Portfolio reconciliation is a central aspect of collateral management. DerivSource’s Julia Schieffer investigates how buy-side firms are improving this operational area through new technology in response to a changing market environment.
Proactive portfolio reconciliation is a goal shared by the signatories of the Fed Letters and is central to multiple industry initiatives for collateral management. Collectively, the industry initiatives call for daily portfolio reconciliation and propose new best practices to make this process more efficient. The buy side, however, is less driven by these market initiatives and more so by the immediate need to automate portfolio reconciliation processes for the improvement of internal risk control and collateral management.
“In the context of what the Fed letters say, the buy side wants to [improve portfolio reconciliation] anyway because they want to be able to effectively manage their operational exposure,” said Scott Carpenter, head of operations at CQS, the asset management company. “[Buy-side firms] have been far more keen to do portfolio reconciliation since the financial crisis of 2008 and are more focused on being on top of their day-to-day collateral movements,” he added.
For many buy-side firms, the default of Lehman Brothers in 2008 was the catalyst for this new focus on improving portfolio reconciliation of Over–the-Counter (OTC) derivative trades.
During the Lehman crisis, many investment managers and hedge funds found their collateral management departments in utter chaos; firms were over collateralized on positions, collateral was frozen and many firms struggled to sort out the real-time status of open positions and resolve margin disputes in a timely manner. If a firm had reconciled its portfolio regularly, matching trades with the counterparties and checking for discrepancies such as unequal valuations, it would have had a better view of its positions and its credit counterparty risk exposures during the financial crisis.
Many investment managers are now very aware of collateral management, noted a senior official at a US-based fund management firm.
He said: “After the Lehman Brothers failure we realized the risk in not knowing the status of collateral in real time. We are now more cognizant of collateral, where it is posted, and where we might have posted in excess. I think all buy-side firms are starting to realize portfolio reconciliation needs to be done daily as opposed to weekly or monthly.”
More generally, the financial crisis has tightened credit terms for all market participants and many firms need to manage their collateral assets (both pledged and received) more vigilantly as well as the higher frequency of margin calls that have grown out of the fragile economy, noted Cubillas Ding, a senior analyst in Celent’s securities and investments practice.
As a result, firms are under pressure to ‘self-regulate,’ which means they need to generate timely counterparty information to mitigate credit risk, have reporting metrics for collateral, and reconcile portfolios as a way to prove the existence of strong risk controls, said Ding. “The discipline to self-regulate shapes perception of governance and risk management capabilities, which in turn influences the reality of how risky your counterparties perceive you to be,” he added.
To support this need for stronger controls over collateral, some buy-side firms are installing new collateral management software while others are outsourcing to third party service providers, such as fund administrators.*
The US-based fund management firm recently reviewed several collateral management solutions including Lombard Risk, Algorithmics and Omgeo. The firm is currently in the process of negotiating the licensing contract with the selected vendor.
“We were looking specifically to license a collateral management system that would speed up the portfolio reconciliation process, help us respond faster, and manage disputes more effectively,” said the buy-side official. Specifically, the firm will replace manual processes with an automated solution to reduce the amount of time spent reconciling portfolios, answering margin calls and resolving disputes. The expectation is that the use of a collateral system – instead of excel spreadsheets – will shave off a significant amount of time spent daily managing collateral.
Automation of portfolio reconciliation processes will also reduce the rate of errors currently caused by relying on excel spreadsheets and manual work, said the buy-side official. “There have been times where there were errors, which were caught too late in the day, which meant we had to bear that risk overnight and until the next morning when someone could fix the situation, he said. “That was a big concern of the firm.”
The fund management firm eventually selected a collateral management system based on cost, implementation time and the functionality it required to support the firm’s high volumes. The fund management firm also required a system that had the flexibility to interface with new software, such as a new portfolio management platform, as well as connect with the fund’s custodian, which manages the collateral in a tri-party arrangement.
Some investment managers and hedge funds will opt to subscribe to TriOptima’s portfolio reconciliation hub, triResolve instead of installing new portfolio reconciliation software. TriResolve is a centralized, peer-to-peer matching engine where users can submit portfolios in any format to be matched and the results are then accessible via the TriOptima website.
