Effective product control controlling for trading desks

Effective Product Control Founded in 1807, John Wiley & Sons is the oldest independent publishing company in the United States With offices in North America, Europe, Australia and Asia, Wiley is globally committed to developing and marketing print and electronic products and services for our customers’ professional and personal knowledge and understanding The Wiley Finance series contains books written specifically for finance and investment professionals as well as sophisticated individual investors and their financial advisors Book topics range from portfolio management to e-commerce, risk management, financial engineering, valuation and financial instrument analysis, as well as much more For a list of available titles, visit our Web site at www.WileyFinance.com Effective Product Control Controlling for Trading Desks PETER NASH This edition first published 2018 © 2018 Peter Nash Registered office John Wiley & Sons Ltd, The Atrium, Southern Gate, Chichester, West Sussex, PO19 8SQ, United Kingdom For details of our global editorial offices, for customer services and for information about how to apply for permission to reuse the copyright material in this book please see our website at www.wiley.com All rights reserved No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, except as permitted by the UK Copyright, Designs and Patents Act 1988, without the prior permission of the publisher Wiley publishes in a variety of print and electronic formats and by print-on-demand Some material included with standard print versions of this book may not be included in e-books or in print-on-demand If this book refers to media such as a CD or DVD that is not included in the version you purchased, you may download this material at http://booksupport.wiley.com For more information about Wiley products, visit www.wiley.com Designations used by companies to distinguish their products are often claimed as trademarks All brand names and product names used in this book are trade names, service marks, trademarks or registered trademarks of their respective owners The publisher is not associated with any product or vendor mentioned in this book Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose It is sold on the understanding that the publisher is not engaged in rendering professional services and neither the publisher nor the author shall be liable for damages arising herefrom If professional advice or other expert assistance is required, the services of a competent professional should be sought Library of Congress Cataloging-in-Publication Data Names: Nash, Peter, author Title: Effective product control : controlling for trading desks / by Peter Nash Description: Chichester, West Sussex, United Kingdom : John Wiley & Sons, 2018 | Includes index | Identifiers: LCCN 2017029434 (print) | LCCN 2017040992 (ebook) | ISBN 9781118939796 (Pdf) | ISBN 9781118939802 (epub) | ISBN 9781118939819 (cloth) Subjects: LCSH: Financial institutions—Risk management | Financial services industry— Risk management | Portfolio management | Stocks | Investments Classification: LCC HG173 (ebook) | LCC HG173 N27 2018 (print) | DDC 332.1068/1—dc23 LC record available at https://lccn.loc.gov/2017029434 A catalogue record for this book is available from the British Library ISBN 978-1-118-93981-9 (hardback) ISBN 978-1-118-93980-2 (ePub) ISBN 978-1-118-93979-6 (ePDF) ISBN 978-1-118-93978-9 (obk) 10 Cover design: Wiley Cover image: Top: ©Shai_Halud/Shutterstock, Bottom: ©Inozemtsev Konstantin/Shutterstock Set in 10/12pt Times by Aptara Inc., New Delhi, India Printed in Great Britain by TJ International Ltd, Padstow, Cornwall, UK I dedicate this book to my family, especially my children, who have forgone a great deal of Dad time for this book to come to life To Phoebe, Xani and Matilda Thank you In memory of Patrick Spratt, a product controller and friend who was larger than life Contents Preface xiii Acknowledgements xv About the Author xvii PART ONE Working in Product Control CHAPTER An Introduction to Product Control The Emergence of Product Control The Purpose of Product Control Different Types of Product Control Skills, Qualifications and Experience Organizational Structure The Desk 3 10 CHAPTER Changing Landscape of Product Control 15 Offshoring XVA Greater Levels of Capital Greater Focus on Liquidity Notes CHAPTER Key Stakeholders Front Office: Sales and Trading Desk Chief Operating Officers (COOs) Operations Middle Office Market Risk Financial Reporting Management Reporting Finance Change 15 19 19 20 21 23 23 25 26 27 28 29 29 30 vii viii CONTENTS IT Operational Risk Regulatory Reporting Accounting Policy Tax Audit Finance Shared Service Summary Notes 30 32 32 34 34 36 37 37 37 PART TWO Technical Skills CHAPTER Accounting Standards: Recognition and Measurement IAS 39 Financial Instruments: Recognition and Measurement IFRS 9: Financial Instruments IFRS 13: Fair Value Measurement Notes CHAPTER Market Risk What Is Market Risk and How Is It Generated? How Is Market Risk Measured by a Bank? Note CHAPTER Pricing Financial Instruments How to Approach the Pricing of a Financial Instrument Pricing Examples Notes CHAPTER Internal Control What Is Internal Control? Establishing an Internal Control Framework Example of Front to Back Internal Controls Notes 41 42 60 66 71 75 75 77 85 87 87 89 105 107 107 110 117 122 PART THREE Profit and Loss Controls CHAPTER System Feeds, End of Day Rates and Profit and Loss Estimates System Feeds End of Day End of Day Rates 127 127 129 130 Contents P&L Estimate Note CHAPTER Review of New and Amended Trades New Trades Amended Trades Notes CHAPTER 10 