Operational and Model Risk

Some of the largest trading losses in history had nothing to do with markets moving the wrong way in ordinary fashion. They came from a software deployment gone wrong, a rogue trader hiding losses, a fat finger order or a model that everyone trusted but nobody truly understood. Operational risk is the risk of loss from failed internal processes, people, systems or external events. Model risk is the risk of loss from models that are wrong, misapplied or misunderstood. Both are harder to measure than market risk, and both can be catastrophic.

Operational risk categories#

Banking regulation, through the Basel framework, requires banks to hold capital for operational risk.

Famous operational failures#

The common thread is weak controls: separation of duties, reconciliation, limits and monitoring.

Model risk#

Controls for operational risk#

1. Separation of duties: traders do not control settlement, accounting or risk reporting.
2. Daily reconciliation of positions and cash with independent sources. See Trade Accounting and Reconciliation.
3. Pre trade limits and kill switches. See Risk Controls and Kill Switches.
4. Change management for software, with testing and rollback.
5. Audit trails of all actions. See Logging, Audit Trails and Incident Response.
6. Business continuity and disaster recovery plans. See Failover, Backups and Disaster Recovery.
7. Mandatory leave for staff, which can expose hidden activity.

Controls for model risk#

US banking regulators' guidance known as SR 11 7 (2011) set out widely followed practices:

• Independent validation of models before use and periodically.
• Documentation of assumptions, limitations and intended use.
• Ongoing monitoring comparing model outputs with outcomes, such as VaR backtesting.
• Model inventory with owners and approval status.
• Conservative use where uncertainty is high, with overrides documented.

For individual traders#

Individuals face the same risks at small scale: an order typed with an extra zero, a bot with a bug, a spreadsheet error in position sizing, or trusting a backtest too much. Double checking order tickets, using platform limits, testing code and reviewing assumptions are cheap protections. See Pre-Trade Checklist.

Frequently asked questions#

What is operational risk in trading?#

The risk of losses from failed processes, human error or misconduct, system failures or external events, rather than from market moves.

What is model risk?#

The risk of losses from models that contain errors, rest on wrong assumptions or are used outside their intended purpose.

How do firms reduce operational risk?#

Through separation of duties, reconciliation, limits, kill switches, change management, audit trails and continuity planning.

Next, learn about risks to the whole financial system in Systemic Risk.