The G14 and many major financial institutions use triResolve to reconcile trades between themselves. This readymade network is what attracted CQS to subscribe last year in replacement of its in-house and labor-intensive portfolio reconciliation system, said CQS’s Carpenter. “What we liked about triResolve was that most of the banks that we have been trading OTC derivatives with at that time had signed up to triResolve,” he said.
There are additional operational benefits in the use of triResolve due to the data mapping service TriOptima provides. For instance, if a firm trades with 15 counterparties, it may receive between 30 and 50 position and valuation statements because the desks and departments within a counterparty will use different statement formats and this volume makes the process difficult to automate, explains Carpenter. CQS dealt this volume and variety of statements and found its use of triResolve resolved this operational headache, he added.
“Use of triResolve has helped us overcome some of the issues that we were having around the disparate nature of some of the counterparties that we are dealing with,“ said Carpenter. “TriResolve did away with that problem because they did the mapping of data for us and publish the data on their website on a daily basis.”
TriResolve normalizes and maps data formats for all new subscribers so they can automatically start reconciling with any of the other triResolve users, said Viktor Johannsson, global business manager of triResolve.
Use of the single hub such as triResolve and the automation of reconciling portfolios with multiple counterparties creates operational benefits outside of the collateral management discipline, Johannsson said. For instance, with automated portfolio reconciliation, a firm has the opportunity to validate its valuations against those of its counterparties, which assists with internal controls.
“I think it is useful for the trade control area to have the ability to validate the firm’s mark-to-market valuations and ensure that trades are valued in a consistent way…and to see if a particular desk is consistently making errors,” said Johannsson. TriResolve includes sophisticated analytics to help a user pinpoint and understand where the errors in valuations are generated, identify the root causes of a dispute and resolve the problem, he added.
TriResolve initially focused on the larger, sell-side institutions including the G14, but now TriOptima is actively marketing the solution to smaller banks and buy-side firms and is also extending the service to cater to the demands of buy-side and smaller sell-side clients, said Susan Hinko, global head of Industry Relations at TriOptima.
Hinko said: “We have actually started to expand beyond portfolio reconciliations and now we are introducing functionality to support other aspects of collateral management including margin call management and dispute resolution. [This move] is in response to requests from the buy side and smaller financial institutions who have joined the service and are looking for broader functionality.”
Specifically, TriOptima is adding the capability to support reconciliation of both collateralized and non-collateralized portfolios and various other instrument types, adds TriOptima’s Johannsson. “We are adding support to be able to reconcile [repurchase agreements], securities financing transactions on the platform and the functionality is live now,” said Johannsson, who noted this additional instrument coverage is of particular interest to buy-side institutions.
“Repo and securities lending are two obvious asset classes that need to be managed with other collateralized transactions. We are seeing demand for other asset classes such as FX forwards and TBAs,” said John Burchenal, managing director, Market Growth, at Omgeo, the provider of portfolio reconciliation solution, Crosscheck and collateral management solution, ProtoColl.
A challenge for the industry is that current processes are fragmented across asset classes and geographies, which means collateral inventory is not managed efficiently, said Burchenal. Increasingly, firms are looking to unify collateral management processes into a single environment to reduce operational inefficiencies, said Burchenal.
“This inefficiency costs money by not optimizing collateral usage and creates operational risks,” said Burchenal. “Optimal collateral management cannot be achieved until fragmented legacy systems are retired and brought into one place where risks can be better managed and costs can be reduced.”
Efficiency in portfolio reconciliation and collateral management is also of increasing importance because the terms of collateralization are getting increasingly complicated, notes Ding of Celent.
Ding said: “The bar is being raised in terms of collateralization approaches. For instance, more sophisticated firms are embracing cross product/cross-asset netting, optimization of the type of collateral pledged/received, and efficient, event-driven, configurable workflow with up-to-the-minute information on margin calls, collateral movement, and settlement.”
A further complication to collateral management operations is new financial regulation both in the U.S. and in Europe. Both buy-side and sell-side firms will need to be able to adapt systems and processes to comply with new rules as these rules will impact OTC derivatives processing and collateral management, noted the buy-side official.
He said: “We need to be as nimble as possible because what works today may not work tomorrow and we really don’t know what the future is going to hold,” he said.
* DerivSource will be publishing a feature evaluating the growing rate of collateral management outsourcing in the coming months as part of this Collateral Management Series. Previous articles include: