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The Resource for the Global Finance Profession

Portfolio Reconciliation is the OTC Market’s New Obsession

  • By Susan Hinko and David White
  • Published: 2014-06-16

When new regulatory requirements in Europe and the United States mandated portfolio reconciliation, there was an explosion in the number of market participants looking to comply. In America, only swap dealers and major swap participants are required to comply; however, because of these obligations many corporate end users also are affected.

It is expected that Canadian portfolio reconciliation rules will follow the U.S. model and come out later this year. Meanwhile, under European Market Infrastructure Regulation (EMIR), all non-financial as well as financial counterparties are affected by the new rules. This has meant that thousands of corporate treasurers have had to participate in these activities and ensure they are meeting the new legal and regulatory commitments.

Both the Dodd-Frank Act (from August 2013) and the EMIR rules (from September 2013) have a rolling implementation schedule based on size of portfolios. Firms are required to establish portfolio reconciliation procedures and dispute investigation and resolution procedures with their counterparties. As of March 15, 2014, all firms affected by Dodd-Frank and EMIR regulations must enact portfolio reconciliation processes and dispute resolution procedures with their counterparties for any portfolio of uncleared swaps.

In reality, many corporates began implementing measures to modify their collateral relationships and credit risk mitigation processes after the Lehman crisis in 2008. Firms with an inaccurate view of their exposure (not to mention those that had over-collateralized their positions with Lehman) lost access to their assets. Corporates wanted to reconcile their outstanding trades with their counterparties, including valuations, to maintain an accurate view of their exposures and, where there was collateralization, keep collateral disputes to a minimum. ISDA, the International Swaps and Derivatives Association, issued a best practice document in 2010 which helped firms begin to incorporate these practices into their workflows. The new regulatory requirements set deadlines to complete the process and convert the best practice into regulation.

The key to reducing credit risk
Why the emphasis on portfolio reconciliation and dispute investigation and resolution? Without an accurate understanding of swap portfolio exposures, firms cannot monitor risk or where they collateralize, ask for, or deliver collateral efficiently. Collateral calls are made on the aggregate exposures but for that call to be valid and agreed, the trade-by-trade exposures must be compared on a regular basis—and not just when there is a collateral call dispute.

This means that portfolio reconciliation moves from a reactive to a proactive activity occurring on a regular basis. Many dealers recognized the benefits of this approach and started daily reconciliations with their larger dealer counterparties by 2008, but corporates were slower to convert.

In reconciling their portfolios proactively, firms with advanced reconciliation processes were able to identify differences in both their own and their counterparties’ pricing methodologies and data standards. In establishing the root causes of these differences and then resolving the upstream issues over time firms are sable to ensure that their exposures are aligned.

Accurate collaterization is key to reducing your credit risk, and is the first step towards optimizing your collateral where applicable. In the new landscape of scarcer capital resources and increased regulation, firms view optimized collateral resources as a competitive advantage.

But algorithms and allocation engines designed to achieve reductions in cost and efficient funding are only effective if the exposure and collateral balance inputs are correct. Another important factor is the new requirement by 2015 to post initial margin (not just variation margin) by both corporates and dealers. While there is no agreement on how to calculate this bilaterally, the need to reconcile exposures is fundamental so that firms are in agreement as to the trades upon which the Initial margin calculation is performed.

Recognizing that some corporates still do not collateralize their OTC portfolios, it is still important to underscore the benefits of proactive portfolio reconciliation. Verifying the trade details of your transactions before there are payment or calculation problems will eliminate time-consuming research and dispute resolution later on. Regulators have also included uncollateralized trades in the portfolio reconciliation rules to ensure accurate credit risk assessment and prevent future losses like those seen in the Lehman bankruptcy.

Susan Hinko is global head of industry relations at TriOptima. David White is a product marketing executive at TriOptima.

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All rights reserved.

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