Stone House Consulting

Strategic, operational and IT consulting for investment managers and hedge funds

Critical Recordkeeping: Trade Tickets and Order Memoranda


It is remarkable the number of buy-side firms that have overlooked the importance of maintaining proper trade tickets and order memoranda in a timely fashion. Three weeks ago, the US Securities and Exchange Commission (SEC) charged New York-based Ark Asset Management Co., Inc. with fraudulent trade allocation as well as disclosure and books-and-records violations. This latter charge involved violations of Section 204 of the Advisers Act and Rule 204-2(a)(3) which requires registered investment advisers to make and keep true, accurate and current order memoranda for the purchase and sale of any security on behalf of a client.

Today many investment managers and hedge funds utilize electronic order management systems to track order creation, modification and deletion as well as trade execution details. These same systems typically will calculate order size, allocate block orders across multiple accounts and track trade execution details. Some more sophisticated systems will further perform pre- or post-trade compliance checks to ensure portfolios remain in compliance with client- or firm-imposed guidelines and restrictions, such as concentration limits or list restrictions (e.g., ‘no tobacco’).

Automated systems, however, can obfuscate for some just what is happening and the information required to ensure a firm remains in compliance with the recordkeeping requirement. Likewise, Rule 204-2(a)(3) is clear as mud for many. So we shall try to shed a little light on best practice for this aspect of maintaining books and records.

Orders v. Trades
To understand what managers should be doing to track orders and trades, it is important to understand the difference. At a restaurant, a diner gives his or her order to the waiter. LedgerOnly when the waiter returns from the kitchen with the food is the order actually executed or filled. At times, the waiter may return to the table to announce the kitchen has run out of a requested dish. At that point, the diner may modify the order and ask for something different or s/he may even cancel or kill the order.

Similarly, when making purchase and sale decisions for one or more portfolios, the portfolio manager creates an order and then places that order with one or more counterparties for execution. Only when an order is fully or partially executed does it become one or more trades.

Paper – The Old-Fashioned Approach
To illuminate best practice, we shall describe here the way orders and trades were recorded in the old days – on paper. This approach will take some of the systems mystery out of the process. For those Paperfirms with tight budgets who cannot justify automated systems yet, this will lay out a paper-based approach that is manageable to a point. And for many, this description will help to explain why some investment management firms spend significant sums to automate this process. But a detailed description of old order / trade forms will go a long way toward explaining the information that needs to be tracked.

Rule 204-2(a) says that managers “shall make and keep true, accurate and current the following books and records relating to its investment advisory business” and then goes on to detail each type of books and records to be maintained. Paragraph (3) within that rule states:

A memorandum of each order given by the investment adviser for the purchase or sale of any security, of any instruction received by the investment adviser from the client concerning the purchase, sale, receipt or delivery of a particular security, and of any modification or cancellation of any such order or instruction. Such memoranda shall show the terms and conditions of the order, instruction, modification or cancellation; shall identify the person connected with the investment adviser who recommended the transaction to the client and the person who placed such order; and shall show the account for which entered, the date of entry, and the bank, broker or dealer by or through whom executed where appropriate. Orders entered pursuant to the exercise of discretionary power shall be so designated.

Many firms, in days gone by, had two types of tickets. The first type was for a single security traded across multiple accounts. The second type was for a single account trading multiple securities. For the purposes of this description, we will review forms that include a single security traded across multiple accounts.

Order Details
So to track an order, generally the investment management firm creates a form that identifies:

  • Trade type (buy, sell, sell short, cover short) – Please note that we distinguish here between selling and selling short. WhileTradingboth trades are sales, the short sale is an ‘opening’ transaction and the sale of a long position is a ‘closing’ transaction. It is important to distinguish between the two for proper reporting and recordkeeping. The same holds true for buys and cover short transactions. For firms that prohibit short sales, paper tickets generally do not include the ‘sell short’ and ‘cover short’ trade types. In some organizations, the same paperwork is used to track free delivery and free receipt of securities, in which case those two trade types are added to the form
  • Security – A clear identification of the security to be traded. Ideally, this would include BOTH a CUSIP or Sedol number AND a security description. For equities, many firms utilize the ticker symbol in lieu of a CUSIP or Sedol, but the ticker can create confusion in global markets. CUSIP or Sedol is preferred over ISIN for the same reason. One security can use the same ISIN in multiple markets (and currencies!) so CUSIP / Sedol provide the best clarity. For fixed-income instruments, the coupon and maturity date should be recorded. If there are multiple classes of shares, the specific class should be noted. The logic behind using both an identifier and a description is to avoid problems due to typos or poor penmanship. For this same reason, the check digit should be recorded on the security identifier. There is nothing worse than trading the wrong security, so we cannot overemphasize the importance of care here.
  • Portfolio(s) – Any order should include an up-front identification of the portfolios participating. In the old days, pre-printed forms were provided to investment teams of all the portfolios they managed and they could check off those to include. Identification of the portfolio number or identifier is acceptable, but best practice calls for inclusion of the portfolio’s short name as well for all the same reasons that the security is described. Trading first and deciding which accounts will participate is an SEC violation, as the Ark case clearly establishes.
  • Quantity(ies) – For each portfolio participating, an indication of the amount to be purchased. This could be an absolute number of shares or par amount or a percentage of the total portfolio (e.g., 2% position or all shares currently held). In the case of mortgage-backed securities, the original face amount (rather than current face amount) is indicated. In some instances, the order ticket will indicate the size of the block and request a pro-rata allocation across all accounts participating based on their respective market values. So if three accounts are participating with market values of $100, $250 and $150 and a total of 1,000 shares were to be purchased, they would be allocated with 200 shares, 500 shares and 300 shares, respectively. There are different approaches to allocation that should be discussed with the chief compliance officer, but the critical point here is that the allocation should be identified before the order is placed with a counterparty – not after execution.
  • Ordered by – An indication of who placed the order with trader (for a buy-side organization, this is not simply the name of the investment management firm). Typically, this is the client or, in the case of discretionary portfolios, the portfolio manager. ForHanding Off an Order portfolios managed by teams, it is important to note which portfolio manager placed the order. If it is the client, who exactly placed the order. And here it is critical to ensure the person placing the order is authorized to place an order for the account in question (e.g., is Mr. Smith authorized to place orders on Mrs. Smith’s account? Is his attorney? Is the portfolio manager for the Large Cap Growth strategy authorized to place orders for the Large Cap Value strategy? Is the trader authorized to place orders in lieu of the portfolio manager? Is the portfolio manager’s administrative assistant authorized to place orders? Really?)
  • Date – The date the order is placed (not the trade date, but order placement date). Ideally, both the date and time are recorded for both order creation and for order receipt by the trading desk.
  • Limits and Notes – A variety of additional information might be included, such as the counterparty to which the trade is to be directed, the exchange on which the trade should be executed or any limits on price. Often a portfolio manager will use this portion of an order ticket to provide instructions to the trader on how to execute the order. On closing trades (sells and cover shorts), this may also include instructions for operations on the specific tax lots against which to apply the closing transaction. A ‘GTC’ or ‘good-till-cancelled’ indication might be noted here or an indication to kill any remainder left open at the end of the trading day.

Order tickets might also track how an order was placed if the individual placing the order did not sign the ticket. So orders accepted over the Recordkeepingphone would be so noted, though in most instances the phone lines were also recorded to ensure the order taker did not make any errors in transcribing the telephone request.

Perhaps the most important concept here is that the order details are recorded BEFORE the order is placed with a counterparty for execution. In the event an order is subsequently modified, the details of what was modified, who requested the modification and when it was done are also recorded. The same applies to cancellations of orders and killing the remaining portions of orders partially filled.

For most investment management firms, an indication of whether the trade was a ‘principal’ v. an ‘agency’ trade is irrelevant, though not in all cases. In those instances where principal trading occurs, a tick box on the order ticket also applies.

Trade Execution Details
As the order is traded or filled, the trader will then create a trade ticket (or ‘deal ticket’) with execution details. Since the trade ticket relies on some key data that is also on the order ticket, the paper-based tickets of days gone by often were divided into two parts with the order details at the top and the execution details at the bottom of the same form.

Data from the order ticket that needs to be included in the trade ticket includes:

  • Trade type (buy, sell, sell short, cover short)
  • Security
  • Portfolio(s)
  • Quantity(ies)

This is then supplemented with execution-specific information, including:

  • Trade date – The date on which the trade was executed. Ideally, both the date and time would be recorded.
  • Settlement date – The date on which the trade is scheduled to settle.
  • Counterparty – The broker with whom the trade is executed.
  • Exchange – The exchange on which the trade was executed.
  • Currency – The currency in which the security was traded. Ideally, this will be noted using an ISO currency code (e.g., USD) soCurrency as to avoid confusion whether ‘$’ means US dollars, Canadian dollars, Hong Kong dollars, Australian dollars or New Zealand dollars. The implication generally is that all currency amounts on the tickets are in this currency unless otherwise noted.
  • FX rate – The FX rate between the trading currency and the portfolio’s base currency. (In many firms, there is a policy to use the previous business day’s ‘closing’ FX rate on all trades based on some pricing feed. This rate is then applied by Operations to all trades for the currency pair in question or, more commonly, by the firm’s investment accounting system.)
  • Price – The unit price at which the security was purchased or sold. (Note that for bonds this is expressed as a percent of the par value or face amount, e.g. $97 means 97% of par value.)
  • Commission – Either the commission per share or total commission (ideally both!) paid to the counterparty for the trade.
  • Accrued interest – For fixed-income securities, the total accrued interest to be paid or received at settlement.
  • Taxes – The taxes to be paid on the trade.
  • Fees – The fees to be paid on the trade.
  • Net money – The net amount of the total transaction. For purchases, generally this is (quantity x (unit price + unit commission)) + accrued interest + taxes + fees. For sales, typically this is calculated as (quantity x (unit price – unit commission) + accrued interest – taxes – fees.
  • Trader – The trader who executed the trade.

