Comparing the key terms of over-thecounter derivatives trades against the data held by a counterparty is standard practice for many over-thecounter derivatives participants, but incoming regulation on both sides of the Atlantic will change some of the requirements, make it a compliance issue for the first time and – crucially – will force many smaller players to put completely new processes in place.
For firms that have not had to think too deeply about trade reconciliation before, the regime could come as a nasty shock. The obvious solution – possibly the only one, given the timeline – is to use one of the available third-party services, but this has problems of its own. Important regulatory processes can, of course, be outsourced, but it does not transfer the compliance responsibility away from a regulated entity. As a result, the decision needs to be a careful, considered one – but with US reconciliation requirements due to take effect on July 1 and the European equivalents scheduled for September 15, there is a danger that some derivatives users may rush to adopt a third-party provider without thinking the consequences through.
Mandatory portfolio reconciliation is an attempt to apply clearing-style valuation discipline to the uncleared market – a response to a perceived failure of OTC trade counterparties to identify and resolve valuation differences and the underlying causes of these differences. Both the European Securities and Markets Authority (Esma) – given the responsibility by the European Market Infrastructure Regulation – and the Commodity Futures Trading Commission (CFTC), as required by the Dodd-Frank Act, have implemented distinct, but broadly similar requirements (see table A).
The requirements apply to all derivatives users and all uncleared trades, but the frequency of the reconciliations depends on both the customer type and size of portfolio. On both sides of the Atlantic, trades between dealers will have to be reconciled daily, weekly or quarterly. In Europe, this standard applies to all financial institutions as well as any non-financial institution that is subject to a clearing requirement, which will include some relatively small firms – and this population is likely to find the rules most onerous.
Click here to see table.
What data needs to be reconciled? US and European rules say this depends on terms agreed between the counterparties, but to ensure standardisation, the industry is likely to take its lead from the primary economic terms data appended to the CFTC’s January 2012 rule on swap data record-keeping and reporting. Using interest rate swaps as an example, that would include new items such as the regulatory classification into which each counterparty falls, the legal entity identifier for the counterparties, details on which parties are responsible for reporting the trade, and a unique swap identifier. More traditional items include the execution time stamp, start date, day count convention, floating-rate payment frequency, and so on.
Compared with current practices, the number of data points being reconciled is expected to increase substantially. That could have a knock-on effect on the number of breaks identified – more points of comparison means more opportunity for the two sides to disagree – in turn, leading to an increased dispute resolution workload. In the US, dealers have five days to settle valuation discrepancies – defined as a difference of more than 10% between the two sides – while trades involving other counterparties have to be resolved “in a timely fashion”. That latter standard applies on a blanket basis in Europe.
Adding to this, the differing requirements that apply to each class of counterparty will require market participants to track counterparty status and introduce mechanisms to monitor compliance with the reconciliation thresholds and timetables – in the US, valuation breaks worth $20 million or more have to be reported to the regulator, while the same applies to breaks above €15 million in Europe.
As a result of all this, an institution that prefers to perform reconciliations in-house will, in most cases, need to redesign its existing platform to comply, and some banks anticipate a fivefold increase in the size of their reconciliation and dispute resolution teams.
For many institutions, however, a move to a third-party reconciliation platform may be more appealing. Major financial institutions are proceeding on the basis that their entire portfolio will be reconciled – so any resulting migration to a new platform requires careful planning, with a first step being to understand how existing data sets can be reconfigured to the new data fields. The discrepancies between fields will need to be addressed using rules that translate existing information into a compliant form. It will also be necessary to migrate or extract data allowing the number of swaps per counterparty and the counterparty class to be determined. Inevitably, some brute force is required for data migration exercises and it is anticipated banks will see a spike in manual effort.
Any system will need to include reporting functionality allowing the generation of internal management information and data required by the regulator. Again, this is likely to be a change from the current practice of many market participants but should be specified as a requirement with any reconciliation platform – whether in-house or third-party.
But while outsourcing may have obvious attractions, it has less-obvious pitfalls. Data security is one of the fundamental concerns regarding a third-party solution, and portfolio reconciliation demands the wholesale transfer of vast amounts of data to a platform operated by a third party.
This will set alarm bells ringing for any regulator. Using a system hosted by a third party – or a process allowing a third party to access bilateral trade data – therefore requires careful thought. It is not necessarily the short cut it appears to be.
In the UK, any institution regulated by the Prudential Regulation Authority (PRA) and the Financial Conduct Authority (FCA) will need to consider some of the systems and controls requirements and the overarching principles set out in the combined FCA and PRA handbook. The handbook rules under SYSC8 – which deal with general outsourcing requirements – are demanding. Firms are warned that when they outsource critical or important operational functions – defined as those that would materially impair a firm’s ability to comply with regulatory obligations – they remain fully responsible for all those obligations. A number of conditions and requirements follow on from this. For example, a firm’s senior staff must not delegate their responsibilities as a result of the outsourcing arrangement; the firm must be able to assess the provider’s standard of service; the firm has to supervise the provider and manage risks associated with the outsourcing – ensuring it still has the staff numbers and expertise needed to do so; and the firm must be able to terminate the outsourcing arrangement without harming its own business.
Put simply, the handbook requires compliance in a number of areas such as reporting, audit and co-operation with the regulator. All these must be documented as part of the outsourcing agreement.
Similar requirements apply to banks elsewhere, of course. Due diligence regarding the technology standards employed by the third party, its security policy (including compliance with standards such as ISO27001), business continuity arrangements and personal data processing undertakings, would all be necessary, at a minimum, as part of an agreement with a provider of portfolio reconciliation services. An institution also needs to focus on how it will continue to comply with its own obligations – for example, whether it will still be responsible for retaining data, or whether that will be part of the third-party service.
The cross-border element of many derivatives trades, requiring data to be collected from clients in far-flung jurisdictions, may also result in compliance issues that the institution will need to resolve.
In summary, the relatively short implementation timetable for the reconciliation requirements – partly a result of delays in clarifying their scope – may lead regulated firms to rush through changes to the way they source and manage their reconciliation processes. That could be dangerous. We would urge firms to pause, take a deep breath and then approach the issue in a more considered way, with a clear understanding of the desired outcome.
This article was originally published in the July 2013 issue of Risk Magazine.