In derivatives trading, traders and sales staff enter into a trade, risk management staff check limits, and operations staff handle confirmation, settlement and reconciliation. When a trade passes between units, the people who create the record and the people who check it are different.

Why the units are separated

A financial institution that deals in derivatives puts the people who trade and the people who record, check and settle those trades in different units. The unit that enters into trades is the front office (sales and trading), and the unit that records and settles them is the back office (operations and settlement). The unit that checks risk and prices independently of trading is the middle office (risk management and similar functions).

The units are separated because, if the people who trade also keep the records and make the payments, no one else can notice when they hide losses or misappropriate assets. Not letting the same person or unit combine trading with recording, confirming and settling those trades is called segregation of duties. In its 1998 principles for internal control, the Basel Committee on Banking Supervision calls for conflicting duties (such as holding both front- and back-office roles in a trading unit) to be assigned to different people as far as possible1.

The examination manual of the US Federal Reserve Board (FRB) describes what to separate in more detail. People who execute trades are not given authority to sign trade confirmations, reconcile records or control payments of collateral2. Receiving and paying cash and safekeeping assets are also kept away from traders3.

The supervisory guidelines of Japan's Financial Services Agency (FSA) also look at how roles are divided in managing market risk. For major banks and similar institutions, a point of focus is whether the roles and authority of the managers of the front, middle and back offices are clearly defined4. For securities firms and other financial instruments business operators, a point of focus is whether roles and authority are clearly defined and the units are organized to check one another5.

Roles of each unit

Of the three units, the front office enters into trades and manages positions, while the middle and back offices check those trades independently of the front office3.

Unit Main roles
Front office Enters into trades with clients and counterparties and manages positions. Before entering into a trade, a trader checks that it fits within the counterparty's credit limit and the trader's own risk limit. Sales staff offer trades to clients based on prices they receive from traders6
Middle office Independently of the front office, identifies market risk and reports it to management7. Traders also calculate their own P&L and risk, but the official P&L and risk reports given to management are produced independently of the trading units8
Back office Records the trades the front office has entered into, confirms their terms with the counterparty, and delivers cash or securities. It may also reconcile positions, post entries to the accounting system and report to the authorities3

Besides the three units, other units support trading and operations.

Unit Main roles
Credit review Reviews the creditworthiness of counterparties. As one example of a credit management framework, the supervisory guidelines cite keeping the units that promote business separate from the credit review units9
Compliance Checks that laws and internal rules are followed. Approves in advance any sharing of corporate information (undisclosed material information about listed companies) across an information barrier10
Accounting Records trades in the accounting books and records P&L. Entries are made outside the trading units, and the fair values used in accounting are derived from prices and rates from independent sources rather than values entered by traders11. People who execute trades are not involved in approving accounting methods or entries2
IT Develops and runs the trading and operations systems. The business units that use a system take part in testing it during development. Systems are audited by the internal audit unit, which is independent of the IT unit12
Internal audit Independently of the units it audits, checks that controls are working and reports to management13

Viewing this division as three lines (the business units, the risk management function and internal audit) is called the three lines model. The three lines model and the tools for managing operational risk are covered in Operational Risk in Derivatives.

How a single trade passes between units

A single trade moves from execution to settlement and reconciliation, with the responsible unit changing at each stage. Once the front office has initiated a trade, most of the processing is handled by the back office14. The table below lists the stages for one OTC derivative trade, following the description in the FRB examination manual.

Consider a hypothetical example in which Bank B enters into one interest rate swap with its counterparty, Company A, with a notional amount of 10 billion yen. Figure 1 arranges the stages from the table below by unit: execution, capture, confirmation, risk and limit checks, and settlement (stages 1, 2, 3, 6 and 8 of the table). Stages 4, 5, 7, 9 and 10 (lifecycle events, valuation and P&L, collateral, reconciliation and regulatory reporting) are omitted. The middle office's stage is not in time order. Arrows are drawn only between stages for which the source describes the order (execution to confirmation, and confirmation to settlement).

Front officeMiddle officeBack officeCheck credit andrisk limits, thenexecute the tradeEnter thetradeSend confirmationto counterpartyCheck risk andlimit usageDeliver cashand securities
Figure 1How one Bank B trade passes between the front, middle and back offices
Figure description

A trader at Bank B checks that the trade fits within the credit limit and the risk limit, and executes an interest rate swap with Company A. Once the trade is agreed, the back office sends a confirmation to Company A. The figure shows the case in which the back office enters the trade. Who enters it, and the order of entry and confirmation, depend on how the systems are set up (stage 2 in the table). The middle office, independently of the front office, checks risk and limit usage. After sending the confirmation, the back office settles the trade by delivering cash and securities. The trader who executed the trade does not handle sending the confirmation or settlement. This is segregation of duties.

