Like all post-trade operations, it often draws the attention of C-level executives only when something goes wrong. Even worse, as evidenced in a recent case involving Merrill Lynch, mistakes can also elicit unwarranted attention from regulators who may want to make the firm the whipping boy for others in the industry.
According to the press release from the US Commodity Futures Trading Commission (CFTC) that announced the settlement and $1.2 million fine, the problem was bad management of the reconciliation and client billing of fees that originated from two exchanges. However, details were slim, leaving other middle-office executives, derivatives clearing experts and software firms to speculate on the real story.
Everyone contacted by FinOps Report, declined to comment specifically on what may have gone wrong at Merrill Lynch, but say that the case is a warning that C-level executives better ensure that their fee reconciliation is up to snuff. They can no longer afford to neglect their middle office for two critical reasons, First, regardless of how minor any errors might seem, clients could take their business elsewhere if they have been overcharged. In a market with razor thin margins, financial firms can ill-afford to lose business. They can also ill-afford to have a regulator with the clout of the CFTC shining a public spotlight on their operational shortcomings.
Reconciliation is the process of matching up the exact number of trades, their values and attributes between a financial firm and third-party providers such as custodians, prime brokers, clearinghouses and exchanges. Mistakes can lead to incorrect portfolio valuations, profit and loss statements, risk calculations, and even customer fees as happened with Merrill.
“For any clearing broker, the reconciliation process is supposed to highlight discrepancies so they can be corrected before there is any financial impact to the end customer,” says Sonia Goklani, chief executive of Cleartrade, a South Brunswick, NJ firm specializing in customized technology and consulting for the over-the-counter derivatives market.
That’s not what happened with Merrill. It was fined by the CFTC for failing to correctly reconcile the trading and clearing fees charged by two exchanges — the CME and Chicago Board of Trade — with what it charged its customers from January 2010 to April 2013. Without denying or confirming the charge of “poor supervision,” Merrill agreed to hire an outside firm to train staff and review procedures. A unit of Bank of America , Merrill Lynch executes futures trades and serves as a clearing agent or futures commission merchant (FCM).
Here are the details provided by the CFTC announcement: Merrill paid more than $318 million in exchange and clearing fees to the two exchanges during the three-year period in question, but in passing on the fees, it overcharged some customers and undercharged others. Although the CFTC did not disclose all the numbers numbers, the futures regulatory agency did say that Merrill Lynch received $415,318 more than it should have from 196 customers over the three-year time frame.
The amount of the fine is small potatoes for Merrill’s deep pockets, but the CFTC’s disclosure of its failings is undoubtedly more painful to the firm. The value of total transactions affected might also seem miniscule — only 0.14 percent of total fees paid the exchanges — but not to the CFTC, which blasted Merrill on its internal practices. “Merrill Lynch did not hire qualified personnel to conduct and oversee its reconciliations and did not provide any completed procedures manuals regarding fee reconciliations to its staff until April 2013.”
‘What was Merrill doing before then? Here is where the CFTC issued its harshest criticism: Within the fee group, the written fee reconciliation procedures were “not fit for purpose” because they were “fundamentally flawed” and if any fee reconciliation procedures did in fact exist, the fee group didn’t understand them and had not been properly trained in accounting and controls.
Is Merrill’s scenario all that unusual? Apparently not. It’s that not that fee reconciliation and billing is the hardest process or the most likely to generate errors. Rather, it’s because this is a middle-office process at all.
The middle office is the part of a financial firm the sits between the trading desk and the clearance and settlement units, and has historically been a sore spot for financial firms. It’s often considered the cost center of the first and receives the least attention and funding, gripe middle office specialists. “We’re the forgotten middle. The traders make all the money so they get the bulk of the IT spend and everyone wants to clear and settle trades on time so the back-office also gets some of the budget,” one manager of a brokerage middle-office department tells FinOps Report. “What do we get? A lot of grief in cleaning up errors and hoping we get it all right.”
With input of middle-office specialists and several specialist consultants, FinOps has broken down the process into the critical phases, which a firm needs to get right before it all goes seriously wrong.
Just what must be reconciled or matched when it comes to futures contracts? For clearing brokers, the answer is everything required for a proper accounting, according to Goklani. This includes the number of transactions executed, the number of trades cleared, all of the attributes of the trades, and the trading and clearing fees from derivatives exchanges to be charged to the ultimate customer — an introducing broker or fund manager. Exchanges running their own clearinghouses may only send the executing broker (often the FCM as well) a total figure on the bill, but it is up to the FCM to allocate the correct amount to each customer on a transaction by transaction basis.
