Stage five of the trade lifecycle: Ongoing position and risk management
The successful settlement of a trade is not the end of the story.
There are numerous trade-related events and market changes that can impact a trade while it is live and result in changes to the trade position or underlying asset.
Because of this, for any entity involved in trading, there is a requirement for various ongoing position and risk management activities to be carried out.
Some examples of these activities include:
- Asset servicing, such as services related to corporate actions that impact securities
- Managing the counterparty credit risk associated with derivatives trades
- Trade reporting for both internal and external purposes
- Reconciliation to ensure that the impact of trading is correctly recorded in the different accounts
- Post-trade transaction cost analysis
- Profit and loss reporting
- Risk reporting, including value at risk and various sensitivity measures
Ongoing position management
Asset servicing and corporate actions
Asset servicing refers to the processing of rights and obligations associated with an investor’s securities. It is a broad function with often different interpretations, but broadly speaking, it incorporates all of the operational processes underlying securities – such as corporate actions, compliance, reconciliation, and performance measurement.
A corporate action refers to an action that impacts a security. Corporate actions may be initiated by the issuer of a security, the holder of a security, or a third party. They may be predictable or unpredictable.
Processing corporate action events is a complex undertaking involving many different market participants and including many possible event types.
Corporate actions can be placed into one of three categories:
- Mandatory
- Mandatory with options
- Voluntary
Managing counterparty credit risk
Derivatives are securities whose cash flows are a function of the value of an underlying asset. Exchange-traded derivatives are bought and sold on exchanges, while OTC derivatives trade on decentralized markets where traders buy or sell from an informal network of dealers.
An important characteristic of derivatives is that one or both counterparties may be faced with an obligation to make a payment or deliver the underlying asset in the future.
Reporting
A huge amount of information is generated and communicated through trading. Reporting is a central function throughout the life of a trade and during ongoing position and risk management.
Reports provide information that is obtained through investigation and/or system data interrogation. The information provided in a report allows interested parties to understand the business better and make informed decisions.
Effective reports are those that are:
- Accurate
- Contain useful and relevant data
- Clear and concise
- Current
- Flexible
Reconciliation
Reconciliation refers to the process of:
- Confirming that the balances recorded in different accounts are in agreement
- Working to resolve any discrepancies that are identified
Reconciliation works to ensure that there is agreement across accounts regarding the size of positions, the records of ownership of positons, and the location of positions, such as the identity of the relevant custodian or bank account.
Post-trade transaction cost analysis
There are a wide range of reasons why trading takes place. For example:
- An individual requires cash and therefore sells securities
- An insurance company faces exposures and therefore trades to hedge
- An institutional investor trades to ensure that its investment portfolio is well-diversified
- A speculator has a view about the direction of a given asset and trades to monetize this view
Once trading is completed, traders will have many questions about how well the trade performed. What did it cost? Why did it cost this amount? How successful was the trade?
Answers to these questions and others are provided by performing a transaction cost analysis. This refers to the estimation and measurement of transaction costs as well as the analysis of trade performance.
Profit and loss and risk reporting
P&L (profit and loss) measures change in value over a period of time. A position that is held within a portfolio will increase or decrease in value over time. If the position increases in value, the portfolio experiences a profit. Conversely, if the position decreases in value, the portfolio suffers a loss. P&L takes into account the gains or losses associated with trading, any revenue generated by the positions held in the portfolio, and any expenses associated with trading (such as commissions, fees, taxes, and funding costs).
Risk measures are used to quantify exposure and take into account the probability that a portfolio may lose value and the expected magnitude of possible losses.
P&L and risk reporting are used to evaluate success and exposure at many levels of an institution, ranging from the P&L and exposure attributable to a given trader to the entire institution’s P&L and exposure. Institutions report P&L and risk over different periods, such as daily, weekly, and monthly. They also prepare financial statements, on a quarterly and annual basis, for example.
