-‐Company 136 7.2.4.2 Inter-‐Company Trades 137 7.2.5 DEPOT TRANSFERS & CONVERSIONS 139 7.2.6 CONFIRM MATCHING 140 7.2.7 SETTLEMENT MATCHING & SSI’S 140 7.2.7.1 In Securities 141 7.2.7.2 In FX and Payments 141 7.2.8 COLLATERAL MANAGEMENT -‐ CCPS, COUNTERPARTS AND CLEARERS 142 7.2.8.1 OTC Counterparts 143 7.2.8.2 Clearing Members 144 7.2.8.3 CCPs 144 7.2.9 RECONCILIATIONS GAFFES -‐ MY PERSONAL MUPPET OLYMPICS 144 7.2.10 PRIVATE CLIENT INVESTMENT BUSINESS & INVESTMENT MANAGEMENT 146
7.3 CCPS – CENTRAL COUNTERPARTS 149 7.3.1 NOVATION VS. OPEN OFFER 153 7.3.2 TYPES OF CCP OPERATING MODEL 153 7.3.3 COLLATERAL SEGREGATION 153 7.4 MOVING NOT ELIMINATING RISK 154 7.5 TOOLS AND PROCESS DESIGN 154
8 THE REGULATORY ENVIRONMENT 156
8.1 DODD-‐FRANK AND EMIR AND OTC DERIVATIVES 156 8.2 THE FINANCIAL TRANSACTION TAX (FTT) 157 8.2.1 EU FTT 159 8.3 INDIVIDUAL COUNTRY FTTS 160 8.3.1 ITALY 160 8.3.2 FRANCE 160 8.3.3 US 160 8.4 SARBANES-‐OXLEY (SOX) 161 8.5 FATCA – FOREIGN ACCOUNT TAX COMPLIANCE ACT 161
9 PRODUCTS -‐ FX 163
9.1 REGULATORY ENVIRONMENT 164 9.1.1 FX DERIVATIVES -‐ DODD-‐FRANK / EMIR – CCPS 164 9.2 KEY MARKET INFRASTRUCTURES 166 9.2.1.1 The CLS Community or Ecosystem 167 9.2.1.2 The Mechanics 167 9.2.1.3 Funding 171 9.3 THE FX LIFECYCLE 174 9.3.1 TRADING 174 9.3.2 FX PRIME BROKERAGE 175 9.3.2.1 The Prime Broker 175 9.3.2.2 Executing Brokers 175 9.3.2.3 Managing the Lifecycle 177 9.3.3 TRADE REPORTING 180 9.3.4 TRADE CONFIRMATION 181 9.3.4.1 Cleared Trades: Matching and Clearing 181 9.3.4.2 Non-‐Cleared Trades: Confirmation 182 9.3.5 FX ROLLS 182 9.3.6 SETTLEMENT 183 9.3.6.1 Cleared Trades 183 9.3.6.2 Non-‐Cleared Trades 183 9.3.6.3 Safe settlement 184 9.3.6.4 Netting 185 9.3.6.5 FX. vs. the rest of the Bank 185 9.3.7 RECONCILIATIONS 185
10 PRODUCTS – EQUITIES & BONDS 187
10.1 REGULATORY ENVIRONMENT 190
10.2 KEY MARKET INFRASTRUCTURES 191 10.3 THE LIFECYCLE 192 10.3.1 TRADING & ORDER EXECUTION 192 10.3.2 USING A BROKER 193 10.3.3 EQUITY PRIME BROKERAGE 193 10.3.4 TRADE REPORTING 194 10.3.5 TRADE CONFIRMATION 194 10.3.6 SETTLEMENT 194 10.3.7 SECURITIES LENDING & BORROWING (SLB) 195 10.3.7.1 Why do people short securities? 195 10.3.7.2 Borrowing securities 195 10.3.7.3 The Ops issues with securities lending 196 10.3.7.4 Front-‐Office vs. Back-‐Office 197 10.4 REPO & COLLATERAL MANAGEMENT 198 10.5 RECONCILIATIONS 199
11 RATES & CREDIT 200
11.1 REGULATORY ENVIRONMENT & DOCUMENTATION 202 11.1.1 DODD-‐FRANK / EMIR – CCP’S 203 11.2 OTC / NON-‐CLEARED TRADES 204 11.2.1 REGULATORY ENVIRONMENT 204 11.2.2 THE LIFECYCLE 204 11.2.2.1 Confirmation 204 11.2.2.2 Settlement 205 11.2.2.3 Collateral Management 205 11.2.2.4 Open item reconciliation 205 11.2.2.5 Trade Reporting 205 11.3 CLEARED TRADES 206 11.3.1 REGULATORY ENVIRONMENT 206 11.3.2 KEY MARKET INFRASTRUCTURES & STANDARDS 206 11.3.2.1 SEF’s 206 11.3.2.2 CCP’s 206 11.3.2.3 SDR’s & Trade Repositories 207 11.3.3 THE LIFECYCLE 208 11.3.3.1 Trading 208 11.3.3.2 Limit Management 209 11.3.3.3 Confirmation 210 11.3.3.4 Settlement / Collateral Management 210 11.3.3.5 Collateral Management 210 11.3.3.6 Open item reconciliation 211 11.3.3.7 Trade Reporting 211 11.3.3.8 Trade Compression aka Tear-‐Up’s 211
