Compliance Automation – If the Gears are Grinding, “We Hear You”

By Jane Stabile, President IMP Consulting

A few years ago, AAMCO released a series of “We Hear You” commercials where customers walked into the shop and imitated the sounds that their car made in order for the mechanic to diagnose the problem.

Much like the sounds that our cars make as it steadily declines into a small fortune of repairs, trading compliance libraries also notify us when it’s on the verge of breaking down. Like cars, many people see their trading compliance library as a self-contained machine. As long as the car gets us to our final destination, or in this case, the compliance reports run on a daily basis and pre and post-trade compliance is running—the system is working and the investment team can safely traverse the market without worrying about a trading problem. However, when we look under the hood, the compliance automation is actually an interaction between the automated rules, the data and trading. When those three key gears are properly moving together, we see a well-oiled machine. When one or more of the gears is grinding, we need to figure out what’s making that noise before we end up with an old jalopy that is destined to break down at the worst possible time.

When you start hearing those sounds from your trading compliance library, here are three likely causes of gear grinding issues:

Gear Grinding Noise #1: The Rule Library

Most implementations and conversions are done under tremendous time pressure. The automated compliance library is often tied to the go-live of the trading system and as time runs out, many compliance teams find it impossible to write and test the rules themselves. Vendors have attempted to address that gap by offering rule-writing services. The vendor provides a resource who codes the rules and works with the compliance team to test them and move them quickly into production. Unfortunately, under the pressure of time, many implementations defer a thorough review of the source documentation (regulations, prospectus/SAI or client agreements). As a result, the rules in the library are often based on the vendor’s understanding of the requirements from the compliance team. Lacking the resources to do any rigorous testing, the rules are migrated to production with a basic check of before and after results—if the test results look like they are within an acceptable tolerance of the results of the prior system, the rules are migrated to production.

Gear Grinding Noise #2: The Data

Data feeds are never perfect, but some gaps impact results more than others. Missing or incorrect shares outstanding data can lead to regulatory violations if a firm owns more than the regulations allow.

Similarly, gaps in issuer data can leave a firm overexposed to an entity, either through direct holdings or derivative positions. The nuances of how a compliance system treats issuer and security data varies from product to product and gaps can often go unnoticed until they result in a trading error. Too often, the closure of data gaps discovered during the project is deferred until the “Phase 2” that never happens; when the inevitable error emerges, it is traced back to bad data.

Gear Grinding Noise #3: Trading

Proper testing methodology includes two, distinct types of testing:

1. Unit testing - tests the math of a rule to ensure the results are correct.

2. Use case testing- tests the appropriateness of a test for an account.

Even when tests are mathematically correct, skipping use case testing often results in compliance rules that are poorly suited for the way an account trades. For example, a test restricting the use of currency spots may be correct and working properly for an equity account, yet creating hundreds of “false positive” results for the emerging markets desk as they go about their normal trading day. This creates the kind of grinding that slows down the trading desk and results in frustrated traders and missed opportunities. Worse, the resulting “noise” can hide legitimate violations as they are drowned out those that are false and misleading violations, leading to a major breakdown in the critical business process.

Maintain the Machine Before the Dreaded Noise

All three gears—trading, data and the rules themselves—and the interaction between them are critical in keeping things turning smoothly. Scheduling and committing to regular maintenance and testing before hearing “the noise” will ensure reliable performance, and no need to call that tow truck, for years to come.