TechBrief: Dealing with OTC derivative reconciliation

by Nolan Gesher, senior product manager, North America, CheckFree

OTC derivative reconciliation should leverage existing automated processes and platforms already in place for more traditional investment vehicles while also being flexible enough to address potential future regulatory requirements.

Financial institutions have long increased investment in OTC derivatives in order to add product flexibility and to hedge investment risk. Recent market turbulence has only served to heighten investment in derivatives as investors seek to guard against amplified fluctuation of nearly every type of commodity. Rising investment in derivatives has come with a corresponding increase in trading volume. This combined with anticipated and likely increases in regulatory compliance mandates has led to a renewed focus on the ability of an institution’s back office to process and support the settlement of OTC derivative transactions. This specifically includes the ability to reconcile the holdings and transactions of instrument types that are largely dealt with in a manual environment in a timely, accurate and compliant manner.

The simple truth is that the reconciliation of derivative products is substantially more complex than traditional investment vehicles. Derivatives are often a result of bilateral agreements that impose little or no standardization from deal to deal. The resultant sharing of data for reconciliation is subject to vagaries such as:

▪ Contractual stipulations between counterparties on whether to reconcile their books and records at all

▪ How often such reconciliation should take place

▪ What is considered a good match (although ISDA does provide some guidance on this front)

As a result derivative reconciliation often exists as an island of manual processing surrounded by a sea of automated reconciliations. The challenge is to create an automated process for reconciling derivatives and to do so in a manner that leverages existing automated processes and platforms already in use for more traditional investment vehicles while also ensuring flexibility to address potential regulatory requirements. The overriding objectives in automating the reconciliation of OTC derivative products are consistent with the objectives commonly sought in the automation of most middle/back office processes: reducing risk through the diminishment of manual errors; further risk reduction via more timely reconciliation processing and segregation of duties; the reduction/reallocation of headcount, or the ability to enable increased trading volume without the corresponding need to increase headcount; increasing transparency into the reconciliation process as demanded by clients, auditors, and senior management; and adherence to external regulatory guidelines and internal compliance initiatives.

So, what attributes should a firm look for in a reconciliation platform so that it can meet these objectives in the face of the specific and complex challenges associated with OTC derivatives?

Are collateral calls on OTC derivatives accurate? Do you know how your counterparty valuates? Can you validate that this is correct?

If the answer to any of these questions is “no” it is likely that incorrect collateral calls may be made, and as a result funds will be over/underinvested. The potential long term impact of such a scenario on overall portfolio performance and to a firm’s bottom line is immense. Inherent variability exists within the mark to market process for assets like derivatives in which the underlying value of the asset is difficult to pinpoint. This variability can easily balloon within illiquid markets or with lightly traded securities. We need look no further than the recent sub-prime turmoil for an unfortunate example. The importance of agreement between counterparties on how to value derivatives and when therefore to place collateral calls lends even more primacy to the need for a platform that can accurately match both sides of a derivative trade in a timely manner. Thus, reconciliation solutions must deliver extreme flexibility in terms of match rule creation in order to rapidly accommodate fast changing and complex data comparison requirements.

Perhaps more important is the integration between the matching platform and workflow component of a solution. There will always be exceptions. A solution that delivers tightly integrated exception management and workflow capabilities provides a firm with an enhanced ability to manage the exception resolution process. The ever-increasing complexity of new derivative products leads to a decrease in the ability to do real-time analysis and investigation, thereby increasing the risk exposure and opportunity costs from poorly or underinvested funds. A functionally rich, automated and integrated workflow platform mitigates these risks and reduces the potential for underinvested funds.

Multiple counterparties, multiple formats

Various source systems from different counterparties often provide data in inconsistent formats (e.g. - FpML, XML, .xls, delimited, flat file, etc …). Although ISDA has provided guidelines on standardising formats these remain only guidelines. ISDA standardisation also calls for reconciliation data to be presented in FpML format. An additional layer of complexity occurs when counterparties do not deliver the same set of data elements for reconciliation purposes. OTC derivatives are based on contracts between counterparties and these contracts are not always standardised, especially in the case of “exotics.” Lastly, the data that is delivered may be at differing levels of detail. Some data is provided at the lot level while other data may be delivered in aggregate. All these factors combine to create a highly complex reconciliation process. Reconciliation solutions, therefore, must provide a good deal of flexibility in terms of their ability to manage inconsistent and “non-standard” data formats as well as the ability to compare data at various levels of detail in order to be effective.

