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The Operational Impact of

Belated Trades
Trades entered late into systems of record are a sometimes overlooked form of operational risk. But what
steps can firms take to identify and classify belated trades? Why is this important and how can firms quantify
the operational impact of such trades? Kevin Kindall, Xianqiao Chen and Neil Walter provide a roadmap.

lthough the integrated oil industry is quite

distinct from the banking industry that is
most familiar to GRR readers, there are certain operational risks that are common to
both. Trades entered late into systems of
record, for example, are operational risks
shared by both industries. But the oil industry certainly
has its own methodologies for classifying late trades and
quantifying their operational impact.

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In this article, we will explain these classification and

quantification methods and also identify and analyze the
challenges facing risk managers who must measure this
form of operational risk. But before we begin to address
these issues, it makes sense to first get a handle on the definition of operational risk.
The Basel II capital accord describes operational risk as
the risk of loss resulting from inadequate or failed internal
processes, people and systems or from external events.1

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Heuristically, operational risk is generally thought to

include those risks that are not considered market or credit
risk. It is frequently considered in the singular, when in fact
operational risk is a combination of many different risks
embedded in business processes. Often, discussions about
operational risk are left open ended, and outside of banking there are virtually no specific guidelines suggesting
what components make up operational risk, let alone how
one might begin to measure and model the risk. Indeed, the
Basel accord does not specify the approach or distributional assumptions a firm should use to assess operational risk
just the qualitative and quantitative standards that an
operational risk measurement must satisfy.2
Taking all of this into account, why is monitoring and
modelling exposure from late trades relevant? One might
argue that the expected mark-to-market impact of late
trades would be zero or immaterial to earnings; therefore,
resources spent monitoring and modelling late trades
would be poorly allocated.
However, while this line of reasoning has some surface
appeal, the shortcomings of this argument quickly become
illuminated when its examined in the proper context.
Consider, for example, the distribution of outcomes that
are produced from simulating a one-day value-at-risk
(VaR) estimate. Presuming that the expected change in the
portfolio mark-to-market is zero does not immediately render the VaR estimate useless.
Moreover, a closer look at the underlying assumption in
the statement that the outcome of late trades is immaterial
reveals a second fault. It is not obvious that the impact is
immaterial unless the analysis is performed. Particularly for
physical commodity trades, a large chain of events is initiated when a trade is executed and certain types of errors
may have significant consequences to groups downstream
of the front office.
Furthermore, late trades produce volatility in various
market risk measures. This is especially true for VaR
reports. Spikes in the reported VaR may sometimes be
caused by incomplete deal entry, particularly if the missing
trade provides an offset to an existing trade, as in the case
of a spread or basket. Whats more, monitoring late trades
will identify inefficient business processes and reveal gaps
in other controls.
Initiating a methodology for monitoring late trades will
typically result in outcry from a group of traders who claim
they never have any belated trades; in all likelihood, these
traders will also assert that another risk control will be overly onerous. But we recommend verifying their assertions by
setting up a process to evaluate their claims!
While there will always be some traders who rarely have
late trades, there will likely also be others who frequent the
late trade reports in spite of their contrary assertions.

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Moreover, if there are in fact no late trades and the monitoring process is well designed, then monitoring trades should
not be intrusive and should require very little resources.
In addition, regular monitoring and reporting of trades
could provide incentives for a firm to improve its dealentry process, and could also enable a firm to provide hard
evidence of trading competency to a regulator or auditor.

ID and Measurement Approaches

Identifying and quantifying the potential impact of a late
trade begins at the most fundamental level: definition. There
are at least two basic approaches that can be taken with
regard to defining a belated trade. First, one can define as
late any trade that is so tardy that it would require restate-