Review of Mark-to-Market P&L Defining Mark-to-Market P&L Attributing MTM P&L Risk-Based P&L Estimates Changes in the End of Day Prices When to Validate the MTM P&L CHAPTER 11 Funding, Fees and Charges Funding Fees and Charges Note CHAPTER 12 Profit and Loss Adjustments The Need for P&L Adjustments Controlling P&L Adjustments Notes CHAPTER 13 Profit and Loss Commentary Who Is the Reader? When Is P&L Commentary Required? CHAPTER 14 Profit and Loss Reconciliations and Sign-Offs Flash vs Actual Desk P&L Sign-off P&L Reconciliation ix 135 136 137 137 152 164 165 165 166 170 173 176 177 177 185 187 189 189 190 194 195 198 198 201 201 203 205 PART FOUR Valuations CHAPTER 15 Independent Price Verification 209 Components to IPV Process Note 210 224 x CONTENTS CHAPTER 16 Valuation Adjustments Why Valuation Adjustments Are Required Bid–Offer Day Reserves Model Valuation Adjustment XVA and Collateral Agreements Recording and Reporting of VAs Notes 225 225 225 234 234 235 239 239 PART FIVE Balance Sheet Controls CHAPTER 17 Balance Sheet Substantiation and Analysis 243 Substantiating the Balance Sheet Frequency of the Balance Sheet Substantiation Evidencing the Balance Sheet Substantiation Unsupported Balances Lines of Responsibility 243 248 249 249 255 CHAPTER 18 Dividending of Profit and Loss and FX Selldown 257 CHAPTER 19 Controlling Nostros 261 Introduction to Nostros Controlling Nostros – Cash Breaks Risk-Weighting Cash and AVE breaks Provisioning for Nostro and AVE Breaks Notes 261 262 266 267 268 PART SIX Financial Accounting and Reporting CHAPTER 20 Financial Accounting Entries Financial Accounting Entries Chart of Accounts Accounting Rules Engine Notes CHAPTER 21 Financial Reporting and Note Disclosures Context of Financial Reporting Profit and Loss 271 271 284 286 289 291 291 293 Contents Balance Sheet Netting Fair Value Hierarchy Notes xi 295 297 304 309 PART SEVEN Supplementary Controls CHAPTER 22 New Product Proposals Starting Line The Review The Sign-Off CHAPTER 23 Rogue Trading The Forefathers of Rogue Trading The Fallout from Rogue Trading – The Bank The Fallout from Rogue Trading – The Industry Going Rogue UBS Rogue Trading Incident, 2011 Notes Index 313 313 314 319 321 321 323 325 325 327 343 347 340 SUPPLEMENTARY CONTROLS Product Control Significant increase in proprietary trading P&L Balance sheet reconciliation breaks Operations Something is wrong! Frequent & material reconciliation breaks Frequent & material P&L adjustments FIGURE 23.13 Consolidated lens Source: FINMA “Summary Report: FINMA Investigation into the Events Surrounding Trading Losses of USD 2.3 Billion Incurred by the Investment Banking Division of UBS AG in London,” 21 November, 2012 Unhelpful systems: The UBS systems were unhelpful for the controlling of the ETF desk Product control were not provided with trade level P&L reports, operations’ T+14 report wasn’t operational for almost a year and trend analysis couldn’t be performed on the SCP alerts.70 Lack of collaboration: A bank is fragmented into multiple departments, all of which need to work together to maintain a strong internal control framework At UBS, there was a lack of collaboration amongst the business and support functions, which meant that an overall picture of the control exceptions was never created.71 I refer to this picture as a consolidated lens For UBS, a consolidate lens could have highlighted, to the business and senior management in operations and finance, the collective control exceptions listed in Figure 23.13 This information would provide management with strong evidence that something was seriously wrong with the ETF desk and an immediate collaborative investigation could ensue Lack of governance for P&L adjustments: Product control’s lack of controls around P&L adjustments allowed material P&L adjustments to be entered at the discretion of junior employees with limited control experience.72 All these shortcomings weakened the control framework and made it more difficult to identify the rogue trading that occurred on the ETF desk How Was the Fraud Detected? By 13 September, 2011, Adoboli’s life on the run was fast approaching its end, as senior finance managers started to question large uncollateralized assets created by the fictitious deferred settlement ETF trades As these balances were uncollateralized, they exposed UBS to significant amounts of credit risk, which the finance managers wanted mitigated against by calling collateral from the counterparties During a phone call between the financial controller, product control and Adoboli, the latter was requested to confirm the exposures and counterparties were accurate Rogue Trading 341 so that UBS could go ahead and make the collateral call Knowing the ruse was finally up, the trader left the office and went home to pen the following email to the product controller he had been misleading CASE STUDY: UBS, KWEKU ADOBOLI The following email was sent by Adoboli to his product control colleague Dear Will, It is with great stress and disappointment that I write this mail First of all the ETF [exchange-traded funds] trades that you see on the ledger are not trades that I have done with a counterparty as I previously described I used the bookings as a way to suppress the PnL (profit and loss) losses that I have accrued through off book trades that I made Those trades were previously profit making, became loss making as the market sold off aggressively through the aggressive sell off days of July and early August Initially, I had been short futures through June and those lost money when the first Greek confidence vote went through in mid-June In order to try and make the money back I flipped the