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