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Reducing operational risk and operating costs through Straight Through Processing

www.fnx.com

Many firms are seeking to adopt a Straight Through Processing (STP) solution to manage their financial transaction processing. According to a recent Tower Group Study, the primary driver for increased IT spending post Y2K will be STP solutions. Firms seek to implement STP for primarily two reasons - the reduction of operating costs and the reduction of operational risk. But what exactly is Straight Through Processing? While there is a lot of discussion, a definition is rarely given. Therefore, let us begin our examination by defining STP as:

Use of a single system to process or control all elements of the work-flow of a financial transaction, including what is commonly known as the Front, Middle, and Back office, and General Ledger.

The definition of cost reduction seems obvious, but operational risk is less so. Therefore, the next concept we must define is operational risk:

Operational risk is the risk that is inherent in the actual processing of financial transactions, and can include risks caused by deliberate actions, non-deliberate actions, or by errors/gaps in trading systems.

With these definitions in place, how does STP help to reduce operational risk while also reducing cost? Let's start this analysis with a consideration of how the absence of STP can create conditions in which operational risk is difficult or impossible to control.

Problems with Multi System Operations
The key to STP is that one system is used for all processing. A major disadvantage of using multiple systems is that P&L or valuation discrepancies frequently occur between them. Disparate systems tend to employ different methodologies, resulting in the inconsistent valuations of financial positions. This difference is usually accepted on a day to day a basis with P&L reconciliation done either monthly or annually. The acceptance of a daily P&L discrepancy can mean that operational errors are masked by the 'normal' P&L discrepancy.

Multiple systems also give rise to the possibility for deliberate P&L arbitrage. With two systems making different valuation assumptions, it is possible to create fictitious P&L by creating synthetic positions. Consider the case of a FX Options desk hedging with FX Forwards. Most option pricing models present value options. However, some FX forward trading systems forward value P&L. The trader can arbitrage this difference in valuation, and create fictions P&L by creating a series of implied forwards (using two options) in the option system, perfectly offset by a real forward. While this position should be matched, the difference in pricing between the two systems allows the trader to create fictitious profits.

Another problem can occur when one system prices more products than the other. A front office application may value an interest rate swap, but the legacy back office may be unable to value the swap as a single product. Oftentimes, the solution is a band aid approach whereby a vanilla swap is represented as a strip of time deposits or as a bond and a floating rate note. By representing the transaction in two separate pieces, an important control feature is lost, and as such it will be more difficult to reconcile the positions between systems.

Operating Costs Efficiencies Through the Use of One System Versus Multiple Systems
As discussed above, a great deal of time and effort can be spent on P&L reconciliation. STP eliminates this need, resulting in what can be substantial manpower savings. Multiple systems require more interfaces, and interfaces between two or more systems tend to be quite complex and difficult to maintain. This can lead to problems with system upgrades. If one vendor upgrades their version, then typically the interface needs to be upgraded as well. The result is either that the interface must be updated very frequently (not desirable for a highly complex piece of software), or new upgrades to other applications are held up by interface issues.

Event management can also either complicate the interface issue or, if an interface for events does not exist, require redundant event processing. For example, an interest rate swap fixing must be done in both the front and back office in order to produce correct valuations and risk measures. Either a complex interface must be created to feed this fixing from one side to the other, or the fixing must be done in both locations. The issue is compounded even further if you consider the actions that need to be taken to undo an erroneous fixing.

A final issue to consider is the cost of maintaining multiple systems. Multiple systems imply both multiple vendors and perhaps even multiple hardware platforms. By combining systems and platforms, IT costs savings can be achieved. Perhaps even larger savings can result from the ability to manage static data in only one location. Multiple systems mean redundant static data maintenance. The addition of a single counter party or currency, which would only need to be defined once via a true STP solution, would have to be defined seven times for a desk using seven systems. This also leads to the need to reconcile static data between systems, another task eliminated via the use of a STP solution.

Given the problems with multiple systems, a STP solution can be effective in both reducing operational risk and costs. To be effective, a STP solution must:

n Cover all products handled by an existing desk

n Be a truly integrated solution not requiring additional interfaces

n Price products in a consistent way in all phases of processing (front, back, ledger)

nMaintain static data in a central location Opportunities available via STP

Having explored the problems that arise from multiple systems, let us next ask "Does the use of STP offer any advantages other than the elimination of multiple systems?" The answer is yes.

First consider a typical operational flow for a transaction. The work-flow for even a simple financial transaction tends to be quite complex. An effective STP solution will allow the user to monitor the flow at various points to prevent problems such as missed trades or unverified positions. A STP solution should allow the user to create a STP monitor, that is a screen or report that shows the processing status of any and all transactions. This screen or report shows trades that have been accepted into the back office, the verification status, the payment status, etc. The STP monitor screen or report permits the user to:

n Quickly spot trouble areas, including fictitious and hidden trades

n Ensure that all trades and events are processed

n Track verification and integrity of data

nTrack work-flow failures which may indicate other problems

The status screen or report described above promotes efficiency as problems are quickly identified. Creating a more efficient work-flow can be extended to the concept of exception processing.

One of the main benefits of STP is that an automated processing environment can be implemented, which in turn leads to substantial time and cost savings. With the introduction of 'exception criteria', the automated STP environment can become even more useful, allowing for operations time to be spent researching and examining those financial transactions that match the defined criteria.

Exception criteria definition lets the user, for example, flag trades from a particular trader or counter party, trades of a certain size, or even trades outside a preset tolerance level. The incorporation of exception criteria can make for the more intelligent use of time by better directing examinations of certain trades.

Exception criteria must be flexible and easy to modify so that new conditions can be easily integrated into the criteria set. A sample list of exception criteria is shown in. The exception criteria should fit into any part of the work-flow process.

A STP solution will also allow for the automated processing of all transactions not meeting the exception criteria, which subsequently streamlines operations. Any transaction that does meet the exception criteria can be flagged for further analysis, resulting in better use of staff time. A STP system can offer the user new tools for controlling operational risk and costs. An effective STP solution will provide:

n A work-flow monitor screen or report

n Automated work flow processing

n Flexible exception criteria definition

nThe ability to place exception criteria in various points in the work-flow

Summary
STP can combat operational risk and reduce operational costs by eliminating the problems and procedures inherent in multiple systems. Furthermore, STP provides the user with the tools necessary for controlling operational risk and focusing operational effort.

Farid A Naib
FNX

 

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New Millennium
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Global Straight
The road to T+1
Closing the gap
financial services
CLS and Liquidity
STP: Within and Between
STP - seeing the light
Some case studies
Reducing operational risk
Not Easy!!
Hidden barriers
Thinking Panaceas
Less hype!
End to End
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