Stage Main unit What happens Detailed page
1. Execution Front office Checks that the trade fits within the credit limit and the risk limit, and agrees the terms with the counterparty6 Trade Capture and Approval
2. Trade capture Front and back office If the front- and back-office systems are separate, the back office enters the trade from the trader's trade ticket. If the systems are linked automatically, the front office enters it and the back office checks it before accepting it15 Same as above
3. Confirmation Back office Sends a confirmation to the counterparty and uses the counterparty's response to find differences in the terms16 Booking Errors and Confirmation Mismatches
4. Lifecycle events Back office Issues payment instructions at maturity. Removes the trade from the books on maturity, early termination, exercise and similar events17 Lifecycle Event Processing
5. Valuation and P&L Front office, and control staff independent of it Traders value their own positions during the day, and control staff check the effect on P&L every day18 Daily Valuation and P&L Sign-Off
6. Risk and limit monitoring Middle office (risk management) Identifies the amount of risk and how much of each limit is used, and reports limit breaches under set procedures19 Daily Risk Management Operations
7. Collateral exchange A unit independent of trading (middle or back office, depending on the institution) Exchanges collateral with the counterparty. Traders are not allowed to control the payments2 Collateral Operations
8. Settlement Back office Delivers cash and securities. Checks the amount and direction of each payment under a payment netting agreement14 Settlement
9. Reconciliation Back office Reconciles traders' position reports with the accounting books and other records. The person who reconciles is not the person who entered the trade data20 Accounting Operations
10. Regulatory reporting Back office and others Prepares reports to the authorities from the accounting books and other records, and checks them against the books320 Regulatory Reporting

The units in the table are one example. Whether the middle or the back office checks valuation and P&L, monitors risk and exchanges collateral differs between institutions (see the section "How the division and the names differ").

Records and data passed between units

Everything the units pass to one another is based on the trade record that the front office creates. The FRB examination manual says a trade record should include the trade date, time of execution, settlement date, counterparty, product, amount, price or rate and, for some products, the method and place of settlement21. From this record, the back office prepares confirmations, posts entries to the accounting books and issues payment instructions at maturity17.

The front and back offices each keep their own record of the same trade. Traders keep a blotter, a book that records trades in time order so they can track their positions21. The back office keeps a record of positions separately from the front office, and traders reconcile their daily positions with it14.

Record Created by Who uses it and how
Trade record (trade ticket, input screen) Front office The back office checks it and uses it for confirmations, accounting entries and settlement
Blotter Front office The front office uses it to track its trades and positions
Trade confirmation Back office Compared with the counterparty's response
Position record Back office The front office reconciles its own positions with it
Accounting books (general ledger) Back office or accounting Reconciled with position reports and regulatory reports

The table is based on the FRB examination manual's description211420.

How the division and the names differ

There is no single fixed way to divide the units. The FRB examination manual (1998) states that trading operations vary significantly among financial institutions. The reasons it gives are the size of the trading operation, staff expertise, organizational structure, the sophistication of computer systems, business strategy, and the types and complexity of the products traded. As a result, practices expected at one institution may not be needed at another22.

The differences also show up at the boundary between the back and middle offices. What this manual calls the back office may be a single department or several units, such as financial control, risk management, accounting and securities custody. Some institutions combine part of the back office's work into a middle office that is independent of trading. Monitoring trades against limits and reporting risk may be done by the back office or by an independent risk management unit3. The organization inside the front office also varies with its roles and the range of products it trades. An institution that makes prices in many products has many trading and sales desks and manages them by business line23.

The names also differ. The FSA's Comprehensive Guidelines for Supervision of Major Banks, etc. call the front, middle and back offices the markets division, the risk management division and the operations division4.

When the division of duties breaks down

Without effective segregation of duties, losses and unauthorized trades can grow without being detected. The Basel Committee's 1998 principles state that, in cases of banks that suffered large losses from inadequate internal controls, a lack of segregation of duties is often one of the main causes24. For banks' overseas offices, a supervisory point of focus is likewise whether internal checks work, in light of past cases of large losses at Japanese and foreign financial institutions and their causes25.

The duties to separate are not only those between the front and back offices. The Basel Committee's principles list combinations that can cause problems if one person holds both, such as approving a payment and actually making it, or handling client accounts and the bank's own accounts. They call for areas where conflicts of interest can arise to be monitored carefully by people independent of the business26.

Cases of rogue trading and the control weaknesses that authorities' and firms' reports identified are covered in Rogue Trading Cases: Barings, Societe Generale and Others.

Notes

  1. Basel Committee on Banking Supervision, "銀行組織における内部管理体制のフレームワーク" (A framework for internal control systems in banking organizations; provisional translation by the Financial Services Agency), September 1998, Principle 6 and paragraph 27 of the main text (in Japanese). ↩

  2. Board of Governors of the Federal Reserve System (FRB), "Trading and Capital-Markets Activities Manual," Section 2060.1 "Operations and Systems Risk (Back-Office Operations)" (April 2003), "INTERNAL CONTROLS," page 2. ↩ ↩2 ↩3

  3. Board of Governors of the Federal Reserve System, "Trading and Capital-Markets Activities Manual," Section 2060.1 (April 2003), page 1. ↩ ↩2 ↩3 ↩4 ↩5 ↩6 ↩7

