They call it the “kill the fax” programme.
For years banks and others involved in trading in shares, derivatives and foreign exchange have been working to modernise the unglamorous back office processes that take place after trades are done.
The idea has been to get rid of the paper trail used to handle the crucial post-trade processes that take place after traders have struck deals with each other.
But the alleged rogue trading scandal that has hit UBS, the Swiss bank, shows how a gulf still exists between the trading desk, equipped with sophisticated trading equipment, and the middle- and back-office functions without which most trading cannot happen.
Central to the alleged deception by UBS trader Kweku Adoboli is his knowledge of such functions, in particular of how confirmation that trades have been done – so-called “trade confirms” – can happen after settlement, where cash is exchanged for the security being traded, so completing the transaction.
Contrary to the image of high sophistication and split-second accuracy exuded by trading desks, the trade confirms and settlement part of the chain are often dogged by inefficiency, overlapping and sometimes outdated practices that help explain why they can be exploited.
Tom Kloet, chief executive of TMX Group, operator of the Toronto and Montreal exchanges, says: “The question is: have back office systems kept up with the ‘front office’ – the trading desk? It seems they haven’t.”
Trade confirms allow both parties to a trade to check that what they think they did with each other – buy or sell a particular financial product at a certain agreed price and time – did in fact happen. They also may specify how and when settlement occurs.
But confirmation often does not take place immediately, and may not happen on the day a trade is done. Brian Traquair, president of capital markets and investment banking at Sungard, a trading technology company, says: “You would think ‘same day confirmation’ would be routine and it’s not. Same day can mean ‘fax the next morning’. It’s a fairly scary thing.”
In the UBS case, people familiar with the matter say Mr Adoboli is suspected of exploiting the fact that several European banks’ exchange traded funds arms did not issue confirmations until after settlement had happened.
Industry experts point out that the phenomenon is largely confined to the over-the-counter markets, where products are traded away from exchanges. There, post-trade processes are an embedded part of the plumbing needed to connect to an exchange. ETFs fall into the OTC category, as do FX options, derivatives on precious metals and money market instruments.
Trade confirms are not mandatory. Nor is there an industry-wide standard for how they are done.
Yet this was not supposed to happen. The collapse of Lehman Brothers in 2008 was a wake-up call to the financial services industry as thousands of parties who had trading exposure to it were unable to work out what those were as record-keeping had been primitive.
Regulators forced dealers in the OTC derivatives markets to move away from paper-based confirmations. The Dodd-Frank law in the US – and similar proposals emerging in Europe – require that derivatives be reported to electronic databases called “trade repositories” where records can be viewed by regulators. That has prompted greater adoption of “straight through processing”, a process that enables everything after execution of a trade right through to reporting to a repository.
Denny Dewnarain, deputy managing director of treasury and capital markets in Europe at Misys, a software company, says cases like the UBS one “reinforce that the process has to be speeded up”. But he adds that the work is complex and time-consuming. “We can’t say banks are not investing in this. It’s how long it takes,” he says.
However, industry experts say that where new products are concerned – such as ETFs, which were created relatively recently, banks can sometimes be more focused on making sure the product gains traction. Fabian Vandenreydt, head of securities markets at Swift, the payments messaging system, says: “They may look at things like confirmation and settlement really as an afterthought.”
Investment in the middle and back office has also lagged because it is not perceived as a revenue-generator – unlike the trading desks, where huge sums are being pumped into building faster trading systems, often associated with “high-frequency trading”.
Some progress is being made. Last year, the US Securities and Exchange Commission approved the use of a type of Swift message in trade confirmations, helping to eliminate errors in the confirmation process.
But ultimately regulators may need to step in to create standards and enforce industry-wide adoption, experts say. “There is an urgent need for global market participants to review standards for confirming the economic details of all trades,” says Marianne Brown, chief executive of Omgeo, a post-trade company. “Regulators are well positioned to drive this.”