trade long through the rally Although I had a couple of opportunities to unwind the long trade for a negligible loss, I did not move quickly enough for the market weakness on the back of the first back macro data and then an escalation Eurozone crisis cost me the losses you will see when the ETF bookings are cancelled The aim had been to try and make the money back before the September expiry date came through but I clearly failed These are still live trades on the book that will need to be unwound Namely a short position in DAX futures (which had been rolled to December expiry) and a short position in S and P 500 futures that are due to expire on Friday I have now left the office for the sake of discretion I will need to come back in to discuss the positions and explain face to face, but for reasons that are obvious, I did not think it wise to stay on the desk this afternoon I will expect that questions will be asked as to why nobody else was aware of these trades The reality is that I have always maintained that these were EFP [exchange for physical] trades to the member of my team, BUC [product control], trade support and John Di Bacco [Adoboli’s manager] I take full responsibility for my actions and the s∗∗∗ storm that will now ensue I am deeply sorry to have left this mess for everyone and to have put my bank and my colleagues at risk Thanks, Kweku.73 That is the one type of email you don’t want to get from your trader and it must have sent a chill down the spine of the product controller, whom Adoboli had been misleading to conceal his losses 342 SUPPLEMENTARY CONTROLS Once Adoboli confessed his losses, the City of London Police and FINMA, the Swiss Financial Markets regulator, were notified by UBS FINMA subsequently issued a press release stating that they would arrange for an independent investigation into the events that led to the trading loss Kweku Adoboli was charged by the City of London Police with two counts of fraud by abuse of position and four counts of false accounting He faced criminal proceedings in Southwark court and on 20 November 2012, was found guilty on two counts of fraud by abuse of position but acquitted of four charges of false accounting He was sentenced to jail for seven years The rogue actions of Adoboli were considered sophisticated and so serious that they almost wiped out UBS His actions led to many people losing their jobs and damaged the morale of many of the Swiss bank’s staff, myself included Adoboli has now served his time and I think it’s important to give him the liberty to create a new career for himself, which will hopefully include assisting the banking industry to prevent rogue trading from reoccurring on this scale Other Significant Operational Losses Although not considered to be a case of rogue trading, there has been a trading loss in recent history which is also worth exploring JP Morgan’s “London Whale beaching” in 2012 was a significant event for the company, as within the space of six months the firm had unwittingly walked into more than $6 billion of trading losses Bruno Iksil, nicknamed the London Whale, worked with colleagues in the chief investment office (CIO), whose mission was to reduce JP Morgan’s risk level However, instead of reducing risk, the London office engaged in trading complex derivatives to generate trading profits Sometimes this worked, pulling in huge profits for the bank but, eventually, their strategy failed and became a target for other market participants As losses continued to unexpectedly mount in the CIO structured credit portfolio, the firm established a task force to investigate the cause of the losses74 and the trades also drew the attention of U.S prosecutors Whilst Iksil appears to have made a deal with prosecutors, his supervisor and junior colleague were charged with securities fraud While the trades weren’t illegal, prosecutors acted on the charge that the traders concealed the magnitude of losses from the bank’s management The incident shed light on how oversight can fail, as a U.S Senate investigation report showed that the bank did not disclose key information to regulators and overlooked risky trading habits, including more than 300 risk-limit breaches in the first four months of 2012 JP Morgan’s reputation took a hit and CEO Jamie Dimon took a 50% paycut “When the Whale’s trading first came to light, Dimon dismissed it as ‘a tempest in a teapot.’ Later he was more contrite, calling the trades ‘flawed, complex, poorly reviewed, poorly executed and poorly monitored.’ ”75 In the bank’s task force report, all functions within the CIO business drew criticism, including the traders, trading management, risk and finance These key findings reinforce the notion that all functions need to maintain their lines of defence in order for the overall control framework to be effective For product control, the report reinforces the importance of having appropriately skilled people in the role who provide transparency into the desk’s trading activity through the channels available to them Frequently I hear senior management in the front office asking for product control to challenge their staff and that is exactly what was required in the CIO function at JP Morgan Rogue Trading 343 Fraud and trading losses, whether significant or not, will always be a real risk for banks where trading desks exist A diligent review of incidents in the past can help reduce the risk of history repeating itself Always be on your guard, remain part of the collective control fabric and remember to remain independent of the front office NOTES Rodrigues, Jason, “Barings collapse at 20: How rogue trader Nick Leeson broke the bank,” The