Here's a good Dow Jones article in case you missed it.  It covers the risks inherent in processing trade transactions and discusses solutions such as automation and using standards.  Nothing new here.  It does, however advocate outsourcing mid and back office services to independent third party vendors such as Houston-based Confirmation Clearing Corp.  It's worth the read...

 -----Original Message-----
From: 	djcustomclips@djinteractive.com@ENRON [mailto:IMCEANOTES-djcustomclips+40djinteractive+2Ecom+40ENRON@ENRON.com] 
Sent:	Thursday, April 26, 2001 4:55 PM
To:	168842@mailman.enron.com
Subject:	Fred Philipson: Deal confirmation: Weak link in the risk management chain    No matter how fast ...


04/01/2001
Global Energy Business
Copyright 2001 McGraw-Hill, Inc.

  According to The New York Times, on March 2 of this year a broker misplaced
the decimal point while executing an order on the Nasdaq stock exchange. A day
trader, who thought he had made a profit of $145,000, later discovered he had
actually lost $130,000. Although all the systems executing the trade were
electronic, the error was made by a human.

  This anecdote should strike a nerve at energy trading firms, which spend the
bulk of their time trying to quantify and manage the risks they take. One of
the first and most valuable lessons they learned about risk management came
courtesy of Nick Leeson, the rogue trader who brought down the investment bank
Barings in the mid 1990s. That lesson was: You can't control risk unless you
separate your front and back offices.

  However, the careers of many energy traders begin in the back office.
Managers believe that if a ``kid'' makes a mistake there, at least it won't
bring down the company. But although on-line energy exchanges have increased
the velocity and volume of trading, they've done nothing to reduce the amount
of work involved in confirming deals. Confirmation is still a manual,
paper-driven process of verifying signatures and assembling evidentiary
documents to support deals. While the front office turns to fancier and more
powerful analytical software and the middle office deploys state-of-the-art
risk management systems, life in the back office continues to test humans'
tolerance for tedium.

  The importance of deal confirmation cannot be overstated. In addition to
being a legal and binding act, confirmation serves as the last opportunity to
prevent a deal from being transacted wrongly. As transaction volumes rise, so
do the opportunities for introducing human error during the deal confirmation
process. Confirmation represents a potential source of operational risk that
cannot be hedged.

  Zero tolerance
When asked what he considers the biggest offense a trader could make, Jim
Donnell, CEO of Houston-based Duke Energy North America, answered without
hesitation, ``doing a deal and not recording it.'' He says he'd even fire a
trader for being that sloppy. ``The only thing worse,'' adds Greg Hickl, head
power trader for Tulsa-based Williams Energy, would be ``if a trader tries to
hide a trading mistake.''

  At energy trading firms, mistakes have little chance of remaining covered up
for long. If their electronic systems are working correctly, both the middle
and back offices should receive a confirmation from the broker or counterparty
for every deal made. But when markets are volatile, Hickl explains, ``honest''
mistakes are more likely to happen, and the back office may have a difficult
time catching them. The proliferation of streamlined systems that enable a
trade to be entered in 15 seconds or less and generate its own confirmation
are giving front offices more control over the risks inherent in the use of
manual, back-room processes.

  It's important to realize that although process automation and systems
integration can mitigate confirmation risk, they cannot eliminate it--because
humans are still involved in the process. Once two traders make a deal, the
middle or back office of their companies still must contact each other to
confirm its details.

  Go with the deal flow
Although the front, middle, and back offices have slightly different
responsibilities at different energy trading firms, this is not evident to the
outside world. All energy traders do business in much the same way (Figure 1).
At most trading houses, trades are made and entered--captured, in other
words--in the front office by traders, their analysts, assistants, deal input
clerks, or even by a pool of deal-capture specialists.

  Trade capture is important for several reasons: for correct invoicing,
proper risk control, and acknowledging ``intent to pay.'' Depending on the
type of deal (see table), the confirmation desk will either phone or fax the
counterparty to confirm it, wait to receive a confirmation from the other
party, or initiate a confirmation. If the deal was done on an on-line
exchange, the confirmation desk will also check to see that the exchange
recorded the transaction. If a trade has a physical component, the seller's
scheduling desk also plays a role, by ``nominating,'' or scheduling, the flow
of energy.

  A steep learning curve
As mentioned, neophytes may comprise much of the staff of back-room
confirmation desks. They have a lot to learn back there, including the jargon
of the industry and the difference between floating- and fixed-price deals.

  It helps if these entry-level personnel are quick studies, because in many
ways energy trading is more complicated than financial trading. In financial
markets, no more than 20 currencies or 10 interest rates comprise the universe
of traded commodities. In equity markets, there are thousands of stocks, but
no forward market (with the exception of equity options).

