Portfolio Reconciliation: why an industry utility makes sense

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    Portfolio Reconciliation: why an industry utility makes sense

    As over-the-counter (OTC) trade reporting is being implemented around the globe, concerns about the accuracy of the data being reported are growing among market participants and regulators alike. In fact, both the US Commodity Futures Trading Commission (CFTC) and European Securities and Markets Authority (ESMA) stipulated that institutions must establish processes to identify and monitor disputes for bilateral trades, creating an urgent need for firms to be able to identify and resolve any data discrepancies. In addition, trade repositories (TRs) are expected to perform inter-TR and intra-TR reconciliation and potentially extend this service to participants. In this article, Dheeraj Joshi and Ravi Jain address the need for reconciliation as an industry utility and the advantages for trade repositories and financial institutions.

    Portfolio reconciliation is a post-trade process used to ensure that OTC derivative portfolios are synchronized between counterparties. The process is comprised of two steps: matching and reconciliation. For reconciliation to occur, both parties must submit the trade data to a reconciliation platform. The platform will first match the trades, which is a process of finding the same trades from both sides. Once a match is found, the system reconciles the trade by comparing relevant trade terms.

    The goals of portfolio reconciliation are to:

    • Provide early identification of any discrepancy in both the material and valuation terms of the OTC
      derivative contract
    • Ensure alignment of trade terms and valuation between the counterparties throughout the trade lifecycle by continually performing the reconciliation process
    • Facilitate identification and resolution of discrepancies between counterparties with regard to the valuation of collateral held as margin

    Industry participants in the global OTC market need to build or utilize existing portfolio reconciliation solutions to meet regulatory requirements, while ensuring that OTC derivative portfolios are, and remain, synchronized between counterparties to help minimize settlement disputes.

    RECONCILIATION PROCESS CHALLENGES

    Industry participants execute reconciliation processes on their end to verify whether the trades booked by both entities have similar terms. To achieve this, the party to the trade must have access to data from different entities like counterparties, brokers and trade repositories. This not only makes the process inefficient, but creates a number of other challenges as well. These include:

    • Redundancy: Each party involved in the trade must perform the reconciliation on their end, thus duplicating the effort. Even if one of the parties reconciles, regulators require that both parties be responsible for any break identification and therefore need to validate the results of the reconciliation process.
    • Cost: Individual parties must develop and maintain an infrastructure and processes for reconciliation. Regulatory updates or other changes will need to be incorporated, possibly requiring changes to the system already in place. Manual matching and reconciliation is an alternative approach, particularly for many small and Tier 2 entities; however, it does not reduce costs and has a high margin of error.
    • Turnaround time: The process involves manual sourcing of the data. Since the systems from both sides are not seamlessly integrated, it takes longer to get the reconciliation reports, which may impact the firm’s ability to meet regulatory timelines. A subsequent lag in identifying disputes may adversely impact regulatory reviews. In addition, stale results created by a delay in the reconciliation process reduces their usefulness for any party, rendering the exercise futile.
    • Lack of standardization: Both parties are able to book a trade in their own formats, which are likely to be different from one another. Each entity could use an entirely different date format from another entity, and seemingly distinct trade field names can have a similar meaning. For example, the maturity date in some asset classes may be denoted as an expiry date or exercise date. Deploying measures to streamline data across multiple counterparties (thousands, in the case of Tier 1 banks) requires considerable initial set-up as well as continuous update efforts.

    RECONCILIATION AS A REGULATORY REQUIREMENT

    Firms need an accurate and dynamic understanding of their portfolio exposures, without which they cannot efficiently monitor risk or manage collateral. Portfolio reconciliation is the process that helps firms identify differences in pricing methodologies and data standards—and, ultimately, to align exposures. It also helps firms verify transaction trade details before there are payment or calculation methodology disagreements, which helps to eliminate time-consuming and costly dispute resolution later on. Disputes impact not only profitability, but also the reputation and business of the firms involved.

    CFTC and ESMA have specified requirements for portfolio reconciliation as outlined in Figures 1 and 2. Other regulators across jurisdictions are expected to follow suit.

    CFTC requirements

    The CFTC rules require swap dealers (SD), major swap participants (MSP) and other entities to engage in portfolio reconciliation with respect to swap transactions, other than those that are cleared by a Derivatives Clearing Organization (DCO). The counterparties are required to agree, in writing, to the terms of the reconciliation. The final rules do not prescribe any specific procedures that must be followed to resolve a discrepancy in valuation. Figure 1 provides a snapshot of the portfolio reconciliation rules.

    ESMA requirements

    EMIR specifies that all European entities, classified as a Financial Counterparty (FC) or Non-Financial Counterparty (NFC), must participate in portfolio reconciliation. The frequency of portfolio reconciliation depends on the status of the counterparty (FC, NFC+ or NFC-) and on the number of outstanding contracts the counterparties have with each other. The trades that are covered in the rules are all collateralized or uncollateralized swaps which are not cleared by a third party.