Guardian, 25 February 2015, https://www.theguardian.com/business/from-the-archive-blog/ 2015/feb/24/nick-leeson-barings-bank-1995-20-archive Leeson, Nick, Rogue Trader Little, Brown Book Group Kindle Edition Iguchi, Toshihide, My Billion Dollar Education, Inside the Mind of a Rogue Trader, 2014 Ibid Wearden, Graeme, “The biggest rogue traders in history,” The Guardian, 25 January 2008, https://www.theguardian.com/business/2008/jan/24/europeanbanks.banking Pignal, Stanley, “Rogue Traders who went off the rails,” FT Magazine, 24 January 2009, https://www.ft.com/content/2d78785c-e755-11dd-aef2-0000779fd2ac Wearden, Graeme, “The biggest rogue Traders in history,” The Guardian, 25 January 2008, https://www.theguardian.com/business/2008/jan/24/europeanbanks.banking APRA, “Report into Irregular Currency Options Trading at the National Australia Bank,” 23 March 2004 Soci´et´e G´en´erale Group, 2008 registration document 10 Daneshkhu, Scheherazade, ‘SocGen €5.5bn rights issue oversubscribed,” Financial Times, 11 March 2008, https://www.ft.com/content/10bfb5fe-ef3f-11dc-8a17-0000779fd2ac 11 Soci´et´e G´en´erale Group, 2008 Registration document 12 Soci´et´e G´en´erale, “General Inspection Department, “Mission Green Summary report,” 20 May 2008 13 Roland, Denise, “Rogue trader J´erˆome Kerviel leaves prison less than five months into three-year sentence, Former banker who lost Soci´et´e G´en´erale nearly €5bn has secured job in IT consultancy firm,” The Telegraph, 25 March 2017, http://www.telegraph.co.uk/finance/newsbysector/ banksandfinance/11081554/Rogue-trader-Jerome-Kerviel-leaves-prison-less-than-five-months-into -three-year-sentence.html 14 Sebag, Gaspard and Benedetti Valentini, Fabio, “Kerviel Bill Cut to $1 Million from $5.5 Billion by Judges,” Bloomberg, 24 September 2016, https://www.bloomberg.com/news/articles/2016-0923/kerviel-must-pay-socgen-1-million-euros-over-2008-trading-loss 15 FINMA, “UBS trading losses in London: FINMA finds major control failures,” 26 November 2012, https://www.finma.ch/en/news/2012/11/mm-ubs-london-20121126 16 National, Concise Annual Report 2003, p 43 17 Ibid., p 61 18 Ibid 19 National, Annual Financial Report 2004, p 20 FINMA “Summary Report, FINMA Investigation into the Events surrounding Trading Losses of USD 2.3 billion incurred by the Investment Banking Division of UBS AG in London,” p 13, 21 November 2012, https://www.finma.ch/en/news/2012/11/mm-ubs-london-20121126 21 FSA, “FSA fines UBS £29.7 million for significant failings in not preventing large scale unauthorised trading,” 26 November 2012, http://www.fsa.gov.uk/library/communication/pr/2012/105 shtml 22 National, Concise Annual Report 2004, p 61 23 Committee of European banking Supervisors, “Reactions to the Soci´et´e G´en´erale loss event: results of a stock-take,” 18 July 2008, https://www.eba.europa.eu/documents/10180/16166/ 20080718survey.pdf 344 SUPPLEMENTARY CONTROLS 24 Fortado, Lindsay, “Kweku Adoboli: A Rogue Trader’s Tale,” FTfm, 22 October, 2015, https://www ft.com/content/0fa0b42a-783a-11e5-a95a-27d368e1ddf7 25 FINMA “Summary Report: FINMA Investigation into the Events Surrounding Trading Losses of USD 2.3 billion incurred by the Investment Banking Division of UBS AG in London,” p 3, 21 November 2012, https://www.finma.ch/en/news/2012/11/mm-ubs-london20121126 UBS, Annual Report 2011, Page 43, https://www.ubs.com/global/en/about_ubs/investor_ relations/annualreporting/archive.html 26 FINMA “Summary Report, FINMA Investigation into the Events surrounding Trading Losses of USD 2.3 billion incurred by the Investment Banking Division of UBS AG in London,” page 4, 21 November 2012, https://www.finma.ch/en/news/2012/11/mm-ubs-london-20121126 27 Ibid., pp 4–5 28 Ibid 29 FINMA “Summary Report, FINMA Investigation into the Events surrounding Trading Losses of USD 2.3 billion incurred by the Investment Banking Division of UBS AG in London,” page 4, 21 November 2012, https://www.finma.ch/en/news/2012/11/mm-ubs-london-20121126 30 Ibid 31 Ibid 32 Ibid 33 Ibid., p 12 34 APRA, “Report into Irregular Currency Options Trading at the National Australia Bank,” pp 17–18, 23 March 2004 35 FINMA “Summary Report, FINMA Investigation into the Events surrounding Trading Losses of USD 2.3 billion incurred by the Investment Banking Division of UBS AG in London,” p 5, 21 November 2012, https://www.finma.ch/en/news/2012/11/mm-ubs-london-20121126/ 36 Ibid., p 37 Ibid 38 Ibid., p 10 39 Ibid., p 40 Ibid., p 41 Ibid., p 11 42 Ibid., p 43 Ibid 44 Ibid 45 Ibid., p 10 46 Ibid 47 Ibid., p 48 Ibid., p 49 Ibid 50 Although other traders on the desk were aware of this P&L smooth mechanism, there is no evidence that suggests they knew Adoboli was using this mechanism to conceal his unauthorized trading losses 51 Ibid 52 Ibid., p 10 53 Ibid 54 Ibid 55 Ibid 56 Ibid., pp 6–7 57 Ibid 58 Ibid 59 Ibid 60 Ibid Rogue Trading 61 62 63 64 65 66 67 68 69 70 71 72 73 345 Ibid Ibid., p 12 Ibid., p Ibid Ibid., p 13 Ibid., p 10 Ibid Ibid Ibid., p 11 Ibid Ibid Ibid Rankin, Ben, “ ‘I take full responsibility for the s∗∗∗ storm that will now ensue’: rogue trader’s email to colleagues,” Mirror.co.uk, 20 November 2012, http://www.mirror.co.uk/news/uk-news/kwekuadoboli-read-bombshell-email-1446637 74 JP Morgan, “Report of JPMorgan Chase & Co Management Task Force Regarding 2012 CIO Losses,” 16 January 2013, http://files.shareholder.com/downloads/ONE/2272984969x0x628656/ 4cb574a0-0bf5-4728-9582-625e4519b5ab/Task_Force_Report.pdf 75 Hurtado, Patricia, “The London Whale.” Bloomberg, 23 April 2015 Bloomberg L.P Copyright© 2015, http://www.bloombergview.com/quicktake/the-london-whale Effective Product Control: Controlling for Trading Desks By Peter