More inconsistencies

Among other inconsistencies in the reconciliation of derivatives is the fact that different counterparties often use unique, if not proprietary, security identifiers. Because OTC derivatives are traded via contracts this occurrence is hardly the exception to the rule. To meet this challenge, financial institutions must arm themselves with a reconciliation platform that brings with it either substantial security master functionality, or the ability to interface with and reference enterprise security masters. The solution must deliver the ability to dynamically link new security identifiers with existing or “known” IDs, and must be able to propose matches of new derivative transactions with differing identifiers in order to deal with the processing complexities that multiple security identifiers present.

Dynamic intervention

Derivative securities are so complex due in part to the large number of data elements associated with them. In addition to multiple amount and date fields for OTC derivatives, the potential for inclusion of other fields that are not typically associated with traditional securities also exists. For example, mortgage backed securities include current and original face values, paydown factors, tranches, etc. There are so many more data elements requiring validation as part of the reconciliation process it is unlikely that any “predetermined” set of rules, no matter how inclusive, will bring a sufficient number of matched sets together.

Therefore, a solution that facilitates the application of human capital to the process provides significant value to the organisation. In such a scenario automated matching occurs, but given the large number of data elements to be compared a high percentage of good matches across so many elements is unlikely. As unmatched items move through the resolution workflow the ability for users to dynamically apply rules to match the data and the ability of the system to then present all possible matches back to the user for acceptance creates a condition in which human capital is applied in its most effective and efficient manner – within an audited, segregated and automated process.

Expanding on this concept, a best of breed solution should provide the ability to scan contract details. These details are often contained within a physical document scanned into a document management system. The ability of the reconciliation solution to reference this data without forcing the user to leave the reconciliation platform adds even more efficiency to the process.

Extreme settlement lifecycles

OTC derivative based transactions go through three phases of reconciliation:

▪ Original: this phase is the equivalent of the affirmation/confirmation process for traditional securities. SwapsWire and Deriv/SERV are the major industry utilities in this space for ‘vanilla’ derivatives. The ability for a reconciliation solution to leverage output from these utilities is a critical requirement in making the initial reconciliation process as efficient as possible. For exotic derivatives which are not eligible for processing via the industry utility the data management and matching capabilities discussed earlier are the keys to a valuable solution.

▪ Resets: this phase may actually occur as multiple phases spread over years or even decades. They represent corporate events that affect the security’s issuer, and therefore have a material impact on the security itself, or may be as simple as an interest reset as in the case of a mortgage backed security. Regardless of what form the event takes, a reconciliation platform must be able to accept the changed data produced from the event and perform reconciliation versus the firm’s counterparty for each event to ensure that the books and records of both parties remain in synch. Within an automated environment this is accomplished by a reconciliation solution’s ability to easily integrate with the corporate action platform that manages these events. Data must flow seamlessly between the two platforms and, once any discrepancies have been identified, correcting entries require an automated update process to the firm’s ledger(s).

▪ Close: this phase is the final settlement of an OTC derivative transaction and is operationally similar in nature to the many resets that may have preceded it.

Because the lifecycle of OTC derivative securities can be so long there is an enhanced need to ensure the use of industry standard technology that is easily upgradable. Given the extended timeframes associated with derivatives, long term vendor viability must be considered as a key requirement when evaluating solutions.

Compliance must also be considered

Best practice processes focus the back office on delivering key operational benefits such as reduced risk and reduced cost while also satisfying internal audit controls and external regulation. This dual focus allows for a two-pronged benefit from the implementation of a reconciliation solution that will address both traditional instrument types as well as OTC derivatives – a platform that meets the demands of reconciling complex derivative instruments while still satisfying auditors and regulatory bodies.

The current, largely manual, handling of OTC derivatives is unsustainable. Increasing volumes, growing complexities and heightened regulatory pressures will assure that this is the case. While the industry is moving towards further standardisation and automation there remains a great deal of work to do.

The benefits of an OTC derivatives ready reconciliation solution are many. The implementation of a solution that meets the general requirements specified above will lead to operational efficiencies that also support future growth in derivatives investment. The key is identifying a solution that delivers these capabilities as part of the firm’s larger reconciliation solution so that existing investments are leveraged and the manual ‘island’ slips effortlessly into the sea of automation.

Nolan Gesher, senior product manager, North America, CheckFree