  In the North American gas market, by contrast, there may be 60 basis
locations each trading two years out at any time. Newcomers also have to learn
to handle options, thousands of price points (specifying delivery location and
time period), and deals for transmission and storage capacity. If the market
has high volatility, large notional values, large transaction volumes, low
margins, and long settlement cycles--as physical energy markets do--the
dangers of using antiquated processes are far greater than in financial
markets, which trade in ``virtual'' money.

  The physical nature of commodity electricity raises the complexity of
trading it to another level. In the U.S., electricity is specified on an
hourly basis. In the U.K., it's half-hourly. In Germany, it's every 15
minutes. Volumes and prices must be specified for each time slot. In physical
deals, the high penalties for throwing the delivery systems out of balance
behoove counterparties to capture and confirm deals with great accuracy.

  To err is human
As the transaction volume and volatility of a market increase, so do the
chances of making a mistake and the penalties for doing so. Mistakes can be
made when a trade is made, when it is entered into the system, when it is
confirmed, when energy is delivered, and even as late as when a payment is
made. Modern electronic trading systems incorporate many checks and balances
to help catch human errors, but some still slip through.

  The manual process of deal confirmation is particularly error-prone because
it may require the handling and matching of media as different as paper faxes,
tapes of phone conversations, and electronic files. Exacerbating the problem,
there is no industry-standard confirmation form. Nothing prevents a trading
firm from burying a paragraph of legalese at the bottom of its document, which
is why traders like to hire people for the back office with a strong attention
to detail. Ironically, paper fax and verbal confirmations are still the
preferred media, as e-mail is still not considered secure enough. Even the
simplest deal may generate three to five faxed pages for confirmation
purposes.

  Because energy trading is so complex and demands such high  accuracy, deal
confirmation is a stressful job. One trader reports that the people who do
deal confirmation at his firm dread hearing from the firm's traders, because
they only call when someone in the back office makes a mistake. Some companies
try to reduce the stress by distributing the confirmation workload throughout
the day. But at most others, the rule remains hard and fast: All transactions
of the previous day must be confirmed by noon the next day.

  To catch an error, divine
How successful are humans at catching errors made at the deal-confirmation
stage? It depends. One top trading firm--whose confirmation desk is staffed by
new hires that typically last only last six months on the job--estimates that
as many as two out of every five deals it makes contain an error of some kind.
Another--which entrusts this task to more-senior personnel--estimates a 5%
error rate. But this does not include spot deals which start the next day.

  Unlike market risk, which can be managed, the operational risk related to
errors in deal confirmation cannot be hedged in ways other than building a
wall between the front and back offices, endless checking and rechecking, and
using good personnel and procedure management practices. Money is also a
factor in dealing with confirmation errors. If a firm fires someone who makes
a $500 mistake, it will then have to spend many times that to train someone
else to do his or her job.

  Legal risks
Rather than wait to receive deal confirmations, some traders initiate them,
both for legal reasons and to exert greater control over the process. There
are two types of confirmations in use today: positive and negative. A positive
confirmation requires both parties to agree that a trade has been made between
them, and that the trade meets agreed-upon specifications.

  A negative confirmation, by contrast, presumes that the other party has
agreed to the deal unless it is notified to the contrary by a certain date and
time. This practice, which speeds up the confirmation process (and therefore
enables increases in transaction volume) is the norm at on-line exchanges.
EnronOnline, for instance, automatically sends a confirming fax to every party
with whom it does a deal. If it fails to receive a response to the contrary
within a certain number of business days, Enron assumes that the deal is
confirmed. The main problem with negative confirmation is that it allows a
counterparty that spots a mistake in its favor to keep quiet about the error.

  Toward automation
Several vendors of trading software have added automatic deal confirmation to
the list of features of their integrated product suites. Among them is
Houston-based Altra Technologies, whose vice president David Hanson explains
that, ``Automatic trade confirmation is the first step on the road to
straight-through processing.''

  Trading firms have begun to take notice of straight-through processing (or
STP, a term that implies the removal of humans from all points along the
deal-processing chain) for obvious reasons. Less-costly and more-powerful
integrated systems and middleware will doubtless foster the proliferation of
STP, allowing more traders to automate their existing, manual
deal-confirmation processes. However, the complete automation of energy
trading industry-wide will still require standardization. All market
participants--including their legal departments--will have to agree on a
common format and procedures for confirming deals.