Nash © 2018 Peter Nash Index above the line expenses 185–6 accountability see RACI accounting 41–73 brokerage fees 186–7 fair value measurement 65–71 IFRS 42, 60–5 policy 34 standards 42–70 see also financial accounting entries; International Accounting Standards accounting rules engine (ARE) 286–9 flows 287 general ledger 286–8 use of trade data example 287 accretion 183–4 actual vs expected (AVE) breaks 264–8 add-ons 104–5 adjustments, P&L 189–94, 337–8, 340 Adoboli, Kweku 323, 327–42 AFS see available-for-sale assets Allied Irish Bank 322 amended trades 137, 152, 154–64 avoidable/unavoidable amendments 160–1, 164 HSBC example 155 presentation of P&L 161, 163 reasons for amendment 152, 154–60 reviewing 152, 154–64 trends 161, 162, 164 types of amendments 154–60 American options 102 amortization 50, 57–9, 63, 183 ARE see accounting rules engine Asian options 102 assets see financial assets at the money (ATM) 215, 104 audit 36–7, 113 available for sale (AFS) assets IAS 39 51–3, 56, 57–8 impairment 57–9 U.S GAAP 56, 58–9 AVE breaks see actual vs expected breaks back-to-back interest rate swaps 238–9 balance sheet substantiation 243–55 appropriateness of account 245–7 balance in line with activities 247–8 escalation example 254 evidencing 249, 250 frequency of 248–9 lines of responsibility 255 source supporting balance 244–5 unsupported balances 249, 251 balance sheets financial reporting 295–7 forecasted usage 26 types of control 5–6 UBS rogue trading 338 banks/banking 77–85, 323–5 see also individual banks Barings bank 184, 321–2 barrier options 102 Basel III 19, 20–1 basis points 143 basis swaps 97 below the line expenses 185 benchmarking 134–5, 174 Bermudan options 102 bid-offer 225–32 bid-offer spreads 231–2 fair value measurement 67 new trades 146–7, 148 quantifying the VA 228–32 valuation adjustments 225–32 Bloomberg financial services 174–6 boards of directors 111–12 bonds accounting entries 276–8 amended trades 156 AVE breaks 265 financial reporting of P&L 293–4 funding P&L 178–84 IPV variances 221, 222–4 pricing 93–5 world corporate prices 217 347 348 booking errors 333–4 books, change of 154, 159–60 borrowing, unsecured term 183–4 brokerage fees 186–7 business model test 61–2 business units 112 capital levels 19–21 captive offshoring model 15–17 cash breaks 262–7 matching entries 263–4 nostros 262–7 risk-weighting 266–7 TLM software 263–6 UBS rogue trading 336–7 cash flows 61, 87–8, 94 cash trades 336–7 CCPs see central clearing counterparties CDSs see credit default swaps central clearing counterparties (CCPs) 154, 158–9, 299 challenge culture 337, 338, 339 charges 177, 185–7 charts of accounts 284–6 chief operating officers (COOs) 25–7, 161 classification, IFRS 60–5 close of business (COB) 141–2 close out netting 297–8 close outs 154, 157 CME Clearing 159 COB see close of business collaboration 340 collateral 235–9, 299, 301, 303 collateral agreements 235–9 see also credit support annex commentary 151, 195–200 Committee of Sponsoring Organizations of the Treadway Commission (COSO) 107–10 completeness 131, 133–4 compliance 108 concealment mechanisms 329–38 confidence levels 83 confirmations 330–1 consensus pricing 212–13 consumer see RACI contractual cash flows 62 control balance sheets 5–6 nostros 261–8 P&L adjustments 190–4 valuation 9–10 see also internal control; product control control, UBS 329–40 effective 332, 333–4, 335–6, 337, 338 summary of weaknesses 339–40 weaknesses 326, 329–40 INDEX COOs see chief operating officers corporate risk management 113 corporate titles COSO see Committee of Sponsoring Organizations of the Treadway Commission cost amortized 50, 57–9, 63 assets carried at 57 COO responsibilities 26 cost of funds curve 99 counterparties amended trades 154, 156, 157–9 CCPs 154, 158–9, 299 financial reporting 295, 297 new trades 145 coupons 93, 182–4 credit default swaps (CDSs) balance sheet substantiation 249, 250–3 new trades 150 price discovery 216, 220 credit desk 204, 258–9 credit ratings 325 credit spreads 216, 220 credit support annex (CSA) 89, 99–100, 235–7 credit value adjustments (CVAs) 147–8, 237–8 crime concealment 327, 329–40 cross currency basis spreads 214–15 cross currency swaps 214–15, 236 CSA see credit support annex currency restrictions 260 CVAs see credit value adjustments Daiwa 321–2 data 138–40, 161 DAX index 327–8, 341 day reserves 234 day one P&L 195–8 debit value adjustments (DVAs) 147–8, 237–8 deferred settlement 330–1, 334–6, 340 delta FX options 103–4 market risk 78, 81 volatilities 215, 218 see also Greeks derecognition 43–7, 59 derivatives embedded 53–4, 63 financial reporting 295, 298–9, 300–1 netting 298–9, 301 OTC 89 U.S GAAP 56 see also financial instruments desks 10–13 credit 204, 258–9 end of day 130 funding 177–80 349 Index internal control 112, 116–17 new trade drivers 150–1 P&L sign-off 203–4 pressures 13 rates 78–9, 230 sales 23–4, 137, 140–1, 144 trading desks 10–13, 112, 116–17 treasury 178, 180 digital options 102 Dimon, Jamie 342 directors 111–12 disclosure 291, 295, 302–3, 307 discounts 98, 99–101, 102, 183 dividending 257–61 dividends 273–4 Dodd–Frank Wall Street Reform and Consumer Protection Act 2010 114–15 doubling down bets 327 DVAs see debit value adjustments economic P&L 20 embedded derivatives 53–4, 63 end of day 129–30 end of day prices 173–6 end of day rates 127, 130–5 completeness 131, 133–4 externally sourced 131–3 market aligned 134–5 significant changes 132–3 stale rates 132, 134 trader sourced rates 133–5 equity investments 53, 64 errors 152, 154–5, 333–4 escalation issues balance sheet substantiation 254 matrices 192–4, 267 nostros 267 P&L 151–2, 192–4, 200 UBS rogue trading 333–4, 339 ETFs see