Swaps are contractual agreements between two parties who agree to exchange one set of cash flows for another. For Hedgers and speculators who buy and sell commodities, swaps play a crucial role in the market and are, of course, heavily regulated. For example, Law 55 states that a speculator who is given 60 SILA of fermented wheat product on credit can expect 50 SILA of corn in physical settlement at the end of the production year. The Code unequivocally states that no transaction is considered valid without a written contract, and a full trade reconstruction of the swap is required to settle accounts.
Wait a minute. What is Law 55 and what does it have to do with buying and selling commodities in this day and age? If you’re not familiar with Law 55, it’s probably with good reason. Law 55 actually comes from the Babylonian Code of Hammurabi (which was the rule of law in Mesopotamia around 1780 B.C.). The Code, perhaps ahead of its time, recognized that farmers were often short on cash (between planting and harvesting seasons), but were still incurring operating costs none-the-less.
By entering into essentially a commodity swap agreement, farmers who negotiated on credit were assured a controlled price for their crops, which they could then trade on the open market for other business related items (in this case ale).
Numerous clay tablets were used to document the terms of the swap, and were presented to the King in the event of a dispute. Suffice it to say, the use of “trade reconstruction” in finance is not a new phenomenon.
Today, trade reconstruction plays an even greater role in documenting transactions and settling disputes. Swap agreements operate under a similar premise, where gains over the course of a swap agreement are considered unrealized until the next settlement date, and timely payment from the counterparty determines profit or loss. Trade reconstructions remain the key to documenting proper execution and compliance with the law. But while the baseline reasons for doing trade reconstruction haven’t changed for thousands of years, the methods have evolved substantially.
It goes without saying that the financial markets are significantly more complex. The volume of trading activity has grown exponentially over the past few decades, as a result of elaborate securities offerings and the availability of instantaneous communication. Throughout the evolution of the markets, trade reconstruction remain the key to documenting proper execution, settling disputes, and demonstrating compliance with the law.
In today’s modern market, the sheer volume of information required to construct a complete trade reconstruction can be overwhelming, and under new regulations, it’s growing every day. Transactions are not limited to individualized one-to-one agreements, they typically include a trader, counterparty, and a customer. Depending upon the size of the organization, firms can employ three support people for every trader (on both sides of the transaction), not including any interactions with risk or compliance.
Each exchange between parties can occur on multiple communication channels – voice, turret, email, chat, or mobile. Legacy systems often store this data in separate repositories, each with a different owner and support team. To complicate matters further, identifying all the relevant data is often a manual process. Retrieving and reviewing large blocks of information from segregated systems requires hundreds of man hours. In the U.S., all of this must be completed within three days. Regulations require C-Suite executives to sign an attestation certifying the completeness of the process, something that can weigh heavily on the signatory.
The constant fear of “did we get it all” looms over every reconstruction presented to regulators. It appears that the clay tablets of ancient Babylon have become digital, but the method of finding the relevant information remains the same.
It is clearly a monumental undertaking – one that consumes enormous amounts of time, and leaves little room for error. New standards worldwide require a searchable, time-sequenced recreation of all communications, both structured and unstructured data. But thankfully, today, firms aren’t relegated to relying on the same arcane trade reconstruction methods of their ancestors of long ago.
Automated trade reconstruction solutions are ushering in a new era of trade reconstruction by applying data management and correlation algorithms to provide higher levels of confidence, and shave days off of trade reconstruction time.
As our markets continue to evolve, so too is our ability to safeguard them.