Reconciliation: The Great Balancing Act

There are those who believe the Dodd–Frank Wall Street Reform and Consumer Protection Act will completely revolutionize the trading of derivatives in the US. Prior to its introduction, all over-the-counter (OTC) derivative trades were executed between two parties, with no obligation to divulge what either party was up to. What little information did exist was submitted to trade organizations voluntarily. Now, most derivatives will have to be traded at a Swap Execution Facility (SEF) or an exchange, cleared through a central counterparty (CCP) and reported to a Swap Data Repository (SDR).

In other words, the Dodd–Frank Act is a big deal.

This sea change is not confined to Wall Street; Europe, Canada, Asia and Australia are all grappling with how best to deal with these instruments, which are often portrayed as controversial in the media and by politicians, but serve a vital function in helping companies manage their risk exposure.

As a result, their utility is often misunderstood by regulators, says Tim Lind, head of strategic development at Omgeo. “Derivatives are a vital part of how the global economy works, and are essential instruments for corporations to manage their exposure to interest rate fluctuations, as well as the cost of many commodities, and counterparty risk,” he says. “They are incredibly important tools to ensure consistency of pricing, therefore enabling corporations to better manage their business.”

On the back of Dodd–Frank, which is rewriting the OTC rulebook, the financial services industry is looking to lead the charge on another pressing issue facing the OTC market: reconciliations. Most recently, the International Swaps and Derivatives Association (ISDA) changed its trade novation protocol to combine the formerly two-step process of “consent and confirm” into a single procedure.

Rising trade volumes and exceptions, caused partially by an increase in instrument complexity, has precipitated problems in the marketplace. Research by consultancy Celent shows there was a compound annual growth rate (CAGR) of 30 percent in OTC derivative transactions from 2000 to 2007. Between 2008 and 2009, however, the value of transactions rose by a staggering 86 percent, placing considerable pressure on the reconciliation process. This is further exacerbated by the lack of a standardized valuation practice, which makes collateral management a difficult task, especially given the increasing use of structured products which often require complex pricing techniques.

Given these issues, it is unsurprising that in its March 2009 report, the Asset Managers Forum (AMF) estimated that 10 percent of OTC trades have breaks. AMF urged investment managers, brokers and custodians to reconcile positions and market valuations daily, or at least weekly. However Lind says this is yet to happen. “The reality is that most buy-side firms—and when I say most I mean more than 90 percent—are not reconciling with any frequency at all and certainly not in an automated way.”

OTC Reconciliation
There are two aspects to the reconciliation process in the derivatives market—the traditional reconciliation of trading positions, and the more complex process of collateral management. Collateral management is the means by which credit risk in unsecured financial transactions is reduced, via posting a margin on a trade against the possibility of counterparty default.

Because derivatives are not liquid traded instruments, this can be a highly complex task to negotiate. A further complicating factor is that firms now have to reconcile not only between each other, but also with a trade repository. Dealers submit their derivative positions into these trade repositories, or trade warehouses as they are sometimes known, so regulators can form an estimate of the notional exposure outstanding from one source. This three-way reconciliation system has created a new level of complexity in the market place.

What has become apparent is that when OTC derivative trades are not properly reconciled, either in terms of collateral management or position reconciliation, it can lead to uncertainty and backlogs in the marketplace.

“High-frequency trading and algorithmic trading are introducing a whole new set of risks to the market, especially now that high-frequency trading approaches are leaking ever more into OTC products,” says Nick Solinger, chief marketing officer at Traiana, a post-trade network for foreign exchange (FX), futures, equities and equity derivatives. “The May 6 Flash Crash was the perfect example of this. Although there may have been a market structure issue that was exacerbated by algorithmic and high-frequency trading, at the end of the day it highlighted the fact that if you’re participating in those markets you need real-time notification of what’s happening. Whether it’s high-frequency FX, equities or futures, having trade-by-trade reconciliation in real time that lets you know what’s going on with your electronic trading infrastructure is absolutely crucial.”

For this reason, the accuracy and frequency of reconciliation is becoming an increasing concern for buy-side firms, says Solinger. “If one leg of a trading strategy doesn’t execute it can cause unintended exposure, and concurrently a firm won’t get the specific exposure it needs.”