12 NETWORK MANAGEMENT 214
12.1 WHAT IS NETWORK MANAGEMENT? 214 12.2 WHAT DOES NETWORK MANAGEMENT DO? 214
12.2.1 GATEKEEPER 215 12.2.1.1 “Account” Opening 215 12.2.1.2 How many “accounts” are needed? 216 12.2.1.3 Group NetMan Philosophy 218 12.2.1.4 The “R” word: reciprocity 221 12.2.1.5 Selection Criteria and the RFP 221 12.2.2 RELATIONSHIP MANAGER 222 12.2.2.1 Periodic Reviews 223 12.2.3 COST MANAGEMENT 223 12.2.3.1 What services can you expect to pay for? 223 12.3 COST CONTROL 228 12.3.1.1 NetMan Systems 229 12.4 COST ALLOCATION 229
13 SETTLEMENTS 232
13.1 FX – FOREIGN EXCHANGE 233 13.1.1 SETTLEMENT METHODS 233 13.1.2 CHALLENGES 234 13.2 SECURITIES 235 13.2.1 EQUITIES & BONDS 235 13.2.1.1 Cleared Trades -‐ Equities 235 13.2.1.2 Non-‐Cleared Trades 235 13.2.1.3 Safe settlement 236 13.2.2 SETTLEMENT METHODS – EQUITIES & BONDS 236 13.2.3 GENERAL SETTLEMENT CHALLENGES -‐ SECURITIES 236 13.3 RATES AND CDS 240 13.4 LISTED DERIVATIVES 240 13.4.1 SETTLEMENT METHODS 240 13.4.2 CHALLENGES 240
14 CASH MANAGEMENT & FUNDING 242
14.1 DEFINITIONS 242 14.2 THE INFORMATION TO DO CASH MANAGEMENT 242 14.3 WHERE “FUNDING TO PLAN” FAILS 244 14.4 FUNDING-‐TO-‐GUESSTIMATE 245 14.5 FUNDING TO ACTUAL 245
15 SHARED INFRASTRUCTURE 251
15.1 SWIFT 251 15.2 RECONCILIATION SOFTWARE 254
16 COLLATERAL MANAGEMENT 256
16.1 DERIVATIVES: OTC & CCP CLEARED TRANSACTIONS 257 16.1.1 EXCESS COLLATERAL 258 16.1.1.1 Substitution 258
16.1.1.2 Concentration Limits 258 16.1.2 CROSS MARGINING 259 16.1.3 DIRECT DEBITS / PPS 259 16.1.4 THE CHALLENGE FOR OPS IN OTC TO CCP 260 16.2 LISTED DERIVATIVES 260 16.3 PAYMENTS & RTGS SYSTEMS 260
17 ASSET SERVICING 261
17.1 ASSET SERVICING FOR THE ISSUER 261 17.2 INCOME EVENTS – DIVIDENDS, COUPONS AND MATURITIES 264 17.2.1 WHEN DO YOU OWN SOMETHING? 265 17.2.2 EX DATE & RECORD DATE 265 17.2.3 DIVIDEND / COUPON COMPENSATION 265 17.2.4 MATURITIES 266 17.2.5 DEFAULTS 266 17.2.6 WITHHOLDING TAX AT SOURCE 266 17.2.7 DOUBLE TAX TREATIES AND RE-‐CLAIMING WITHHOLDING TAX 267 17.2.8 SECURITIES LENDING & BORROWING (SLB) 268 17.2.8.1 Equity Swaps 270 17.3 MANDATORY EVENTS 272 17.4 OPTIONAL EVENTS 272
18 COST CONTROL & ALLOCATIONS 277
18.1 COST ALLOCATIONS 277 18.1.1 WHY COST ALLOCATIONS MATTER 277 18.2 SUGGESTED BEST PRACTICES -‐ CANONS OF COST ALLOCATIONS 280 18.2.1 EFFORT BASED. 281 18.2.1.1 Product aligned services 281 18.2.1.2 Shared Services 281 18.3 PRAGMATIC. DON’T LET THE BEST BE THE ENEMY OF THE GOOD. 283 18.4 BE TRANSPARENT. WHAT IS THAT CHARGE FOR? 283 18.4.1 POOR ALLOCATION METHODOLOGY LEADS TO BAD DECISIONS 284 18.5 COST SAVINGS: WHAT TO LEGITIMATELY COUNT WHEN FIGURING OUT THE BENEFITS 285 18.5.1 WHAT’S THE BENEFIT? 285 18.6 PRICING CLIENT BUSINESS. UNDERSTANDING MARGINAL COST 287 18.7 INTEREST CLAIMS 288 18.7.1 SECURITIES 289 18.7.2 PAYMENTS AND FX 290 18.7.3 USE OF FUNDS 290
19 DURATION: MAKING INVESTMENTS FOR THE LONG-‐TERM 292
20 CROWDING OUT: HOW THE REGULATORY BURDEN IS LIMITING BANKS’ FLEXIBILITY 298
21 WHY GOOD DECISIONS MIGHT NOT BE MADE 301
22 LIQUIDITY: ENSURING THE BANK HAS ENOUGH FUNDS TO OPERATE AND ENOUGH RESERVES 308
23 ETHICS – DOING THE RIGHT THING 311
24 THE LAST WORD: HOPE DIES LAST 313