exchange-traded funds European options 102 EUROSTOXX index 327, 328–9 exchange-traded funds (ETFs) 327, 329–32, 334–6, 338–41 executable quotes 231 executed transactions 212 expenses 185–6 experience 6–8 external audit 36–7 fair value bonds 277 definition 66 IPV 210–19 new trade reviews 145–9 see also mark-to-market fair value hierarchy (FVH) 304–8 day reserves 234 decision tree 306 level 303–4 level 305 level 305–7 U.S GAAP 307–8 fair value measurement 65–71 blockage factors 67 definition of fair value 66 determining fair value 67–70 U.S GAAP 71 fair value option (FVO) 49–50, 54, 57, 64 fair value through OCI 64 fair value through P&L (FVTPL) 47–50, 54, 64 fat-finger mistakes 155 fees 177, 185–7, 336 fee tickets 336 Ferguson, Alex 11–12 finance change 30 finance shared service 37 financial accounting entries 271–89 accounting rules engine 286–9 charts of accounts 284–6 examples 272–84 financial assets carried at amortized cost 57 carried at cost 57 classification 60–4 derecognition 43–7, 59 fair value and IPV 210–11 IAS 39 42–54, 57 IFRS 60–4 impairment 57 measurement 47–54, 60–4 recognition 42–3, 59 financial instruments funding drivers 178 Greeks 78–9 IAS 39 42–59 IFRS 42, 60–5 market risk 77, 78–9 pricing 87–105 special features 89 financial liabilities derecognition 47, 59 fair value and IPV 210–11 IAS 39 42–3, 47–8, 54–9 IFRS 59, 64–5 measurement 47–8, 54–9 recognition 42–3, 59 financial reporting 291–308 balance sheet 295–7 context 291–3 fair value hierarchy 304–8 netting 297–302 350 financial reporting (Continued) P&L 293–5 stakeholders 29–30 types of control 5–6 U.S GAAP 291, 294, 300–2, 307–8 see also International Financial Reporting Standards; reporting FINMA 324, 326, 328–30, 342 firm quotes 212 fixed for floating swaps 95 fixings 170, 173 the flash 135–6, 201–4 FOBO see front office to back office forecast swap curve 98–9 foreign exchange (FX) forwards 91–3, 281–2 Greeks 81 market operating hours 11 notes 314, 317 options 101–5, 167–70, 304–5, 322–3, 330 price discovery 215–16, 219 tax example 34–5 trader-managed exposures 260 see also FX…; spot FX forward points 215–16, 219 forward rate agreements (FRAs) 79 forwards 91–3, 281–2 Frank see Dodd–Frank FRAs see forward rate agreements fraud detection 340–2 front office the flash 135–6, 201–4 front to back internal control 118–19 input error 152, 154–5 main objectives 23 role of 24 stakeholders 23–4 UBS rogue trading 332–4, 338 front office to back office (FOBO) reconciliation 129 front to back internal control 117–22 functional currency 257 funding 177–85 bond examples 178–84 desks 177–80 drivers 177–9 P&L 179–82 rogue trading 184–5 funding value adjustments (FVAs) 148, 238–9 futures 282–4, 330–4 FVAs see funding value adjustments FVH see fair value hierarchy FVO see fair value option FVTPL see fair value through P&L FX see foreign exchange; FX… INDEX FX revaluation 170 FX selldown 257–61 estimation 260 overview 257–8 P&L from 260–1 GAAPs see Generally Accepted Accounting Principles gamma 78 see also Greeks general ledger (GL) accounting rules engine 286–8 balance sheet substantiation 243–8, 254 end of day 129–30 new trades 138–9 nostros 261 P&L reconciliations 205–6 system feeds 127–9 Generally Accepted Accounting Principles (GAAPs) 41, 291 see also U.S GAAP GFC see global financial crisis GL see general ledger global financial crisis (GFC) 15, 19–20 gold lease transactions 246–7 Greeks 77–82 see also delta Hamanaka, Yasuo 322 hedge accounting 60, 65 held for investment loans 57 held for sale loans 57 held to maturity (HTM) assets 48, 56, 58–9 held for trading assets 49, 54, 56 history sets 82–3 holding periods 83–4 HSBC 155 HTM see held to maturity assets IASs see International Accounting Standards IFRSs see International Financial Reporting Standards Iguchi, Toshihide 321–2 Iksil, Bruno 342 impairment 57–9, 65 implied volatility 103 independent price verification (IPV) 209–24 balance sheet substantiation 244 components diagram 210 fair value 210–19 price discovery 211–20 price variances 219, 221–3 reporting outcomes 224 independent verification 190, 209–24 indicative quotes 213, 231–2, 233 information 150–1 see also RACI information technology (IT) 30–2, 130 351 Index initial margin 283–4 input error 152, 154–5 intention to hold 67 intercompany transactions 292 interest on a bond 277 interest rates price discovery 214 regulated, IFRS 63 risk-based P&L estimates 171, 173 STIR trading 177, 180 tenor spreads 214 interest rate swaps (IRSs) accounting entries 278–80, 287 accounting rules engine 287 Greeks 78–80 mark-to-market P&L 171, 173 novations 158 pricing 95–101, 103 swap yield curves 98–101, 102 valuation adjustments 237–9 internal audit 36, 113 internal control 107–23 business types 116–17 COSO 107–10 definition 107–10 establishment of 110–17 framework 107–23 front to back example 117–22 lines of defence 112–13 objectives 110 supporting principles 108–9 International Accounting Standards (IASs) IAS 32 297–9, 302–3 IAS 37 267 IAS 39 42–59, 64, 272, 274, 276, 281, 282 see also accounting… International Financial Reporting Standards (IFRSs) 41–2 IFRS 302 IFRS 42, 60–5, 238, 272–3, 274–5, 276, 281, 282 IFRS 13 42, 66–71, 228–9, 232, 303–4 netting 297–301 see also financial reporting intracompany transactions 292, 294 intraday MTM 196, 198 investment 53, 57, 63 IPV see independent price verification IRSs see interest rate swaps IT see information technology job losses 324 JP Morgan 342 Kerviel, J´erˆome 322–3, 325 key performance indicators (KPIs) 25 Kohlhagen see Garman–Kohlhagen… labelling 293 ledger credits/debits 262–3 Leeson, Nick 184, 321–2, 326 legal entity view 291–2 Lehman Brothers 45–6 leverage 63 liabilities see