Initiating a methodology for monitoring late trades will typically result

in outcry from a group of traders
who claim they never have any
belated trades; in all likelihood,
these traders will also assert that
another risk control will be overly
onerous. But we recommend verifying their assertions by setting up
a process to evaluate their claims.
ment of a monthly mark-to-market figure i.e., a trade is
late when the reported month end mark-to-market is impacted by entering a deal into the system of record that was actually transacted in a prior month. This standard is quite easy
to apply and also simple to evaluate. It is appealing because
it measures impact of the misstatement of the mark to market accrual. But this is a relatively soft standard, and the last
thing a risk manager would want to do is to endorse traders
entering their deals on the last day of the month.
The second approach to defining a belated trade focuses
on the specific attributes that make up a trade. There are
many attributes that describe a trade more than 45 is
not uncommon. For purposes of this article, we focus on
the difference between the system date (date the trade was
entered) and the trade date (date the trader executed the
trade). If the trade date is less than the system date, then the

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trade was entered late. Note that this definition of a late

trade is not unique to the oil industry: if the expiry date
(financial trades) or the delivery date (physical trades) is
less than the system date, then the deal was also entered
late. However, a process based solely upon date fields tends
to produce statistical errors that will need to be removed
from the set of late trades.
Once a late trade has been identified, measuring its
impact requires an understanding of which processes downstream of the deal execution are impacted. A clear distinction must be made between physical trades and financial
trades, as their downstream processes can be materially different. Consider the deal flow diagram for a typical financial trade (see table 1, top right).
Presume for a moment that the trader does in fact document the trade, but the trade does not get entered into
the system (dotted lines represent impacted steps). The
confirmations process should capture the omission, as
the counterparty should also be sending out a confirmation. Until the error is corrected or there is no longer
price risk, the daily mark-to-market earnings may be
misstated. The positions (and therefore the VaR) may
also be misstated, which can also affect trading decisions. This is particularly important when a trader has
exceeded a risk limit. If the trade is done with an overthe-counter counterparty whose counterparty trade documents contain collateral requirements, calls for collateral may be unexpected or appear to be of the wrong magnitude. Also, if the confirmations process is unsuccessful
at capturing the error, a flurry of back-office reconciliation ensues before the exchange of cash can occur as the
trade approaches expiry.
Now that weve analyzed the effect of a late financial
trade, lets consider the potential impact if a forward physical natural gas trade is entered late. The physical deal flow
diagram would have some additional components (see
Table 2, lower right.)
Scheduling involves nominating natural gas flows on an
electronic bulletin board (EBB) by a person known as a
scheduler. If the confirmations process does not catch the
error, then it is not detected until the nomination process
begins. For example, a late trade done in October 2004 for
physical gas that will flow in June 2005 could go undetected until the last week of May 2005.
As with financial trades, mark-to-market exposure and
counterparty exposure can be misstated. This effect is
compounded by the physical daily balancing during the
gas flow month that complements the physical trading
activities in advance of the gas flow month. Traders transact for next day flow to make sure their customers receive
gas, to keep the imbalances on the pipeline within tolerances, and to handle unexpected events. One deal may not

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be material in the context of a portfolio, but it can be

extremely problematic for a pipeline.

Classifying Late Trades

The first step to control the operational risk from late or
omitted trades is to recognize them when they finally do
come into the system and to try to classify them. Classifying
the trades is essential because there are legitimate transactions that will get flagged in this process. System idiosyncrasies may cause trades to be inappropriately flagged.
Periodically, gas must be scheduled differently than was
intended due to congestion, maintenance or force

Table 1:
Financial Deal Flow

majeure and new entries into the system must be made

to represent the new state of the world. In addition to initiating the process of identifying the legitimate activity that
appears to be late, classification helps separate systematic
versus non-systematic events.
Classification goes beyond filtering out legitimate transactions; it reveals a methodology for systematically eliminating

Table 2:
Physical Deal Flow

recurring events that are inefficient or that introduce unnecessary operational risks. One result of classification may be
the automation of an error-prone process or the development of a new process to better take advantage of system
capabilities. This process may also help a firm identify gaps
in existing controls, such as confirmation procedures or endof-day trader sign-off reports, or identify new controls that
will ensure better data integrity and accountability.
This article began with an explanation about how to
track trades entered late into the system of record as a measure of operational risk. A single late trade may not have a

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material mark-to-market impact, but proactively monitoring late trades can quickly begin to have a material impact
on processes and metrics that are exposed to many different components of operational risk.

