Christina Norland – Director of Global Regulatory Solutions at Chatham Financial discusses the thornier issues of portfolio reconciliation and how both parties can share the burden.
Q. The requirements under Dodd Frank and EMIR are well documented, but just starting from the basics, can you explain why portfolio reconciliation continues to be such a stumbling block for market participants?
A. Under Dodd Frank, the portfolio reconciliation requirements apply to registered dealers and major swap participants. This means that swap dealers and major swap participants are required to make reasonable efforts to engage in portfolio reconciliation with their non-dealer counterparties, but cannot compel their non-dealer counterparties to perform reconciliation. However, for many reasons, performing meaningful portfolio reconciliation is not operationally easy for many market participants. And while there are vendors in the market who might be able to provide this service, it can be expensive. This is why, at the moment, many in the industry are still looking for the best way to perform and optimize portfolio reconciliation.
There are end users in the US who are facing US swap dealers that opt out of performing portfolio reconciliation. They are waiting to see how the reconciliation process is going to mature and become more efficient. Some of the inefficiencies we see are a result of the lack of standards in the reconciliation process. The dealer’s valuation may not be in the same currency that its counterparty uses to value its trades, the data may be emailed in an indecipherable form, or the reconciliation could be sent in a non-native language.
On the EMIR side, both counterparties have to agree to documentation on how to reconcile portfolios and engage in dispute resolution. Unlike the US, a non-dealer cannot opt out of performing portfolio reconciliation. The documentation initiative was a long process because there were so many relationships that existed before EMIR went into effect that still had active trades. Market participants worked hard at getting these documents in place, but it took a while to achieve compliance.
The inefficiencies are the same globally. There are different platforms for market participants that can help them reconcile their portfolios, but the cost may be prohibitive depending on their volumes. Right now, market participants are compliant, but the efficiency of the process can definitely be improved. Chatham, for example, couples this process with our trade execution or reporting services, making it seamless for our clients.
Q. Are there any lessons that have been learned from Dodd Frank that can be applied to EMIR?
A. Globally, regulators want to ensure parties agree on the terms of their transactions and the value of their mutual portfolios. One way to accomplish this objective is through portfolio reconciliation, dispute resolution, and timely confirmation. European regulators, however, have also sought to accomplish this objective through dual-sided reporting, which requires the parties to agree on the data they are reporting. In the US, only one party to a trade is required to report according to a regulatory hierarchy, which reduces reporting burdens for the buy-side. As the European Commission conducts its review of EMIR, it will be interesting to see whether regulators believe dual-sided reporting really adds much to the ability to reconcile trades or whether the US model of single-sided reporting is sufficient. Our experience is that, once the operational issues are overcome, portfolio reconciliation identifies disputes and overall, those disputes are minimal and relatively easy to resolve. Additional requirements, like dual reporting, further compound the operational issues that market participants are confronting and provide uncertain benefit to reconciling differences between the parties.
Q. Aside from the data challenges, what other issues are your end-user clients dealing with?
A. A lot of buy-side market participants sign documentation that puts the burden on them to decide whether the bank counterparty’s data and valuations are correct, and if they are not, require them to go back to the bank within a certain time period. While this approach makes sense for many market participants, it does place the burden solely on them to accurately analyze the bank’s data and quickly respond to disputes, otherwise they often are deemed to have agreed the bank’s data. Depending on the circumstances, it may be more appropriate to engage in bilateral reconciliation, which means that both parties have the requirement to share and review data and raise disputes.
Q. What are some of the tools that your end-user clients are using in terms of automating some of these processes, or even just the protocols or standard documentation that’s out there?
A. Market participants have come to us for help after they have tried to use their own internal systems to reconcile with their counterparties, who are often sending data manually to them through email. At Chatham we provide portfolio reconciliation services and our streamlined processes take the burdens away from our clients completely.
Q. Does Chatham also help with the negotiation and documentation of the contracts?
A. Absolutely, we work together with our clients’ counsels on negotiation and documentation of ISDAs and regulatory documentation. If we are providing portfolio reconciliation services, we handle all the documentation requirements as well as the process itself.
Q. Is there a particular area of portfolio reconciliation, large or small, that you think is particularly confusing still for either end users or just the market in general?
A. The biggest area of confusion is whether end users facing US banks are actually required to engage in portfolio reconciliation. In the preamble to the Commodity Futures Trading Commission (CFTC) rule, the CFTC states (and I’m paraphrasing here) that while banks have the obligation to use reasonable efforts to reach out and try to engage in portfolio reconciliation with end users, end users cannot be compelled to engage in that process.
Q. Have market participants started preparing for the portfolio reconciliation requirements?
A. Yes, on the European side, market participants have definitely gotten their hands around documentation requirements for portfolio reconciliation. They have entered into and started performing reconciliations with their counterparties. There still remains some work to be done in streamlining the actual reconciliation process.
From our perspective, we don’t see many disputes that are so significant that they require reporting to EU national competent authorities. Once the operational issues are overcome, the vast majority of trades are actually very close in terms of how parties are valuing those transactions and there are few disagreements, if any, on the core economic terms.
Q. Looking ahead, what do you expect to take place for the rest of the year? Do you expect any major progress made?
A. The industry has continued to streamline the standards for reconciliation, reporting, documentation and other processes. As that continues to happen, progress will continue to be made.
Many in the industry, including smaller financial entities, are currently focused on figuring out the upcoming margin and new clearing requirements, and the next wave of change that these requirements will bring.
