In settlement operations and trade reporting, a single error can surface as replacement funding costs, compensation, or a penalty.

From failure to loss or penalty

Failure Main causes or form Consequences for the institution
Settlement failure Wrong payment instructions, insufficient funds in an account, a counterparty's delay, late reconciliation The cost of replacement funding, the cost of compensation, overdraft charges on an account, and losses when a counterparty does not deliver
Error in a trade report Wrong fields, late reports, missing reports (forms are covered in a later section) Correction effort and penalties

The Japanese capital adequacy notice divides operational risk loss events into seven types. One of them, "execution, delivery and process management," covers losses arising from relationships with counterparties and vendors, and losses from failures in transaction processing or process management1. A failure in settlement processing falls under this type. The notice does not say which type a reporting error belongs to.

Causes of settlement failures and how losses arise

A settlement failure in which a payment due on the settlement date does not arrive is called a settlement fail. It can arise from operational errors as well as from a counterparty's default. The settlement process itself is covered in Settlement. Payments and receipts need careful handling because errors can be extremely costly. Losses can arise if a counterparty fails to deliver2.

The controls in the next table come from a foreign exchange market code of conduct and from the 1998 US supervisory manual. They are not a standard for derivatives settlement in general.

Cause Example of how it happens Control described in the sources
Wrong payment instructions Operational risk rises markedly in payments made through a third party Additions or changes to standard settlement instructions (SSI) are approved by two or more people, and counterparties are told of changes in advance3. Direct payments are requested4.
Insufficient funds in an account When currencies are paid and received through several overseas banks, one account is overdrawn while the others hold surplus balances The back office checks whether cash flows are overdrawing one account5.
Counterparty delay A payment due does not arrive, arrives late, is for the wrong amount, or arrives twice Procedures are in place to find non-receipts and delays and to notify those concerned6.
Late reconciliation A difference between expected and actual cash flows is found only afterward Accounts are reconciled early, by staff who are not involved in processing that account7.

Consider a hypothetical example in which Company D is due to receive 10 billion yen from a counterparty on the settlement date, and the payment arrives two days late. Company D had planned other payments around this 10 billion yen, so it borrows replacement funds for two days at 1.8% a year (calculated on a 360-day year). The borrowing cost is 10 billion yen × 0.018 × 2 ÷ 360 = 1 million yen. When a settlement fail is found, the side that did not pay on the due date is expected to arrange for the correct amount to reach the other side or to pay the cost of compensation6.

This 1 million yen falls on opposite sides depending on your position. If the counterparty was late, Company D bears an extra 1 million yen and is the side seeking compensation. If Company D was late, the counterparty bears the same 1 million yen, and Company D is the side that pays compensation. Which of the two applies depends on where the error occurred. With a counterparty that is repeatedly late, the code says it is reasonable to consider limiting the business relationship6.

Causes and consequences of reporting errors

Trade reporting is the system in which trade information is given to authorities through a trade repository or similar body. The mechanics and deadlines are covered in Regulatory Reporting.

Form of error Example of how it happens Published case
Wrong field The value of a reported field does not match the actual trade (no case)
Late report The reporting deadline is missed (no case)
Missing report A trade, or one side (leg) of a trade, is not picked up as reportable In a penalty imposed by the UK FCA (Financial Conduct Authority), an error in a system's static data table left 68.5 million transactions unreported8.

In Japan, the Financial Instruments and Exchange Act provides for imprisonment of up to one year, a fine of up to 3 million yen, or both for a person who fails to provide trade information or provides false trade information (as of October 2026)9.

Consider a hypothetical example in which Company D finds that it reported the maturity dates of 120 trades incorrectly. If correcting one trade takes 15 minutes, that is 120 × 15 minutes = 1,800 minutes = 30 hours. At a labor cost of 10,000 yen per hour, the correction effort comes to 300,000 yen. This is an internal cost and is separate from whether an authority imposes a penalty. In the FCA penalty case, the error lasted about two years and the missing reports reached 68.5 million.

The FCA penalty case

The penalty that the FCA imposed on Merrill Lynch International is a 2017 case. The final notice is dated October 18, 2017, and was published on October 23. The firm is stated to have failed to report exchange-traded derivatives in breach of Article 9 of EMIR (the European Market Infrastructure Regulation). The failure covers 68.5 million transactions from February 12, 2014, to February 6, 20168. The amount is £34,524,000, after a 30% discount for settling at an early stage. Without the discount it would have been £49,320,000 (49,320,000 × 0.7 = 34,524,000)10.

The cause was an error in a static data table that had existed since the reporting system went live. For transactions involving some third-party brokers outside the EU, the report for the market-side trade was not generated, and this continued until it was found and fixed in February 20168.