financial liabilities LIBOR 95–7, 100–1, 279–80 liquidity 20–1 loans 274–6 accounting entries 274–6 at maturity 275–6 held at amortized cost 58–9 IAS 39 50–1, 57–9 impairment 58–9 U.S GAAP 57 local GAAP 291 London Interbank Offered Rate (LIBOR) 95–7, 100–1, 279–80 London Whale beaching 342 loss see job losses; profit and loss… management reporting 29–30 margin 148, 149, 195–6, 283–4 market alignment 134–5 market best practice 116 market data 213–14 market movement 150 market participation 66 market prices 146–9 market risk 75–85 definition 75–7 generation of 75–7 measured by bank 77–85 stakeholders 28–9 markets, principal/most advantageous 69–70 MarkitServ 159, 160 mark-to-market (MTM) 141–2, 165–76, 196, 198 see also fair value mark-to-market P&L 165–76 attributing 166–73 definition 165–6 end of day prices 173–6 existing positions 196, 198 P&L commentary 196, 198 risk-based P&L estimates 170–4 sub-attribution 166–73 validation 165–6, 176 measurement and classification 60–5 fair value 65–70 financial assets 47–54, 60–4 financial liabilities 47–8, 54–9 IAS 39 47–59 IFRS 60–5 352 measurement (Continued) initial 47 subsequent 47–59 middle office end of day 129–30 front to back internal control 118–19 stakeholders 27–8 UBS rogue trading 332 mismarking 209–10, 327 Mondrian Alpha recruitment 17 most advantageous markets 68–9 MTM see mark-to-market National Australia Bank (NAB) 322, 323–5, 330 nearshoring 16–17 net operating profit after tax (NPAT) 20 net present value (NPV) 101–2, 157, 280 net stable funding ratio (NSFR) 21 netting 297–303 CCPs 299 derivatives 298–9, 300–1 disclosures 302–3 IFRS 297–300 intention to settle net 298 right to set-off 297–8, 300 new product proposals (NPPs) 313–19 pre-approval checklist 314–16 review 314–19 sign-off 319 starting line 313–14 new products 25, 313–19 new trades 137–52, 153 baseline fields 139–40 criteria for review 141–4 data extraction 138–40 detailed reviews 140–4 drivers 138, 149–51 generation of 137–8 presentation of P&L 152, 153 process of review 144–52 reviewing 138–52 with significant P&L 151–2 non-marketable equity securities 57 non-recourse financing 63 nostros 261–8 accounting entries 273, 275, 276, 278, 280, 282, 283–4 AVE breaks 264–8 cash breaks 262–7 controlling 261–8 provisioning 267–8 sources of account balances 261–2 note disclosure 291, 295, 302, 307 notes, FX 314, 317 novations 154, 157–9 NPAT see net operating profit after tax INDEX NPPs see new product proposals NPV see net present value NSFR see net stable funding ratio OCI see other comprehensive income offers, see also bid–offer off-market trades 335 offsetting 303 see also set-off offshoring 15–18, 111 OISs see overnight index swaps one-sided internal futures trades 330–2 operational risk 26, 32 operations 26–7, 108, 112 optionality 88–9 options, FX 101–5, 167–70, 304–5, 322–3, 330 orderly transactions 67 organizational structures 8–10 OTC see over-the-counter other comprehensive income (OCI) 63 outsourced offshoring model 15–17 overnight index swaps (OISs) 143, 146–8, 148 over-the-counter (OTC) agreements 235, 237 brokers 188 derivatives 89 Oxley see Sarbanes–Oxley P&L see profit and loss payment netting 298 percentage of notional 144 performance 25 portfolios see books pre-approval checklist, NPPs 314–16 premiums 183 presentation amended trades 161, 163 new trades 152, 153 pressures of the desk 13 price discovery 211–20 price/pricing bonds 93–5, 217 consensus pricing 212–13 end of day prices 173–6 financial instruments 87–105 interest rate swaps 95–101, 102 market risk 76 mark-to market P&L 174–6 new trades 146–9 spot FX 90–2 SuperDerivatives Inc 131–2 TPAs 35 see also independent price verification price variances 219, 221–3 alternate approach 222 bond prices 219, 221, 222–3 353 Index IPV 219, 221–4 proxy testing 222–3 swap yield curves 221, 222 thresholds 223 untested positions 223 principal markets 69–70 product control changing landscape 15–21 emergence purpose 3–4 review simulation 317–19 types 5–6 products see new product… profit and loss (P&L) amended trades 154–5, 157, 159, 161, 163 at COB 141–2 AVE breaks 267–8 capital levels 20 confidence levels 83 COOs 25–6 desks 13, 203–4 dividending 257–61 drivers of new trades 149–51 estimates 127, 135–6 financial reporting 293–5 front office 23–4 funding 179–82 FVTPL 47–50, 54, 63, 64 FX selldown 260–1 generated at point of entry 142, 143 liquidity 21 market risk 76, 83 MTM 165–76 new trades 138, 140, 141–5, 149–52, 153 nostros 267–8 percentage of notional 144 purpose of product control regulatory reporting 32–3 rogue trading 327, 330–41 significant P&L 151–2 sign-offs 201, 203–4 swap yield curves 221 system feeds 127–9 types of product control 5–6 profit and loss (P&L) adjustments 189–94 categories of 189–90 controlling 190–4 escalation 192–4 example 191–2 need for 189–90 UBS rogue trading 337–8, 340 profit and loss (P&L) commentary 195–200 day one P&L 195–8 escalations 200 new trades 151 other than daily 200 reader of 198 thresholds 198–200 when required 198–200 profit and loss (P&L) reconciliations 201–6 desk P&L sign-off 203–4 flash vs actual P&L 201–4 P&L not reported from GL 205–6 proxy testing 222–3 QRC see quantitative risk control qualifications 6–8 quantitative risk control (QRC) 146 quotes 212, 213, 231–2, 233 RACI matrix 31 RAG ratings 266–7 rates desk 78–9, 230 end of day 127, 130–5 LIBOR 95–7, 100–1, 279–80 stale 132, 134 STIR 177, 180 see also interest rate… receivables 50–1 recognition 42–3, 59 reconciliations 129, 201–6, 263–6, 338 recording/records 191–2, 239 recycling 63 regulatory issues internal control 113–15 rogue trading 323–4 stakeholders 33–4 trading floors 11, 13 repatriation of profits 257–8 reporting