Aligning Product Control Today

Aligning Product Control Today
Copyright 2010 Microgen. All Rights Reserved Microgen Microgen Plc Microgen Aptitude Microgen Aptitude Limited Microgen Aptitude - Patent Pending (Serial No: 1686466) & U.S. Patents Pending
Agenda
What is Product Control?

The Finance Function The Control Environment
The Trade
Valuation Independent Pricing Day 1 P&L
Daily P&L
Decomposition Attribution Estimation (Financial and Management Accounting)
Daily P&L Reporting

Trading Systems? Core Systems?
Balance Sheet Where could we be....?

The role of Finance

The machinery of Finance
The Finance Engine in most organisations is huge and multi-faceted All parts of this Engine are critical and if any component is missing the whole ceases to function on all levels Roles and responsibilities of the Finance Function include the following:
Existence (Validity): Only valid or authorized transactions are processed (i.e., no invalid transactions) Occurrence (Cutoff): Transactions occurred during the correct period or were processed timely. Completeness: All transactions are processed that should be (i.e., no omissions) Valuation: Transactions are calculated using an appropriate methodology or are computationally accurate. Rights & Obligations: Assets represent the rights of the company, and liabilities its obligations, as of a given date. Presentation & Disclosure (Classification): Components of financial statements (or other reporting) are properly classified (by type or account) and described. Reasonableness: Transactions or results appears reasonable relative to other data or trends.
The role of Product Control

All finance roles and responsibilities source from a single starting point
The execution of a Trade If all aspects of the Trade are understood, captured and processed correctly the entire Finance Function has a fighting chance of being able to achieve its goals and objectives It is the responsibility of the Product Controller to ensure that all aspects of the trade are understood, captured and process correctly. The Product Controller is operating at the Coal Face Without effective Product Control the Finance Function cannot operate effectively
Product Control cannot succeed without an effective Control Environment

The Control Environment

5 aspects are required to support any level of control in any organisation:
1. Control Environment: sets the tone for the organisation and influences the control consciousness of its people. This is the foundation stone for all other aspects of control 2. Risk Assessment: the identification and analysis of relevant risks to the achievement of objectives, forming a basis for how the risks should be managed 3. Information and Communication: systems or processes that support the identification , capture, and exchange of information in a form and time frame that enable people to carry out their responsibilities 4. Control Activities: the policies and procedures that help ensure management directives are carried out
5. Monitoring: processes used to assess the quality of internal control performance over time
The IT environment often makes control challenging
Deal Capture
Market Pricing/Valuation Model
Cash Settlement Systems
Reconciliation Systems
General Ledger
Management Information/ Reporting

Most trading organisations grow organically, adding products and complexity through time, bringing further challenges
Multiple trading systems Non-standardised settlement and valuation processes Contrived solutions that jam trades into systems not intended to support them Manual interventions and associated control risk
The Trade
The Trade
Understanding the Trade
The Product Controller must understand the trade and the economic intent behind that trade Critical for all Trades, whether Structured or Vanilla
The component based approach

By breaking trades down into their lowest level components, these components, when combined into a pattern can describe the full lifecycle of the product Common, low level components can be defined and managed in such a way that they can be re-used across the full product set Components can then be used to model transactions across multiple transactions types, trading systems and any upstream processes
The more complex the trade, the more appropriate a consistent component based approach becomes:
Modelling at the component level along with understanding associated behaviour patterns allows support for an infinite number of distinct products with the confidence of generating reliable results
The Trade
Trade Completeness
The Product Controller must ensure that the trade is represented in the Trading System(s) according to its economic intent Critical for trading structures where trades are split across multiple systems, for example, a structure may span a Bond System, a Derivatives System and a Structured Option System. Where booking Interventions have been made, the rationale behind these interventions must be clear, understood and documented Clear Audit Trails must exist otherwise, as time moves on and memories fade, controls will be compromised
It is the responsibility of the Product Controller to ensure that the trade is

booked in such a way that it can be used reliably and predictably by all other areas of the organisation
The Trade Valuation
The Trade: Valuation
The ability to value a Trade is critical. That valuation must reflect:

The economic reality of that trade Current market conditions Regulatory pronouncements at that point in time.
Methods for valuing trades are in the spotlight as a result of the credit crisis We dont know future changes to valuation methodology so, today, the focus must centre around the following:
Ensuring that current valuation processes encompass all trades across all systems Ensuring that all valuation methods, models and processes are consistent and are fully understood and documented Documentary evidence for valuations is available and is in a state which can be provided to the regulators. Processes and models to support multiple valuation methodologies simultaneously are in place All aspects of the valuation process are automated as far as possible

Are current valuations reliable? Regulatory developments focus on transaction information to help make assessments as to whether the valuations for those trades can be verified independently
Categories based upon the ease with which prices can be IFRS 7 requires trades to be classified into broad obtained:
Level 1: Quoted Prices (unadjusted) in active markets for identical assets or liabilities Level 2: Inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly (i.e. as prices) it indirectly (i.e. derived from prices) Level 3: Inputs for the assets or liability that are not based upon observable market data (unobservable inputs)
Allows the focus on transactions based upon the ease and reliability with which valuations have been obtained

Are current valuations tested against independently often enough? Independent Price Verification (IPV) is a hot topic in the global market place today Product Controllers are being asked to focus increasingly upon:
Increased frequency of the IPV process, from quarterly to monthly, bi-monthly, weekly and (sometimes) daily. Greater coverage of the product set Global consistency in the processes and models used Global consistency in the inputs used to generate valuations Complete audit trails supporting the process end-to-end More granular triggers for identifying valuation differences requiring investigation Documentary evidence to support the investigation of those differences and any follow-up action taken.
These requirements are onerous. How can they be supported?
The Product Controller needs tools to be able to support the many and varied requirements associated with Trade Valuations:
IFRS 7 classifications must be integral to the systems used daily. Classification support using spreadsheets does not allow systematic processes focussing on transactions which will attract attention due to lack of price availability. The quest for price consistency is leading to Global Rates and Pricing Repositories Increased frequency is driving attention towards solutions which support partial or full automation. Reporting solutions must be able to capture valuation adjustments at the trade level arising out of the IPV process coupled with supporting audit trails
The Trade: Day 1 P&L

Day 1 P&L is increasingly important as an indicator that something might be wrong ! In normal market conditions, trades executed at market prices as at T0 should not generate large positive or negative P&L as at T1 Large T1 P&L could indicate:
Abnormal trading conditions in relevant market Incorrect / Incomplete trade booking leading to incomplete / incorrect valuation Off-market trading Incorrect / incomplete prices used to generate valuations Trade is significant and should be flagged as such within Finance in general Trader exploiting a market opportunity, an inexperienced counterparty for example.
The Product Controller requires tools allowing the identification of these trades and their subsequent investigation within very tight timeframes
The Trade: Day 1 P&L
Abnormal Day 1 P&L: Identification

Systems supporting tolerances and limits which are time stamped and variable by Product / Market / Currency etc
Investigation
Identification of market conditions as at Trade Execution Analysis of components comprising P&L generated The capture and recording of all investigations and conclusions drawn based upon agreed processes and procedures
Intervention
Tools allowing the suspension of any P&L under investigation coupled with subsequent release of suspended P&L once investigations are completed Routine amortisation of Day 1 P&L over the life of the trade where certain conditions apply
Daily P&L
Daily P&L

Product Control is the first point in the process whereby P&L is analysed and reported. It is the responsibility of the Product Controllers to understand the drivers behind any P&L generated and hence to be able to judge whether P&L has been generated in a manner which supports organisational goals and objectives. Any P&L validly reported by Product Control should be relied upon by Finance throughout the organisation
This is a weighty responsibility....
The Product Controllers need all the help they can get, particularly as the regulatory focus is increasingly demanding information at an increasingly granular level.
Daily P&L: Decomposition