Japan's trade repository system collects trade information on over-the-counter derivatives, so its scope differs from the exchange-traded derivatives in this case11.

In addition to Article 9 of EMIR, the FCA found a breach of its principle on management and control (Principle 3)12.

Reporting controls and verification

For trade reporting, the Merrill Lynch International case shows concretely what was lacking. The FCA cited four points as a breach of Principle 3: the arrangements for oversight of reporting, verification of completeness and accuracy, the number and experience of staff, and delay in responding to problems the firm had already identified12. On verification, the firm had not carried out, since the go-live date, any verification from outside the daily operation of the reporting team. It also had no dedicated verification staff13. The verification timeline is as follows.

  • February 2014 to the end of May 2015: only checks of daily trade counts, records of problems, and investigation of messages received from the trade repository14.
  • May 2015: a manual test of nine trades was carried out, but it could not guard against the risk that one side of a trade is not picked up14.
  • February 2016: automated verification of completeness and accuracy began14.

The firm had recorded the weaknesses in its reporting controls as audit issues it had identified itself, in February 2014 and December 2014. It then took no substantive action until May 201515.

Feb 12,2014The period covered begins;verification is limited to checksof daily trade counts and the likeFeb and Dec,2014The firm records weaknesses in itsreporting controls as audit issuesMay2015Manual test of nine tradesFeb2016The period covered ends on February6. Automated verification beginsOct 18,2017Final notice (published on October23)
Figure 1Main dates of the reporting failure and verification
Figure description

A timeline of the dates in the Merrill Lynch International case, oldest first. The filled dots mark the start and end of the period and the date of the final notice. The spacing of the figure does not represent the length of time between dates.

What this article does not cover

The full set of penalties, and fines on corporations, are not covered on this page.

Notes

  1. Financial Services Agency, 銀行法第十四条の二の規定に基づき、銀行がその保有する資産等に照らし自己資本の充実の状況が適当であるかどうかを判断するための基準 (in Japanese; FSA Notice No. 19 of 2006; title in English: "Standards for Determining Whether the Adequacy of a Bank's Capital Is Appropriate in Light of Its Assets"), Appendix 2 (relating to Article 310, item 1(c)), "Types of loss events" (pages 614–615). It does not mention reporting errors or penalties. ↩

  2. Board of Governors of the Federal Reserve System, "Trading and Capital-Markets Activities Manual," Section 2060.1 (February 1998), page 4, "Settlement Process." ↩ ↩2

  3. Global Foreign Exchange Committee, "FX Global Code" (December 2024 edition; Japanese provisional translation by the Tokyo Foreign Exchange Market Committee), Principle 51 (pages 49–50). ↩

  4. The same code, Principle 52 (page 50). It states that operational risk rises markedly with third-party payments. ↩

  5. Board of Governors of the Federal Reserve System, "Trading and Capital-Markets Activities Manual," Section 2060.1, pages 4–5, "Foreign Payments." It describes checking that one account is not overdrawn when several overseas banks are used. ↩

  6. Global Foreign Exchange Committee, "FX Global Code" (December 2024 edition), Principle 55 (page 52). ↩ ↩2 ↩3 ↩4

  7. The same code, Principle 54 (page 51). ↩ ↩2

  8. Financial Conduct Authority, "Final Notice" (Merrill Lynch International, October 18, 2017), paragraphs 1.1, 2.1.1, and 4.8. Publication date: FCA press release "FCA fines Merrill Lynch £34.5 million" (October 23, 2017). ↩ ↩2 ↩3

  9. 金融商品取引法 (in Japanese; official English translation: "Financial Instruments and Exchange Act," Japanese Law Translation Database System, https://www.japaneselawtranslation.go.jp/en/laws/view/2355/en), Article 198-6, item 17-2-2 (failing to provide, or providing false, centrally cleared or non-centrally cleared trade information). ↩

  10. Financial Conduct Authority, "Final Notice" (Merrill Lynch International, October 18, 2017), paragraphs 1.1 and 1.2. ↩

  11. Financial Services Agency, （取引情報蓄積機関） (in Japanese; title in English: "Trade Repositories"; overview of the system). Section 1, the overview, lists the business of collecting and storing trade information on over-the-counter derivatives. ↩

  12. Financial Conduct Authority, "Final Notice" (Merrill Lynch International, October 18, 2017), paragraph 2.1. The breach of Article 9 of EMIR and the four points of the breach of Principle 3 (paragraphs 2.1.2.1 to 2.1.2.4). ↩ ↩2

  13. The same Final Notice, paragraph 4.17 (page 7). ↩

  14. The same Final Notice, paragraph 4.16 (pages 6–7). ↩ ↩2 ↩3

  15. The same Final Notice, paragraphs 4.18 to 4.20 (pages 7–8). ↩