  STP--the trader's edge
In addition to eliminating human confirmation errors, another big benefit of
STP is that it promises to enable energy traders to do more trades of greater
complexity more quickly. The nomination and confirmation processes being put
in place in the U.K. in preparation for the shift to the New Electricity
Trading Arrangements (NETA) this spring are a good example of how complex and
time-critical energy trading is becoming. Under the new rules, electricity
schedules will be defined on a half-hourly basis, and all 48 time slots in the
day must be specified by volume and price in a two-hour time window from 6:00
to 8:00 p.m.

  Oliver Mills, vice president of European sales for New York-based Caminus,
believes that it will be impossible for traders to meet these time constraints
while doing 100 to 1,000 deals a day, unless they automate their business
processes. So Caminus has added a matching engine called ZGrid to its Zai*Net
software suite.

  Based on a subset of XML standards, ZGrid replaces fax confirmations and
shows an audit trail of all information exchanged between buyer and seller.
The system obviously works when both counterparties have ZGrid, but it also
works when the party on the other end has trading software that is compatible
with the so-called Enron Spec. Developed by Enron, this specification--also
called the Group of Seven spec--is supported by the seven leading participants
in the new U.K. energy market. The spec itself delineates the physical format
of, and procedures for executing, a trade.

  Another software vendor targeting the nascent deal-automation market is
TradeCapture.com, based in Stamford, Conn. According to Chief Marketing
Officer Matt Frye, the company's Integrated Commodity Trading System (ICTS
2000) automatically updates a trading firm's internal records of scheduled,
confirmed, and actual shipments, giving it both a real-time and a historical
view of its positions. The system can initiate the sending of deal-confirming
electronic files, faxes, and telexes.

  Altra's David Hanson hits the nail on the head in describing automated trade
confirmation as the first step on the road to STP. After a deal is confirmed,
it must still be cleared and settled. Two new companies say they have found a
way to automate those processes too.

  One is Houston-based EnergyClear, which says it is the first
industry-sponsored clearinghouse to offer comparison, netting, and settlement
of wholesale energy contracts to over-the-counter (OTC) energy traders.
Co-founder and president Lee Burton believes EnergyClear will revolutionize
the OTC energy markets by reducing traders' credit, legal, operational, and
liquidity risks, which in the long run will increase those markets' depth and
liquidity. Counterparties must still confirm their deals, however, before
turning to EnergyClear.

  The other new firm eyeing OTC energy markets--and other OTC commodity
markets as well--is NexClear Inc., Boulder, Colo. The company says it will
soon be offering centralized clearing, fulfillment, and delivery services to
all OTC-traded commodity markets. In addition, it will also guarantee
transactions, monitor credit risk, provide trade data, and perform necessary
middle and back-office services. The NexClear system will allow traders to use
the Web to enter details of their trades in a confirmation window.

  Outsource to ease risk
Checking the details of deals more diligently and automating the confirmation
process are only two approaches that energy traders can take to minimize their
operational risk. Another is to hire a third party to guarantee that
unforeseen events won't cause financial pain--a practice akin to buying
insurance.

  A company that offers such a service to energy trading companies is
Houston-based Confirmation Clearing Corp (CCC). Founder and President Chris
Papousek advises that, ``A good way to test the readiness of an organization
to cope with a counterparty default is to run an occasional fire drill--to
expose gaps in processes that can then be filled when the clock isn't
ticking.''

  He urges energy trading firms to consider using an independent third
party--such as CCC--to eliminate the legal risks of deal confirmation. If both
parties to a deal are subscribers to the company's service, they would send
their version of its details to CCC and have CCC do the work of matching and
confirmation. Both would be covered against errors and omissions by the
equivalent of an insurance policy. Figure 2 shows how the service works. Note
the connections to EnergyClear and NexClear, which are responsible for
clearing and settlement.

  Papousek believes that a confirmation service such as the one his company
offers can work only if it is centralized, independently owned, and works in
real time with all commodity markets and trading platforms. ``The last thing
you want in the confirmation arena,'' he says, ``is a fragmented solution that
only works with a single system or a finite number of commodities.''

  Visit these sites for more information
Altra Technologies  www.altra.com
Caminus             www.caminus.com
Confirmation Clearing
  Corp              www.confirmcorp.com
EnergyClear         www.energyclear.com
NexClear            www.nexclear.com
TradeCapture        www.tradecapture.com

Photograph: 1. At most trading houses, trades are made and
entered--captured, in other words--in the front office by traders, their
analysts, assistants, deal input clerks, or even by a pool of
deal-capture specialists

Photograph: 2. If both parties to a deal are subscribers to the
company's service, they would send their version of its details to
Confirmation Clearing Corp (CCC) and have CCC do the work of matching
and confirmation.  Note the connections to EnergyClear and NexClear,
which are responsible for clearing and settlement



Folder Name: Rahil Jafry
Relevance Score on Scale of 100: 76

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