Quantifying the Impact

Quantifying the risk associated with late trades requires a
fundamentally different approach from what is typically
used in market risk. Complicating matters further, there is
very little in the risk management literature concerning late
trades. Although we will use a monte carlo approach, the
monte carlo used here will be very different from that used
in a VaR process or option pricing.
The first step is to determine what one wishes to quantify. One could quantify the impact of late trades, for example, using the total mark-to-market value of the portfolio.
Alternatively, one could look at the change in the profit or
loss of the portfolio. Whatever the measure used, it should
be complementary to the set of risk limits used for risk
control. For our purposes here, we will use the change in
profit and loss.
The next step is to develop a model. In the market risk paradigm, one would start by identifying the set of risk factors
usually price and volatility. Upon reflection, however, the set
of risk factors for this problem becomes quite large, as one
must also include other items that affect profit and loss (such
as position size) as well as many of the trade attributes.
Alternatively, one can use an actuarial approach. Within
this framework, there is a tremendous amount of flexibility. While actuarial science is a well-developed discipline, it
may be a bit unfamiliar to many in the risk management
community. But if you want to learn more about actuarial
science, an excellent reference is the book by Klugman,
Panjer, and Willmot.3
For certain types of insurance modelling, the typical
approach is to model independently the frequency and severity of events and then produce an aggregate loss distribution
via Monte Carlo. There are many different ways to implement this strategy. However, our approach is straightforward and although not recommended for a production

environment it is easily implemented in Microsoft Excel.

Briefly, the model uses three distributions and a Monte
Carlo simulation to produce a distribution of the change in
profit and loss caused by late trades. The distributions represent the number of late trades, the number of days late and a
one-day change in profit and loss for all historical late trades.
The most difficult part of model development is to determine the most appropriate distribution for the item of interest. One would clearly use a discrete distribution for the
number of late trades and perhaps for the number of days
late. Some of the more common discrete distributions are the
Poisson, negative binomial, and binomial. However, selecting the best distribution is an extremely broad subject and is
itself worthy of many articles. Regrettably, it cannot be discussed here. However, the Monte Carlo process is straightforward and is based on the idea of inverting the common
distribution function (cdf).
Briefly, the recipe is as follows: determine the number of
late trades; for each late trade, determine the number of days
late; draw a sample from the profit and loss distribution and
suitably scale it for the number of days late. This determines
one point on the total profit and loss distribution.
Determine means to draw a sample from the distribution in question. This is done by first generating a (uniform) pseudorandom number and then inverting the cdf to
produce the item of interest. Intuitively, the pseudorandom
number corresponds to a percentile on the distribution.
For example, suppose that the days late distribution is a
neg. bin.(3,2). A pseudorandom number is generated say
0.5. This corresponds to a trade that is five days late.
Since the approach described above may be a bit unfamiliar,
we have created a simple Excel model demonstrating the technique discussed here. The model is available upon request.4
As mentioned earlier, there are many different approaches within this framework. Assuming one has enough history, one could sample nonparametrically. Also, one could
calculate the profit and loss sample using the same set of
simulated prices that are used in existing market risk measures. This has the added benefit of fully integrating the
late trade measure into existing processes.

FOOTNOTES:
1. Basel Committee on Banking Supervision. International Convergence of Capital Measurements and Capital Standard: A Revised Framework,
June 2004, pg. 137.
2. Ibid., pg. 144.
3. Klugman, Panjer and Willmot. Loss Models: From Data to Decisions. New York:Wiley, 1998.
4. Model requests should be sent to Xianqiao Chen at xianqiao.chen@conocophillips.com.
KEVIN KINDALL is the director of quantitative analysis for the commercial division of ConocoPhillips; he can be reached at
kevin.g.kindall@conocophillips.com.
XIANQIAO CHEN and NEIL WALTER are quantitative analysts within Kindalls division. Chen can be reached at
xianqiao.chen@conocophillips.com; Walter can be reached at r.n.walter@conocophillips.com.

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