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Operational Risk:
deal confirmation, the last chance to say no

by Anne Ku (March 2001)

original draft of article published in March/April 2001 issue of Global Energy Business

On 2 March 2001, someone mistakenly put the decimal in the wrong place in executing an order on the NASDAQ (New York Times Business Section). This caused a flurry of activity, not least accumulating $145 K gain for a day trader. Or so he thought. When the error was finally discovered, his gain turned out to be a loss of $130K. Everything was electronic - yet the error was human.

The lessons we learned from Nick Leeson, the rogue trader who brought down the investment bank Barings in the mid 1990's, were to separate front and back office and have proper risk control. However, the career path of many aspiring traders often begins in the back office, where it is considered less risky. While online exchanges have increased the velocity and volume of trading, it has not reduced the amount of work involved in deal confirmations. This tedious inspection process is still manual and paper-driven, largely due to the legal requirements of physical signature and evidence. As the front office speeds ahead with fancy analytics and the middle office equipped with state-of-the-art risk management systems, the back office is stretched to human limits.

Probably the least glamorous but most labor-intensive area of any trading operation is the mid to back office function of deal confirmation. In addition to being a legal and binding act, confirmation serves as the last opportunity to prevent a deal from being transacted wrongly. Most processes are still very manual and paper-driven. As transaction volumes rise, so does the tendency for such manual activities to bottleneck the process and most importantly, a source of operational risk that is not being hedged. Although it might be the weakest link in the chain, it could easily be the straw that broke the camel's back.

Author: Anne Ku

When asked the biggest offense a trader can make, Jim Donnell, CEO, Duke Energy North America, Houston, Texas, answered without hesitation, "doing a deal and not recording it." He would even fire a trader for it. "Even worse," said Greg Hickl, Head Power Trader, Williams Energy, Tulsa, Oklahoma, "if the trader tries to hide it." If all works accordingly, the middle and back office should receive a confirmation from the broker or counterparty, so such missing deals would be difficult to hide. When markets are volatile, Hickl said, mistakes do happen, and the back office may have a difficult time catching them. However, streamlined systems, that enable a trade to be entered in 15 seconds or less and generate its own confirmation, allow the front office to have more control over the process. Williams Energy is in the last phase of implementing an end-to-end solution to minimize operational risk and improve transaction efficiency. Duke Energy is also in midst of business process systems integration.

While process automation and systems integration may reduce human error, it does not get rid of confirmation risk. The nature of the business is that once traders have transacted with each other, the mid or back office of each company has to contact each other to verify and confirm the details of the transaction. The latter activity carries substantial legal risk if the terms and conditions are incorrectly communicated.

Go with the deal flow

The basic business process of energy trading (see figure 1) varies little, aside from the idiosyncracies in the front, middle, and back offices. In most trading houses, trades are made and entered in the front office by traders, their analysts, assistants, deal input clerks, or even a pool of deal entry staff. Trade capture is important for several reasons: for correct invoicing, proper risk control, and acknowledging "intent to pay". If a trade has a physical component, the scheduling desk would need to nominate or schedule the flow of energy. Depending on the type of deal (as shown in table 1), the confirmation desk may initiate, send or wait to receive a confirmation, or both. This process may be verbal (by phone) or paper (by fax), and the checks may also be against the screen (such as in-house deal summary or online exchange transaction summary).

Not entry level mathematics

In many places, the confirmation desk is staffed by entry-level positions, where a newcomer can learn the terminology of the business. It is considered less dangerous to make mistakes in checking than in entering a deal. Even so, one manager of a confirmation desk said a lot more goes into it than people think. Financial terms like fixed versus floating and type of index are not cut and dry.

Energy trading is in many ways more complicated than pure financial trading. In the financial markets there may be at most 20 key currencies or 10 key interest rates being traded. In equities there are thousands of stocks but no forward market (with the exception of equity options). In the North American gas market, on the other hand, there may be sixty basis locations each trading out two years forward at any one time. That means there are 1,440 price points that can be traded, not including strips. Throw in options, capacity, and storage and you have a real challenge on your hands. And that is just natural gas. Combine that complexity with high volatility, large notional values, large transaction volumes, low margins, and long settlement cycles, it is easy to see why the dangers of using antiquated processes are greater in this market as compared to the financial markets.

Specifications for physical electricity - for nominations or scheduling purposes - require another level of complexity. In the US, electricity is specified on an hourly basis. In the UK, it's half-hourly. In Germany, it's every fifteen minutes. This means volumes and prices have to be s pecified for each time slot. In physical deals, the high penalties for imbalances force counterparties to agree on accurate notifications and details of trades in a portfolio.

To err is human

Complexity aside, as transaction volumes increase, so does the chance of making mistakes and size of mistakes in trading, especially in a volatile market where price movements may swing wildly in a short period of time. Mistakes can be made when a trade is made, when it is entered into the system, when a trade is confirmed, when energy is delivered, and even as late as when a payment is made. While systems having been built to include as many checks and balances as possible to increase efficiency and reduce human intervention and error, some errors still escape the naked eye.