Did Merrill Lynch have the correct straight-through processing technology in place to do so? There is no way to know from the CFTC’s statement on the settlement with Merrill Lynch, because the regulatory agency never mentions the brokerage’s IT systems. Here is how the matching technology should have worked. Merrill would presumably have relied on some type of reconciliation engine — either internal or external — that could electronically match up all the information from internal and external sources correctly.
The reconciliation engine would be integrated with a back-office clearing system and a front office order execution system to collect the in-house data. That information would be matched with the data from the CME, CBOE and other exchanges. Ideally, the reconciliation engine would be matching in as near to real-time as possible. If the system runs in batch or end-of-day mode, there is a risk that the system will not properly handle discrepancies related to later corrected updates.
The CFTC apparently blamed all the errors on untrained and mismanaged staff. At the same time, there appear to have been quite a number of errors that were being handled by the staff. If aging or miscoded systems were the first cause, could the gripes of the middle-office executives be warranted? Is the middle office the ignored middle child when it comes to tech spending? “Most of the technology spending by clearing brokers has likely been done on the front-end analytics and connectivity to meet regulatory timelines which have imposed a major burden,” says Goklani. “Compliance is an evolutionary process and tech spending on the middle and back office is part of the next phase of process improvement.”
Fee Calculations and Invoicing
Another potential technological shortcoming cited by one reconciliations operations specialist: a fee billing and invoice system incorrectly calculating the correct fees for customers. Even if a reconciliation engine matches up all of the necessary information perfectly, executing and clearing, brokers don’t blindly trust on third-party figures. They do their own math to confirm the fees charged by exchanges and clearinghouses.
Therefore, in order to allocate the correct amount of the trading and clearing fee to each individual customer from the bulk invoices provided by the exchanges, Merrill would presumably have correctly coded its fee billing and invoice system with the same rules used by the exchanges, also operating their own clearinghouses, to calculate their fees. These would take into account any preferential treatment — or fee discounts — offered by each exchange and any potential reduction in fees due to cross-margining arrangements. Credit default events would also be accounted for.
Making fee calculations more complicated for FCMs is their use of multiple fee systems for each trading desk and each asset class. Such a scenario — common among FCMs — means that they have to roll up all of the figures from each system before they can allocate the correct fees for each customer. The greater the number of systems used the higher the potential for error. If one or more billing systems was not coded correctly, that could also be the source of the erroneous billings.
The CFTC announcement noted that a director of Merrill Lynch’s fee group informed a manager of possible reconciliation errors in December 2012, prompting an internal review. However, the futures regulatory agency did not specify how the director discovered the mistakes.
Once any system flags discrepancies, it is up to reconciliation staff to investigate. Based on how severely the CFTC has reprimanded Merrill, it stands to reason that Merrill’s staff might not have known how to read any reconciliation reports or how to handle any errors that were found. Typically, fee reconciliations specialists do forensic accounting, tracing and trace back specific trades to specific clients to verify thei fee that should be charged. If they couldn’t find all the information in either a reconciliation engine or a fee invoicing system or the clearing system, they would have to dig back into the order management and trade execution records, which would have information about the allocation of a block trade to specific clients, In other words, they would have to reconstruct the trade.
In its settlement with Merrill, the CFTC acknowledges that Merrill did reimburse some clients for overcharges. but has been unable to track down all of the overcharges to other clients. It is unclear why that’s the case.
Finally, whatever happened to the operations audit process? asks one New York operations audit specialist. Fees billed to customers are always audited on a regular basis, FinOps was told. In a worst case scenario, the customer can be reimbursed if it was charged too much or sent another bill if it was charged too little. Merrill did finally correct its operational shortcomings, but after erroneous invoices had been sent to customers for three years.
Unlike recent high-profile enforcements in anti-money laundering realm, there was no public censure or personal fine levied against the executive in charge of Merrill Lynch’s fee reconciliation and invoicing operations. Though the CFTC action may have been a miserable experience for that executive, he may be a kind of hero to others. Based on what his peers at other firms tell FinOps, the Merrill Lynch case may trigger some long-needed attention and investment in the middle office.