It must be possible for a Product Controller to decompose any daily P&L in a number of different ways simultaneously.
Trading Book Market or Country Currency Trader Source System Strategy Instrument Type Counterparty IFRS 7 classification
Significant Trades
Risk factors Etc...
With the ability to slice and dice daily P&L it is then possible to start to focus on specific focus areas, or on those which may indicate trends which require further investigation The design must be increasingly focussed on maintaining P&L at the trade level with all dimensions as above retained on the record
Daily P&L: Attribution

The ability to attribute P&L to quantifiable drivers is critical and is the only way to validate any reported P&L in any sustainable way. There are multiple ways to attribute P&L and all must be available to the Product Controller in a timely fashion. In addition to tools highlighting P&L attribution, there must also be means available to record the results of any analysis in such a way that other finance users can access the information for internal or regulatory purposes The following are the most commons ways of measuring P&L attribution:
Method 1: P&L analysed by Trading Activity

Day 1 Standard Trading Funding FX Revaluations Cancelled and Amended Trades
Focuses on the activity within the trading book on any particular day Requires information from numerous sources presented in a manner which allows the Product Controller to focus immediately upon areas of interest. Day 1 P&L should be analysed as explained earlier Additional focus on Cancelled and Amended causing significant P&L movements
Method 1: P&L analysed by Risk-based Activity

Day 1 Standard Trading Greeks; Delta, Gamma, Theta
Focuses on the P&L generated in the book as a result of exposure to certain risk based characteristics. This method of P&L analysis is a very powerful P&L validation tool
Requires an understanding of how shift in the curve impact the mixture of transactions within a particular book
Daily P&L: Estimation
The ability to estimate P&L is a significant input to the process and is an important indicator of a Traders knowledge of the transactions within his area of control.
On a daily basis it is the role of the Product Controller to prepare estimates on each of the trading books and to be able to log these estimates in a controlled way.
A further key control measure is the subsequent comparison of estimates and actual reported P&L on a daily basis. Margins of error within a tolerance would be expected but continued differences greater than that considered reasonable may raise questions and should be highlighted.
Daily P&L Reporting
Daily P&L: Reporting

The reporting of Daily P&L from key finance systems is a critical components of the Product Controllers daily tasks. For Daily P&L to be meaningful it must contain all the elements relevant to the generation of Profits or Losses for that business area, including:
Trade adjustments: These adjustments will represent P&L movements as a result of transactions which may be under investigation for some reason. Funding: The impact of maintain an excess or shortfall of cash as a result of trading activities must be captured within trading P&L on a daily basis FX Exposure: For many trading areas there must be a means of tracking and reporting any FX exposure for any business at any point in time.
Before we can consider how these are supported within the Daily P&L process we need to consider the source of Daily P&L

Sourcing Daily P&L: Trading Systems?
Advantages
Quicker as all the information is already there
Information is timely More likely to agree to traders estimates Core finance systems only require monthly updates for non-cash balances Should support the measurement of FX exposure and may include Funding costs
Disadvantages
Not used for reporting in Finance therefore how useful is Trading system P&L Does not reconcile P&L to core systems
Trade adjustments are difficult, if not impossible to capture therefore these are typically spreadsheet adjustments with their consequent lack of audit trails
Reconciliation issues between Trading Systems and Core finance systems may not be identified intra-month therefore, due to month end time pressures, may not be investigated fully
Full monthly P&L still needs to be reconciled in core systems therefore increases time required for month end processing

