Louis Caron, principal at RiskAdvisory, argues that the traditional barriers between the front and middle offices should be removed.

The relationships between the front and middle offices of energy trading firms aren’t much different from those of investment banks or money managers. The front office is where risks are taken; the middle office is where risks are measured and managed. Their goals aren’t mutually exclusive, but they aren’t exactly the same either. Cooperation between the two areas of operation is an essential element of a successful organization.

Somewhere along the way, the front and middle offices split apart, each with a particular agenda that’s often at odds with the other. The front office views itself as the firm’s moneymaker, the group that pays everyone else’s salaries. But the middle office views itself as the group that keeps the front office in check, to make sure that today’s big profits don’t turn into tomorrow’s cataclysmic losses. These competing functions often lead to minor interdepartmental conflagrations and turf wars—which usually end up wasting a lot of time and energy.

The imposition of trading limits is perhaps the biggest area of animosity between the two groups. Almost invariably, front-office traders want their limits to be far higher than those imposed by middle-office risk managers. When particularly strong personalities are involved, the clashes can include angry phone calls and e-mail battles, resulting in tremendous inefficiencies and a whole lot of wasted energy. The best way to handle such situations is for the risk management committee—which should include a cross section of all the relevant players and meet at least once per month—to step in firmly and resolve the dispute. Risk management committees should always be empowered to settle these kinds of disputes.

Another area of conflict is the reporting function. When firms employ the classic front-, middle- and back-office model, in which the middle and front offices are completely segregated, the middle office marks positions to market independently, and often at levels different from the front office’s perception of the market. Again almost invariably, the middle office marks to market at more conservative levels than the front office would. In the eyes of traders, senior management is seeing vastly different risk numbers from what traders perceive as reality, while the middle office views itself as the safeguard for the company’s overall health. The inevitable result: conflict.

The best way to deal with this problem is for a firm to create a more harmonious mark-to-market process. Often the middle office’s market information is inferior to that of the front office—particularly when trying to establish forward pricing curves in illiquid markets. Ideally, risk managers must work with front-office managers in developing forward curves, to really get the best of both worlds.

Another area of conflict is staffing. It is critically important that managers look for middle-office personnel who have some experience in the front office. Risk managers who have taken positions themselves and have dealt with trading limits and controls from the other side are better attuned to the effects of risk controls on traders’ psychologies than are, say, entry-level quants fresh from business school. When relatively inexperienced risk managers, even with unquestioned mathematical acumen, impose strict limits on seasoned traders, the result is often animosity.

A fourth area of conflict is closely related to the last. Front-office personnel are usually compensated better than are those in the middle office. But with that higher salary comes a certain amount of swagger and, in some cases, a heightened or even exaggerated sense of importance. Middle-office personnel should be compensated at levels comparable to those in the front office. It’s easy to measure a trader’s performance, but risk managers—who help traders by making strategy recommendations, handling reporting functions and so on—sometimes get short shrift.

No one would argue for absolute parity, but an effort should be made to level the playing field—in large part, to show risk managers and traders alike the value the firm places on the risk management function. When someone in the front office not only makes huge bonuses but also has a bigger base salary than a risk manager, there’s a tendency to downplay the importance of the risk manager. The easiest way to rectify this is to make sure that base salaries are higher in the middle office than in the front office, while bonuses remain greater for front-office personnel.

Also, in order to attract the right skill levels to the middle office, the appropriate remuneration signals must be sent. Most executive search firms will freely admit that placing qualified risk managers in the energy industry is one of their most difficult tasks. The reason? Demand exceeds supply. The solution: higher prices for this scarce resource.

The blame for the stormy relationship that often exists between front- and middle-office personnel often does not rest solely with front-office attitudes. Middle-office managers must recognize their role as being more than simply a policing function. They should also be aware of their role as a service provider to the front office. This includes the realization of the importance of providing accurate information on the potential impact of transactions on mark-to-market, value-at-risk and credit risk limits in a timely fashion.

Also, the best middle-office managers can be viewed by the front office as an additional resource with respect to the comprehension of risk and value in complex transactions. The middle office should also work with front-office personnel to justify the expansion of permitted products and transactions. All of these activities can lead to a more cooperative atmosphere and a better working relationship between these two vital areas.

What do these four areas of conflict show? It’s time to remove the strict barriers between the front and middle offices and recognize the competitive advantages that can be harvested with a strong middle office working harmoniously with the trading group.

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