Manual checking is tedious, as it involves matching different media. The checks can be paper against paper, paper against system, system against system, or verbal against verbal. But unlike checking standardized things like widgets, confirmations come in many forms. Each company is free to create its own confirmation format with legalese, so checking them requires a strong attention to detail. Ironically, paper fax and verbal confirmations are still the preferred media, as email is not considered secure. Even the simplest deal may generate three to five pages of fax for confirmation purposes.

It is also stressful. One source revealed that people checking confirms fear interaction with traders because the only time they hear from traders is if there is a mistake. Some companies have coped with stress by distributing the workload throughout the day. For others, all transactions of the previous day must be confirmed by noon the next day. Given such tight deadlines, the confirmation desk can easily be the bottleneck.

The biggest reason for mistakes is simply human nature: people get tired, sick, take vacation days, and have personal issues that get in the way of doing their jobs with 100% accuracy. Computers, on the other hand, don't have these distractions. In accounting, numbers have to tie out. In confirmations, it's someone else's word that it ties out.

To catch an error, divine

The success of catching errors at the confirmation stage varies from company to company. One leading energy trading company with high turnover in its confirmation desk (new comers stay 6 months on the job) estimates as high as two out of every five deals contain error of some kind. Another large company which relies on a more senior and permanent team (and thus lower turnover) estimates 95% of errors are caught before a trade commences. However, this excludes spot deals which start the next day.

Unlike market risk which can be managed by the proper use of risk management instruments such as options and futures, operational risk has no hedge other than prudent checks, separation of trading and risk control functions, and proper staff and procedure management. What is the penalty for making a mistake? Do you fire the person and incur more time and money training someone else? The person's salary may not compensate for the money lost. In a manual process, the cost could run as high as $500 per confirmation. Errors almost always result in losses when they are identified by the other party. If party A discovers its counterparty B made an error, party A may only want to inform B if the error is not in A's favor.

Confirmation and legal risks

Rather than waiting to receive, some companies initiate confirmations, that is, actively generate and send out confirmation for legal reasons and to maintain greater control. It is worth noting the two types of confirmations in practice today: positive and negative. Positive confirmation requires both parties to agree that a trade has been made between them, following the specifications.

A negative confirmation, on the other hand, presumes that the other party has agreed (by a certain date and time) unless noted otherwise. The latter type of confirmation speeds up the process (and thereby volume of trades) and is commonly exercised by online trading platforms. EnronOnline, for instance, generates an automatic fax confirmation for the counterparty. Unless a response is received from the counterparty to the contrary within certain number of business days, Enron assumes the deal is confirmed. The main problem with negative confirmation is that it allows the counterparty who spots a mistake in their favor to keep quiet. "If you make a mistake and I catch it, but if it's in my favor, I may not tell you. It's up to you to alert me."

One of the main reasons for the need to confirm a deal is to verify all the details of a trade. Checking details by themselves are tedious enough, but that they are embedded in pages of legal language (see EEI Master Agreement, for example) makes it even more cumbersome. The lack of a standard format forces the checking process to be a manual one. The traditional exchange of confirmation is paper-based, by telex and now by facsimile. The fax, as paper evidence, can become the controlling document in the event of a dispute. The final arbiter of dispute is "pulling tape" - rewinding the tape of the initial trader telephone conversation to ascertain what was said. That is the most tedious of all.

Towards automated confirmation

Several integrated solution providers now offer automatic confirmation in their product suites. Automation helps reduce or remove manually initiated confirmations and deal matching. It generally refers to "automatic generation of confirmation" which can be viewed on the screen or printed out. Altra Technologies, Houston, Tx, have automated trade confirmations in their integrated solutions. David Hanson, Vice President, Altra, said "Automatic trade confirmation is the key part of any straight through processing as that is the initial building block. Other providers include Caminus, New York, NY and TradeCapture, Stamford, Connecticut.

Caminus ZGrid

A good example of the move towards electronic confirmation as a way to overcome the time barrier is the various nomination and confirmation processes being put in place in the UK in preparation for the New Electricity Trading Arrangements (NETA), which will replace the existing UK Pool in late spring.

As the electricity schedules are defined on a half-hourly basis in the UK, all 48 time slots must be specified by volume and price in a two-hour time window (6 to 8 pm) each day under NETA. Given that a participant can trade between 100 to 1,000 deals a day - Matching such schedules will be very difficult indeed.

To anticipate this essentially critical situation, Caminus has recently introduced an automated matching engine 'ZGrid'. Based on a subset of XML standards, ZGrid replaces fax confirmations and shows an audit trail of what has been exchanged, highlighting any mismatches automatically in real time and eliminating the possibility of incorrect trade information being passed to the central systems. It will also reconcile the nominated positions between counterparties as many times a day as required. Trading operations using ZGrid can link automatically with other counterparties using ZGrid or other compatible software solutions, and also includes an API to the so-called 'Enron Spec.' (To be used for Schedule 3A Nominations, under the new Grid Trade Master Agreement (GTMA).

