In a Q&A, TriOptima’s David White explores the impact new financial regulation will have on portfolio reconciliation and dispute resolution processing and how firms can adjust operations to comply with new rules.
Q. What is the current portfolio reconciliation process today within the firms and industry-established best practices?
A.The industry initiated efforts to improve the reconciliation and margining process beginning in 2006. Since 2008 more and more institutions implemented a proactive, automated reconciliation process that complies with the new regulations. In fact in 2010, the International Swaps and Derivatives Association (ISDA) put out a Best Practices for Portfolio Reconciliation that laid out similar standards. The G-15 institutions have been reporting disputes to their financial supervisors regularly since 2008. Many institutions either subscribed to external services or built their own systems in order to meet their commitments. But firms with smaller portfolios may not be in the same place. Luckily there are service providers out there that can easily provide the support needed to comply.
Q. Can you give us a quick overview of the portfolio reconciliation and dispute resolution requirements outlined by the CFTC and ESMA?
A. The U.S. Commodity Futures Trading Commission (CFTC) and European Securities and Markets Authority (ESMA) rules on portfolio reconciliation are very similar in terms of portfolio size and frequency of reconciliation and similar but not totally consistent for dispute resolution and reporting. At the end of the Q&A there are two charts prepared by TriOptima that summarize the rules for each jurisdiction. These are provided for general reference purposes via the link below*.
In the US, all Swap Dealers (SD) and Major Swap Participants (MSP) and in Europe Financial and Non-Financial counterparts above a certain clearing threshold must reconcile daily their portfolios with more than 500 trades, weekly their portfolios with 51-499 trades, and quarterly their portfolios with less than 50 trades. In the US non SD and MSP portfolios and in Europe Non-Financial counterparts below the clearing threshold must reconcile portfolios with more than 100 trades quarterly and less than 100 trades annually.
The CFTC and ESMA both require that policies and procedures for resolving swap valuation discrepancies must be in place for all counterparty types. The CFTC requires that any discrepancies in the material terms of a trade must be resolved immediately and valuation disputes must be resolved within 5 business days for SDs and MSPs . Disputes over three days with a valuation greater than $20 million must be reported to the CFTC, and disputes with other entities over five days in duration and greater than $20 million must be reported. ESMA requires that all entities must establish a process for the resolution of disputes greater than five days, and report all disputes greater than 15 days and €15 million.
While many institutions are already meeting the reconciliation guidelines, valuation disputes can linger for longer than the new thresholds requiring new procedures and resources.
Q. How will firms have to adjust processes to comply with new regulation if they aren’t already capable of meeting the outline practices for portfolio reconciliation and dispute resolution? And what challenges do they face in adhering to new rules?
A. As I’ve indicated, many firms have already implemented these standards and have been proactively reconciling their portfolios so many will be in a position to comply on the portfolio reconciliation side on time. On triResolve (TriOptima’s counterparty exposure management service) alone there are 250 firms reconciling over 6.3 million trades; and there are other service provider platforms like Markit and Algo that offer similar capabilities. Some firms have also invested in building their own reconciliation functionality internally, although that is not the prevailing practice. In addition, the major dealers have been reconciling not just between themselves but have been inputting trades from their buy-side counterparts in order to automate the process and get results quickly. Many institutions also have access to outside or internal platforms that facilitate dispute resolution as well, although perhaps not within the timeframes now required. Nevertheless, many market participants have a basic foundation for moving forward.
However, in establishing a plan for implementation and compliance, there are several areas where firms need to focus attention:
• Who do you need to reconcile with and how will you do it?
For smaller market participants this may not be a big problem; however if you are a large, regional or small financial institution with many types of customers it may prove more difficult if you don’t already have a process in place.
Given that non-collateralized trades are now included and that the environment is dynamic (new trades everyday), the monitoring of the eligible population becomes challenging. Typically the portfolio reconciliation process resided in the collateral department. Now trades across silos will have to be aggregated and monitored.
Once the population of counterparties has been identified, each institution will have to agree a consistent method across all of its relationships or it will be impossible to comply in a timely manner.
• Reconciling the trades
Once the counterparties and portfolios are identified, there needs to be a reconciliation methodology in place based on the data fields required by the CFTC which will be issued later in November, and those identified by ESMA in 2013. Obtaining those fields internally may be a challenge for all types of trades within the scope of the regulations (collateralized, uncollateralized, more complex structured trades, commodity trades that tend to be less standardized). Even more of a challenge will be getting those data fields from smaller counterparties who may or may not be used to supplying them.
Standardizing the counterparty’s file formats and matching the underlying trades quickly will be essential given the dispute discrepancy and resolution timeline requirement in the regulations. At a minimum the process will have to be automated internally if that hasn’t already happened, and a service provider solution might be the best way to meet the deadlines.
• Resolving disputes
The frequency requirements will require changes to data management and processing capabilities internally. Dispute resolution will require firms to establish protocols for interacting externally with counterparties. The timelines are more aggressive than current practice. And for large valuation disputes this will prove particularly challenging since front office involvement is often required. Each institution’s internal written policies and procedures should address these issues, and over time new behaviors will become routine.
ISDA had published Convention for Investigation of Disputed Margin Calls in 2011, but the timeframes for investigation in that document are much longer than the final rules allow. However, that document could form the basis for a revised Convention that will incorporate the new regulations and offer an industry standard of policies and procedures going forward.
• Reporting
There are two kinds of reporting frameworks that will need to be developed – internal MIS for management for information and monitoring purposes and external to the regulators to ensure compliance with the regulations. Once again, if an internal MIS framework doesn’t already exist, the relevant reports for both management and the regulators may be part of a vendor solution that also provides portfolio reconciliation, dispute identification, and counterparty communication networks.
At TriOptima, we have introduced a free service, triResolve QuickPort, that is a first step for market participants new to the reconciliation process. Because so many smaller market participants with portfolios of less than 500 trades will have to reconcile, we are offering triResolve QuickPort free of charge. It’s a secure method to upload their files against their counterparties. Summary reconciliation results will be available to them which begins the process of identifying discrepancies and disputes. The advantage is that they don’t have to send emails with spreadsheets attached, the data terms are standardized, and the matching is done on our triResolve platform against their counterparties’ information. triResolve QuickPort is a great first step for firms who are just beginning to comply with the regulations.
Q. What are the challenges to the legal department and related legal processes?
A. Legal departments are under a lot of pressure these days. Much of the existing documentation needs to be amended to accommodate the new regulations. Fortunately ISDA has developed some protocols so massive renegotiations have been mitigated to a large extent.
Lawyers not only interpret the new regulations but monitor external compliance with the rules. In addition, internal procedures and policies have to be written to ensure compliance and to provide guidance to the functions within the organization that will have new responsibilities.
Q. What’s the long-term impact of new rules on the industry?
A. Of course the long-term impact of the rules will be to introduce more transparency into the market place, to enhance and focus counterparty credit risk management, and to reduce systemic risk. Problems will be identified swiftly and remedial action will be taken before problems overwhelm an institution or the market. The regulators will be able to monitor exposures and minimize risk. For instance, the AIG problems might have been averted if the counterparties had been reconciling daily and seeing large valuation differences emerging. Furthermore, these regulations are part of a larger framework of regulations including clearing, compression, enhanced documentation, reporting, and stricter margining rules.
While the industry may experience some dislocation as it adapts to the new regulations, in the long run these initiatives will work together to improve both the individual institution’s risk management as well as the stability of the global financial system.
*Link to TriOptima’s portfolio reconciliation and dispute resolution regulatory summary:
http://www.trioptima.com/services/triResolve/regulation.html
