Quiz: System Architecture

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3 questions to check your understanding of the chapter “System Architecture”. Choose an answer and select “Check answer” to see the answer and explanation. You can also open “Answer and explanation” to see the answer first.

1. Question 1

   Suppose a financial institution executes one interest rate swap with a counterparty. In what order is this trade processed when automated processing systems are used, as described in the 1998 examination manual of the US Federal Reserve Board?

   1. A.The front office enters it → the back office verifies it and updates the ledger → the confirmation is matched → cash is paid and received
   2. B.The front office enters it → the back office verifies and accepts it → the confirmation is matched → cash is paid and received, and the ledger is updated
   3. C.The front office enters it → the confirmation is matched → the back office verifies and accepts it → cash is paid and received, and the ledger is updated
   4. D.The front office enters it → the back office verifies and accepts it → cash is paid and received → the confirmation is matched, and the ledger is updated
   Answer and explanation

   Answer: B

   As described in 1998 for automated processing systems, the front office (sales and trading) first enters the trade terms into the trading system, and the back office (operations and settlement) verifies them before accepting the trade. The accepted trade data passes to the confirmation, settlement and collateral system, and the back office reconciles the trade confirmation with the counterparty's. For a matched trade, cash is paid and received on the payment date, and the result updates the general ledger. The data created at trade capture is used as the record of the same trade all the way to the final posting.

   Postings to the general ledger are based on the confirmed trade records. So an order that updates the ledger before the confirmation is matched does not fit. Cash is also paid and received for trades that have been matched, so an order that matches the confirmation after the payment does not fit either. The confirmation is matched after the back office accepts the trade and the data passes to the confirmation, settlement and collateral system, so an order that matches it before the trade is accepted does not fit this description either.

   Learn more: Front-to-Back System Architecture

2. Question 2

   In Japan, for certain OTC derivatives transactions, financial instruments business operators, etc. report trade information to a trade repository. Besides the trade terms, which items does the report include?

   1. A.The valuation of the contract, and the amounts of initial margin and variation margin
   2. B.The matching result, and the clearing request
   3. C.The clearing status, and the margin report
   Answer and explanation

   Answer: A

   Besides the trade terms, the reported items include the valuation of the contract and the amounts of initial margin and variation margin. A trade repository is a body that collects and maintains electronic records of trade data, and financial instruments business operators, etc. and central counterparties (CCPs) provide trade information to it.

   Because margin appears, it is tempting to choose what is exchanged with a central counterparty. The clearing status and the margin report are what a central counterparty, which steps in between the parties to a trade and guarantees settlement, exchanges with financial institutions. The matching result and the clearing request are what a financial institution exchanges with a matching platform, where both parties to a trade match the trade terms.

   Learn more: Front-to-Back System Architecture

3. Question 3

   A financial institution decides to adopt a derivatives pricing model through an analytics library supplied by a vendor. How does the 2003 examination manual of the US Federal Reserve Board treat model validation?

   1. A.The institution validates only the models it built itself, and does not validate the library's models
   2. B.The institution validates the library's models instead of the models it built itself
   3. C.The institution validates the library's models in addition to the models it built itself
   4. D.The institution excludes a library's models from validation once the vendor has validated them
   Answer and explanation

   Answer: C

   As described in 2003, institutions should validate vendor models in addition to their internally generated models. The models in an embedded analytics library are also subject to validation.

   It is easy to think that validation is unnecessary because the vendor built the model. The manual calls for validating vendor models in addition to the institution's own, not for excluding them because the vendor built them.

   Learn more: Trading System Types and Vendor Examples