  4. Financial Services Agency, "主要行等向けの総合的な監督指針" (Comprehensive Guidelines for Supervision of Major Banks, etc.) (October 2026), III-2-3-3-2(1)② (page 123) (in Japanese). ↩ ↩2

  5. Financial Services Agency, "金融商品取引業者等向けの総合的な監督指針" (Comprehensive Guidelines for Supervision of Financial Instruments Business Operators, etc.) (October 2026), IV-2-3(1) (page 118) (in Japanese). ↩

  6. FRB examination manual, Section 2050.1 (February 1998), page 1 ("ROLE AND STRUCTURE OF THE FRONT OFFICE"; sales staff) and page 2 ("TRADE CONSUMMATION"; credit limits and risk limits). ↩ ↩2

  7. Financial Services Agency, "主要行等向けの総合的な監督指針" (Comprehensive Guidelines for Supervision of Major Banks, etc.) (October 2026), III-2-3-3-2(1)⑦ and ⑧ (page 124) (in Japanese). ↩

  8. FRB examination manual, Section 2050.1 "Operations and Systems Risk (Front-Office Operations)" (February 1998), "Transaction Reporting," page 3. ↩

  9. Financial Services Agency, "主要行等向けの総合的な監督指針" (Comprehensive Guidelines for Supervision of Major Banks, etc.) (October 2026), III-2-3-2-1-2(2) (page 108) (in Japanese). ↩

  10. Financial Services Agency, "主要行等向けの総合的な監督指針" (Comprehensive Guidelines for Supervision of Major Banks, etc.) (October 2026), III-3-3-3-2(3)①–③ (pages 238–239) (in Japanese). ↩

  11. FRB examination manual, Section 2050.1 (February 1998), page 4 (third item under "SOUND PRACTICES"; fair values and P&L records for accounting) and Section 2060.1 (April 2003), page 1 (entries in the accounting books and where they are made). ↩

  12. Financial Services Agency, "主要行等向けの総合的な監督指針" (Comprehensive Guidelines for Supervision of Major Banks, etc.) (October 2026), III-3-7-1-2(6)⑤ and (7)① (page 266) (in Japanese). ↩

  13. Financial Services Agency, "主要行等向けの総合的な監督指針" (Comprehensive Guidelines for Supervision of Major Banks, etc.) (October 2026), III-1-2-1(5)① and ③ (page 51) (in Japanese). ↩

  14. Board of Governors of the Federal Reserve System, "Trading and Capital-Markets Activities Manual," Section 2060.1 (April 2003), "TICKET FLOW," page 2. ↩ ↩2 ↩3 ↩4

  15. Board of Governors of the Federal Reserve System, "Trading and Capital-Markets Activities Manual," Section 2050.1 (February 1998), "Transaction Flow," page 2. ↩

  16. Board of Governors of the Federal Reserve System, "Trading and Capital-Markets Activities Manual," Section 2060.1, page 2 (April 2003, "TICKET FLOW") and page 3 (February 1998, continuation of "TICKET FLOW"). ↩

  17. Board of Governors of the Federal Reserve System, "Trading and Capital-Markets Activities Manual," Section 2060.1 (February 1998), page 3 (continuation of "TICKET FLOW"). ↩ ↩2

  18. Board of Governors of the Federal Reserve System, "Trading and Capital-Markets Activities Manual," Section 2060.1 (February 1998), page 6 (continuation of "REVALUATION"). ↩

  19. Financial Services Agency, "主要行等向けの総合的な監督指針" (Comprehensive Guidelines for Supervision of Major Banks, etc.) (October 2026), III-2-3-3-2(1)⑦ and (2)⑧ (pages 124–125) (in Japanese). ↩

  20. Board of Governors of the Federal Reserve System, "Trading and Capital-Markets Activities Manual," Section 2060.1 (February 1998), "Reconciliations," page 5. ↩ ↩2 ↩3

  21. Board of Governors of the Federal Reserve System, "Trading and Capital-Markets Activities Manual," Section 2050.1 (February 1998), "Transaction Flow," pages 2–3. ↩ ↩2 ↩3

  22. FRB examination manual, Section 2050.1 (February 1998), page 4 ("SOUND PRACTICES"). Section 2060.1, page 7 ("SOUND PRACTICES FOR BACK-OFFICE OPERATIONS") gives the same explanation. ↩

  23. Board of Governors of the Federal Reserve System, "Trading and Capital-Markets Activities Manual," Section 2050.1 (February 1998), page 2 ("Organizational Structure"). ↩

  24. Basel Committee on Banking Supervision, "銀行組織における内部管理体制のフレームワーク" (provisional translation by the Financial Services Agency), September 1998, paragraphs 2 and 27 of the main text (in Japanese). ↩

  25. Financial Services Agency, "主要行等向けの総合的な監督指針" (Comprehensive Guidelines for Supervision of Major Banks, etc.) (October 2026), III-3-11-2(2)⑤ (page 294) (in Japanese). ↩

  26. Basel Committee on Banking Supervision, "銀行組織における内部管理体制のフレームワーク" (provisional translation by the Financial Services Agency), September 1998, paragraphs 28 and 29 of the main text (in Japanese). ↩