Some firms also track whether any commission might be net or implied.

In the event an order is executed with multiple fills, ideally a trade ticket is completed for each execution or fill. Many firms elect to post a single trade at the end of the day based on the volume-weighted average price for the day.

For short sales, best practice requires that the locate number from the firm lending the securities would be recorded on the trade ticket. This ensures a record that the trader obtained a locate prior to execution of the short.

Signatures and Copies
In a paper-based environment, both the order ticket and the trade ticket should be signed by the individual creating the respective ticket. With automated systems, a digital signature is added, though the value of that signature diminishes significantly if passwords are shared within Signaturean organization. It is common in many firms for an assistant to prepare a ticket, but the signature should be from an individual with appropriate authorization to place an order or execute a trade. As such, the signer then becomes responsible for the accuracy of the information provided – not the assistant.

Copies of trade tickets typically were kept by the portfolio manager (or other order creator), the trading desk and operations, at a minimum. Many compliance departments automatically received copies of all trades. In some organizations, as many as seven copies were retained on multi-part forms. Needless to say, the importance of using ballpoint pens and pressing hard could not be over-emphasized!

Timing
For those who do not think contemporaneous recording of orders and executions is important, the SEC’s charges against Ark should be a wake-up call. Likewise, it is important to ensure each trade ticket is then entered to the firm’s investment accounting system and transmitted toStopwatchthe custodian or prime broker as quickly as possible. (No investment accounting system? Subscribe to our RSS feed at the left to find out why shadow accounting is critical.) It may be necessary to send a copy of the ticket to the fund administrator / fund accountant as well. In instances where an investment manager affirms trades, the ticket may not be transmitted and an affirmation may be sent instead after the trade has been matched to a broker confirmation. (We will do a future post on this.)

100% of all trades should be entered to the firm’s investment accounting system AND transmitted to the custodian / prime broker on trade date with no exceptions. To do otherwise, is to introduce a higher risk of failed trades. In addition, from a business continuity perspective, every minute that a trade has not been entered to a firm’s investment accounting system and transmitted to outside parties, the risk of losing the details of that trade rises. On September 11th, we were fortunate the event did not occur at 2:00 pm Eastern time, when many buy-side traders had paper notes of the day’s activity that had not yet been captured electronically.

Record Retention
All trade tickets must be “maintained and preserved in an easily Filesaccessible place” for five years from the end of the fiscal year on which the record was made (so an order and trade dated 5 January 2010 needs to be maintained until 31 December 2015). During the first two years (in this example, until 31 December 2012), it needs to be held “in an appropriate office of the investment advisor.”

Most commonly, when trades are maintained in paper form, they are filed by date, with a separate folder for each trading day’s activity.

Hedge Funds Take Note
For those hedge fund managers who do not record trade tickets today, take note of this post! Once SEC registration is required (and we believe it is coming), these policies will apply to you. Now is the time to put them into place.

We hope this is a helpful primer in ‘manual best practice.’

For specific issues and questions, including how to find and implement the right order management system to meet your needs, please contact us.

Thanks
A note of thanks to ACA Compliance Group for bringing this issue to our attention in their terrific Compliance Alerts.

Filed under: Hedge Fund / Alternative Investment Management, Operations, Trading and Order Management, Traditional Investment Management, , , , , , , , ,

One Response

  1. [...] Perhaps clients with outstanding invoices have deposited funds to our account without letting us know.  We’d better go check! [1] We refer managers who are using paper tickets to our article, Critical Recordkeeping: Trade Tickets and Order Memoranda [...]

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

Enter your email address to subscribe to this blog and receive notifications of new posts by email.

To get a 10% discount when purchasing a paperback copy of our book, The Top Ten Operational Risks: A Survival Guide for Investment Management Firms and Hedge Funds, subscribe to our corporate mailing list (rather than simply the blog).

Join 54 other followers

Twitter Updates

© 2009-11 Stone House Consulting, LLC All rights reserved.
Follow

Get every new post delivered to your Inbox.

Join 54 other followers