Advantages Daily P&L is fully reflected in core finance systems intra-month
Reduces workload at month end as only the final days P&L requires reconciliation plus some additional monthly tasks.
There is time for P&L analysis as Monthly P&L is largely reconciled Reconciliation items arise during the month when there is more time to investigate Trade adjustments can be supported within core systems and will therefore be audit trailed Funding and FX exposure information is available on a daily basis across business areas contributing significantly to business decisions as to how to manage these key business areas Disadvantages Requires core finance systems to be updated daily for items other than cash leading to processing overhead May take longer to produce as core system reconciliations are a dependency Processes to measure and manage FX exposure are required on a daily basis Funding information is also required in core systems on a daily basis which, again, can add to the processing overhead
Daily P&L: Reporting using Core Systems

When using Core Systems to report P&L there must be a significant reliance on processes and procedures otherwise deadlines become unachievable. Efficient processes and procedures must be defined consistently across business areas otherwise benefits of process change can only be realised within small business units This leads to the requirement for consistent Core System, mainly GL, processing across business units.
The definition of Global Standards without reference to local requirements is a significant requirement and often requires significant change but is the only way that businesses can make effective decisions across business and is the only efficient way to scale.
Balance Sheet
Balance Sheet
If Core Systems are used for Daily P&L reporting... ... P&L is simply the difference between 2 dated Balance Sheets....
Daily Balance Sheet reconciliation is a logical extension to process
Core system reconciliations will be required for Daily P&L reporting
Balance Sheet substantiation is required throughout all organisations on an increasingly frequent basis and is attracting increasing regulatory focus
Reconciliations can also support Balance Sheet substantiation on a daily basis. This brings its own additional benefits including...
Internal Deal control and the ability to manage differences in valuation or timing on a global basis Cross-business funding requirements
Where could we be....?
Daily P&L: Reporting using Core Systems
With the focus moving away from fragmented, system focused, largely manual environments, we have Product Control moving towards a role which is increasingly intellectual. The emphasis moves from number crunching towards analysis The profile of Product Control within Finance will increase significantly as the level of analytical contribution is allowed to rise.
Product Control increases in value to the organisation Product Controllers become more involved in key business decisions and in planning and strategy
Everybody Wins!
Conclusion

The Finance Function The Control Environment
The Trade
Valuation Independent Pricing Day 1 P&L
Daily P&L
Decomposition Attribution Estimation
Daily P&L Reporting

Trading Systems? Core Systems?
Balance Sheet Where could we be....?

Thank you and Any Questions

Aligning Product Control Today

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Aligning Product Control Today

What is Product Control?

Daily P&L Reporting

Balance Sheet Where could we be....?

What is Product Control?

The role of Finance

The role of Product Control

Product Control cannot succeed without an effective Control Environment

The Control Environment

The IT environment often makes control challenging

Market Pricing/Valuation Model

Cash Settlement Systems

Management Information/ Reporting

The component based approach

It is the responsibility of the Product Controller to ensure that the trade is

The Trade Valuation

The Trade: Valuation

The ability to value a Trade is critical. That valuation must reflect:

The Trade: Valuation

The Trade: Valuation

These requirements are onerous. How can they be supported?

The Trade: Valuation

The Trade: Day 1 P&L

The Trade: Day 1 P&L

Abnormal Day 1 P&L: Identification

This is a weighty responsibility....

Daily P&L: Decomposition

Daily P&L: Attribution

Daily P&L: Attribution

Method 1: P&L analysed by Trading Activity

Daily P&L: Attribution

Method 1: P&L analysed by Risk-based Activity

Daily P&L: Estimation

Daily P&L Reporting

Daily P&L: Reporting

Daily P&L: Reporting

Daily P&L: Reporting

Daily P&L: Reporting using Core Systems

Daily Balance Sheet reconciliation is a logical extension to process

Core system reconciliations will be required for Daily P&L reporting

Where could we be....?

Daily P&L: Reporting using Core Systems

What is Product Control?

Daily P&L Reporting

Balance Sheet Where could we be....?

Thank you and Any Questions

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