internal control 108 IPV process 224 management 30 P&L adjustments 192 P&L reconciliations 205–6 regulatory 33–4 valuation adjustments 239 see also financial reporting repurchase agreements (repos) financial assets 44 funding 177–84 netting 299–300, 301–2 Repo 105 45–6 reputation 324–5 responsible, accountable, consumer and informed (RACI) matrix 31 restored method 168–70 revenues, forecasted 26 reverse repos 300, 302 right to set-off 297–8, 300 354 risk offshoring 17–18 operational 26, 32–3 QRC 146 VaR 82, 84 see also market risk risk aggregation 229–31 risk appetite 111–12 risk-based P&L estimates 170–4 risk culture 111 risk management corporate 113 see also internal control risk management systems (RMSs) accounting rules engine 286–8 amended trades 159, 161 balance sheet substantiation 244, 246, 248 bid-offer VAs 229 end of day 129–30 new trades 138–9, 142, 143, 145, 146 P&L reconciliations 205–6 system feeds 127–9 UBS rogue trading 332, 333, 334, 336 risk sensitivities 229–30 risk weighted assets (RWAs) 247 risk weighted cash/AVE breaks 266–7 RMSs see risk management systems rogue trading 152, 154, 160, 321–45 effect on banks 323–5 events diagram 322 funding 184–5 going rogue 325–7 high profile traders 321–3 London Whale beaching 342 see also UBS rogue trading root cause analysis 336–7, 339 run-the-bank (RTB) functions 30–1 Rusnak, John 322 RWAs see risk weighted assets S&P 500 index 327–9, 341 sales 23–4, 57, 137, 140–1, 144 Sarbanes–Oxley (SOX) Act 2002 114 SCP alerts 331–3, 335–6 securities, non-marketable equity 57 selling see sales senior management 111–12 set-off 297–8, 300 settlement 43, 330–1, 334–6, 340 short-term interest rate (STIR) trading 177, 180 sign-offs 201, 203–4, 319 simulation sets 82 skills 6–8 Soci´et´e G´en´erale 322–3, 325, 327 SONIA see Sterling Overnight Index/Interbank Average SOX see Sarbanes–Oxley Act INDEX spot FX internal control 116 new trades 141–2 pricing 90–2, 215–16, 219 restored method 168–70 squawk boxes 11 stakeholders 23–38 accounting policy 34 audit 36–7 COOs 25–7 finance change 30 finance shared service 37 financial reporting 29 front office 23–4 interactions 24 IT 30–2 management reporting 29–30 market risk 28–9 middle office 27 NPPs 319 operational risk 32 operations 26–7 regulatory reporting 32–3 tax 34–5 stale rates 132, 134 standard deviations 199–200 standardization 15, 18 standards 42–70 see also International Accounting Standards; International Financial Reporting Standards Stenfors, Alexis 209–10 Sterling Overnight Index/Interbank Average (SONIA) 146–8, 237 STIR see short-term interest rate trading stock 12, 272–4 stock market operating hours 12 stress testing 85 structured credit 116–17 sub-attribution 166–73 substantiation see balance sheet substantiation Sumitomo Corp 322 SuperDerivatives Inc 131–2 supervisory control panel (SCP) alerts 331–3, 335–6 supervisory reviews 339 swaps basis 97 cross currency 214–15, 236 gold 246 OISs 143, 146–8, 148 yield curves 98–101, 102, 221, 222 see also credit default swaps; interest rate swaps system feeds 127–9 system infrastructure 25 tax 34–5 technical skills 7, 355 Index tenor bid-offer 226–7, 230–1 interest rate spreads 214 mismatch 62 risk aggregation 230–1 terminology 293 testing new products 314, 317, 319 theta 78, 82 see also Greeks time bucketing 230 decay 82, 171, 184 financial reporting 292–3 TLM reconciliation software 263–6 TPAs see transfer pricing agreements trade bookings 327 trade compression services 154, 156–7 trade date accounting 43 trader-managed FX exposures 260 traders end of day rates 133–5 examples of rogues 321–3 going rogue 326–7 trades 137–64 amended 152, 154–64 new 137–52, 153 reviews 332, 334–5, 336, 337 trading floors 10–13 see also desks; rogue trading transfer pricing agreements (TPAs) 35 treasury desk 178, 180 trial balance reports 179, 181, 258–9, 272 UBS rogue trading 322–3, 325, 327–42 activities causing losses 328–9 Adoboli, background 327 balance sheet reconciliations 338 control weaknesses 326, 329–40 crime concealment 327, 329–40 effective controls 332, 333–4, 335–6, 337, 338 email from Adoboli 341 escalation issues 333–4, 339 fraud detection 340–2 late bookings of futures trades 332–4 organizational structure 328 P&L adjustments 190, 192 unsecured term borrowing 183–4 U.S GAAP derecognition of assets 46–7 derecognition of liabilities 47 fair value measurement 71 financial liabilities 47, 55–7 financial reporting 291, 294, 300–2, 307–8 impairment 58–9, 65 valuation adjustments (VAs) 225–40 balance sheet substantiation 244 bid-offer 225–32 collateral agreements 235–9 CVAs/DVAs/FVAs 147–8, 237–9 day reserves 234 model VAs 234–5 need for 225 XVA 9, 19, 235–9 valuation controls 9–10 value-at-risk (VaR) 82, 84 variances see price variances variation margin 283 VAs see valuation adjustments vega 78, 215 see also Greeks verification, independent 190, 209–24 volatility bid-offer 226, 228 FX options 103–4 IPV 215, 218, 223 Volcker Rule 114–15, 165 volume of trade 150 waterfall method 167–8, 170, 171 XVA 9, 19, 235–9 zero coupon bonds 93 zero-notional bullet cash trades 336–7 ... consulting firm specialising in Product Control P xvii Effective Product Control: Controlling for Trading Desks By Peter Nash © 2018 Peter Nash PART One Working in Product Control he opening part of... the past decade T Effective Product Control: Controlling for Trading Desks By Peter Nash © 2018 Peter Nash CHAPTER An Introduction to Product Control THE EMERGENCE OF PRODUCT CONTROL Finance within... changes occurring within product control and introduce the role of product control s primary stakeholders Effective Product Control: Controlling for Trading Desks By Peter Nash © 2018 Peter