Firms are paying attention to reconciliation because without the proper reconciliation technologies and strategies in place, the cost of operating as a fund will be higher than it should, which ultimately impacts returns. The realization that inadequate reconciliation processes can affect the profitability of OTC products is pushing the issue higher up firms’ priority lists, Solinger says. “There is a growing recognition that the liquidity of any given product is tied to the ease with which the product can be traded, and the ease with which the product can be traded is in turn tied to the ease of post-trade processing,” says Solinger. “If it’s a very complex product with a complex confirmation process, that will inhibit trading opportunities, because it will make the cost of putting on that trade more expensive. This, in turn, is driving the push for greater standardization across reconciliation processes.”

Collateral Management
Recent market events have served as timely reminders that the financial industry has traditionally underinvested in risk management capabilities. In order to mitigate the counterparty credit risk to which derivatives transactions expose users, a growing proportion of OTC transactions are collateralized. According to the 2010 Margin Survey by the International Swaps and Derivatives Association (ISDA), 70 percent of all OTC derivatives trades were subject to collateral agreements in 2009, rising to 93 percent for credit derivatives trades. A total of $3.2 billion in collateral was used globally in 2009, mostly in the form of cash or highly rated bonds, according to the same survey, representing a rise of 35 percent annually since 1995. Among firms that responded to both the 2009 and 2010 surveys, the number of collateral agreements grew by 14 percent, most probably a reaction to mounting counterparty credit-risk concerns in the wake of the financial crisis.

However, accurate mark-to-market valuation of derivative positions—which is critical to ensuring collateral management—is a difficult task. Lehman Brothers’ bankruptcy highlighted these difficulties as buy-side firms found they had insufficient collateral to mitigate their counterparty risk. Stephen Bruel, a research director in consultancy TowerGroup’s securities and investments practice, says buy-side firms also face risks from over collateralization. “Over collateralization is a big risk, as is misidentification of the correct counterparty, valuation or set of transactions, but they all amount to the same thing—you don’t know the risk you’re holding on your books.”

Omgeo’s Lind says that while collateral management is seen as one of the main ways to mitigate this risk, it is a trade-off between a subjective risk for a more objective one. As an example, he points to estimating fair valuations for complex derivatives transactions (subjective) for using open market pricing for liquid collateral (objective). “Get it wrong, or fail to recognize one or more of these transferred risks or valuations, and collateral management could unwittingly increase risk, rather than diminish it,” he says.

Regulatory Arbitrage
Because of these issues, the OTC derivatives market has recently come under increasing legislative scrutiny. The US is ahead of Europe in this regard, having passed the Dodd–Frank Act.

In Europe, legislation has yet to be passed but the European Market Infrastructure Regulation (EMIR) looks set to introduce a central clearing facility and the US will almost certainly exert pressure on Europe for fear of regulatory arbitrage.

Omgeo’s Lind says he is uncertain of the efficacy, in terms of reducing risk, a clearinghouse will provide due to the difficulty in calculating collateral. “A central counterparty clearinghouse is essentially a professional collateral manager. And that collateral manager can only perform the task at hand when it understands the value of certain contracts, so it can operate in a standardized way, and reliably calculate the appropriate collateral to offset risk.”

Legislators in the US and Europe are also making tentative advances in the direction of moving trades fully onto exchanges. However, the very reason instruments are traded over the counter is because of their customizability, so migration of risk on-exchange is likely to impact only the most liquid products, with the less standardized products remaining OTC, says Bruel. “The buzzwords regulators talk about, the two attributes they most want to use to describe the OTC industry, are ‘standard’ and ‘transparent,’” he says. “However, in order to create a market that is more standard and transparent you’re going to have to effect change to the actual instruments. But the very reason these instruments are traded OTC is because they need to be customized to some extent. No one is buying OTC derivatives because of robust processes; people are buying OTC derivatives because there are specific needs they have that can only be met by those instruments.”

Given the difficulty in standardizing the instruments themselves, Bruel says there will be a focus on standardizing the processes and messaging protocols. “Because there isn’t a unified way to describe every part of the transaction, different parts of the trade are referred to by different names, which can cause disputes and trade breaks” he says. “So when regulators talk about the need for standardization, in some ways they are talking about standardizing the economics of the trade, but I think they are also talking about the legal description of these fields, standard messaging between counterparties, standard legal documents and so on.”

After the events of the past two years, the financial industry has come to realise that reconciliation and exception management are important support functions that cannot afford to be overlooked. So it’s unsurprising that over and above any regulatory mandates, pressures from within the industry are building up to effect change. Since 2008, major broker-dealers have undertaken commitments to regulators to reconcile portfolios between themselves, initially weekly for portfolios over 5,000 trades, and, using a phased approach, to daily reconciliations of portfolios over 500 trades by April 2010. This daily reconciliation activity is now estimated to account for some 65 percent of total OTC market volume.