Initiated by Enron, this specification standard was developed and agreed by seven leading participants in the new UK NETA market, namely Enron, Entergy, Dynegy Centrica, Innogy, El Paso and PowerGen).

The Enron Spec, is a position nomination specification process document, which details the physical format and procedures to reconcile net positions based on a 30, 7, 2 and 1 day-out basis, each day. Caminus' ZGrid confirmations and nomination positions can also be viewed via a web-browser interface, allowing low-volume counterparties with no need to invest in sophisticated solutions to manually check off their positions online, with the ZGrid user.

Pilot tests in the UK are in their final stages with a community of users in the UK and are on schedule to be operational for the NETA go-live date of 27th March. Caminus is also introducing ZGrid to the US for its Zai*Net clients in power, gas, oil, refined products, emissions, and weather derivatives.

TradeCapture's ICTS

According to Matt Frye, Chief Marketing Officer, TradeCapture its Integrated Commodity Trading System (ICTS Online™) updates a company's internal records on scheduled/confirmed/actual shipments such that the company can have an updated record on their positions at various points and with the variety of products. The communication piece with regard to pipeline nominations/scheduling procedures is somewhat up to the reconciling party. TradeCapture's systems can however initiate electronic files, acting as confirmations to trading counterparties via fax, e-mail, or telex.

However, electronic confirmation does not remove the need for both parties to positively or negatively confirm with each other, as there is no independent arbiter. Two new companies have emerged to alleviate the tasks after confirmation - that of clearing and settlements.

EnergyClear

Formed by a joint venture between Bank of New York, Prebon Yamane and Amerex in November 2000, EnergyClear is the first industry- sponsored clearinghouse to offer comparison, netting and settlement of wholesale energy contracts for the over-the-counter (OTC) marketplace. Lee Burton, co-founder and recently appointed President of EnergyClear Operations Company, Houston, Tex, believed it will revolutionize the OTC energy markets by reducing the credit, legal, operational, and liquidity risks and ultimately increase market depth and liquidity. Counterparties must confirm their deals bilaterally before they go to EnergyClear.

NexClear

Privately funded, NexClear Inc, Boulder, Co, will provide centralized clearing, fulfillment, and delivery services to the OTC-traded commodity markets. In addition, it will also guarantee transactions, monitor credit risk, provide trade data, and perform necessary middle and back office services. NexClear has a web-based confirmation window that requires users to click off trade details.

The industry is starting to take notice of straight-through processing (STP) to avoid human intervention and reduce error. As technology becomes cheaper and easier to implement (thanks to middleware and systems integrators), companies may gradually shift away from manual and paper-based processes. However for true automation to work, standardization requires all market participants to agree on the format and confirmation procedures. This requires legal departments to agree.

In the event of a dispute, it's still one's word against another's. After paper documents, telephone recordings, there is no third party arbiter (unless broker or exchange based). While automation may reduce paperwork and manual headaches, ach counterparty must still take on its own confirmation and legal risks as it cannot offload on a third party.

Third party to take on risk

Insurance companies can insure portfolios against all sorts of trading risks including operational risks. But how do you mitigate the risk of a mismatch? The risk inherent in the confirmation process?

Chris Papousek, founder and president of Confirmation Clearing Corporation, Houston, Texas, advised, "A good way to test the readiness of an organization in the event of a counterparty default is to run an occasional fire drill. This uncovers gaps that are easy to fill when the clock isn't ticking. His company advocates using a neutral, independent third party to mitigate the legal risk in confirmation and eliminate operational risk altogether. Legal terms and conditions are maintained in a Confirmation Clearing Agreement, separate from the trade attributes. In other words, the counterparties send their trade details for matching and confirmation by Confirmation Clearing Corporation, whose subscribers will be insured under an error and omissions policy. This type of legal risk mitigation and operational risk elimination is not available without an independent third party like this. Figure 2 shows how they would fit in the increasingly dynamic and multi-party/multi-system of energy trading.

Papousek believes that a true confirmation service should be: a central, neutral, multi-commodity deal matching system and confirmation repository that is independent of trading system, trading platform, and margining/settlement system. He said, "The last thing you want in the confirmation arena is a fragmented solution that only addresses a single system or a finite number of commodities. To achieve economies of scale the solution must span all systems and all commodities. The end result is simply one interface to one confirmation system (an IT manager's dream). There are many players that try to do this, but not real-time, independent deal confirmation for all trades across all counterparties and commodities consistently and reliably as we strive to do."

Table: Deals and Confirmations
Possible Error Scenarios
Figure 1: Deal Flow Process
Figure 2: 3rd Party Confirmation