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    PortRecon_2

    IS A MARKET UTILITY THE ANSWER?

    With new regulatory requirements in Europe and the United States making portfolio reconciliation mandatory, more entities are looking for cost-efficient and effective ways to comply with the new rules. They must also agree upon portfolio reconciliation processes and dispute resolution procedures with their counterparties for any portfolio of uncleared swaps. While this can be negotiated, agreed upon and implemented bilaterally, a market utility may provide a simple yet effective solution for firms to reconcile their outstanding positions.

    For reconciliation to happen, trade data will be required from both parties of the trade. A market utility will be helpful in terms of data management for everyone involved—including the actual parties to the trade, the brokers facilitating the trades and the trade repositories. A market utility would allow different entities to use a common platform to share the trade extracts, thus reducing the turnaround time for the reconciliation.

    This can be further illustrated with an example in which all parties are sending their trades to the utility (limited fields are shown in Table 1). The utility will try to match the trades based on the unique identifier (if present) or a set of other fields (selected by the users) if the unique identifier is missing. The matched trades are highlighted in the same color. The trades for which no match is found are marked as orphans.

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    PortRecon_4

    HOW WOULD A PORTFOLIO RECONCILIATION UTILITY WORK?

    This utility can be seen as a hub wherein participants can connect and send their trade data. As shown in Figure 4, there are three key elements of the process: matching, reconciliation and break report generation.

    Matching

    Once parties submit trades to the utility, it checks the trade details and finds a match from the submissions made by other parties. This matching process can be done in two ways:

    • Unique identifier: An exact match can be found if there is an identifier in a trade which is unique. The system would try to match both sides of the trade on the basis of this identifier, which could either be a unique swap identifier (USI) or a unique trade identifier (UTI)
    • Matching key: If one or both sides are missing the unique identifier, the system would be provided with a set of fields allowing it to uniquely identify a trade. The utility would allow trade matching based on user-configurable parameters

    Reconciliation

    Once the utility finds the matching trades, it compares all trade fields from both sides. Fields from one side of the trade would be matched with the appropriate field from the other side of the trade.

    Break report generation

    After the trades are reconciled, the utility generates the break report. This report would be available only to the parties involved in the trade and would highlight any differences between the trades, allowing users to take necessary actions to correct them and thus reach a common understanding regarding the trade economics with the counterparty.

    PortRecon_5

    BENEFITS OF A PORTFOLIO RECONCILIATION UTILITY

    A portfolio reconciliation utility meets a growing need in today’s OTC market. In addition to helping participants achieve compliance with CFTC and ESMA mandates, it creates efficiencies by enabling firms to leverage an already established infrastructure and reporting mechanism rather than creating and managing their own, thus reducing costs and redundancy.

    A utility would also enable reconciliation for multiple products and counterparties, offering automated dispute management workflow. This would help to speed the identification and remediation of issues, thus drastically reducing turnaround time.

    Just as important, a utility could manage one of the most tedious aspects of portfolio reconciliation: UTI/USI matching, or confirming that the same trades are being reported with the same identifier, so that the position is not duplicated. This would also help the entities map the UTI/USI of the trades which their counterparty reported.

    With an industry utility, data set-up for on-boarded market participants would need to be done only once, eliminating the need to address the data standardization issue for reconciliation against a counterparty.

    A utility would also be routinely enhanced to align with new or revised regulatory guidelines. This gives firms an advantage with almost ìautomaticî adherence to future regulations, without having to spend money and effort to adjust their internal process and infrastructure. The firm would continue to send its data to the utility, which would decide what fields need to be reconciled for which regulation and where the reports should go.

    The utility will also be capable of generating break reports, and providing regulators with a consolidated report for all market participants. The regulators would then be able to analyze the break trends for a particular entity and take preventive actions to prevent any potential risks.

    CONCLUSION

    Not only is portfolio reconciliation a requirement by the CFTC and ESMA; it could become a mandate by other regulatory bodies in the future. Until the time when OTC derivatives are being traded and reported, reconciliation will always play an important role for all trade parties, trade repositories, brokers and regulators. In today’s competitive environment where operational efficiencies are critical for overall business performance, a utility model could offer much-needed speed, flexibility, accuracy and cost management—not to mention compliance assurance.

     

    The Authors
    Dheeraj Joshi

    Dheeraj Joshi
    is a Senior Associate in Business Consulting focused on Portfolio Reconciliation Solutions. Prior to joining Sapient, Dheeraj worked on front-office applications and regulatory compliance initiatives in large financial institutions.

    Ravi Jain

    Ravi Jain
    is a Senior Associate in Trading and Risk Management and has worked on the implementation of various regulations and trade repositories in the CMRS solution. Prior to joining Sapient, Ravi worked with top US banks on Dodd-Frank compliance and the development of trade capture applications.

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