11 July 2013

Pierides & Charleton: Reconciliation + regulation = complication

Comparing the key terms of OTC derivatives trades against the data held by a CCP is standard practice for many participants. But incoming regulation on both sides of the Atlantic will change some of the requirements, make it a compliance issue for the first time and – crucially – force many smaller players to put completely new processes in place.

For firms that have not had to think too deeply about trade reconciliation before, the regime could come as a nasty shock. The obvious solution – possibly the only one, given the timeline – is to use one of the available third-party services, but this has problems of its own. Important regulatory processes can, of course, be outsourced, but it does not transfer the compliance responsibility away from a regulated entity. As a result, the decision needs to be a careful, considered one – but with US reconciliation requirements due to take effect on July 1 and the European equivalents scheduled for September 15, there is a danger that some derivatives users rush to adopt a third-party provider without thinking the consequences through.

Mandatory portfolio reconciliation is an attempt to apply clearing-style valuation discipline to the uncleared market – a response to a perceived failure of OTC trade counterparties to identify and resolve valuation differences and the underlying causes of these differences. Both the European Securities and Markets Authority (ESMA) – given the responsibility by the European Market Infrastructure Regulation – and the Commodity Futures Trading Commission (CFTC), as required by the Dodd-Frank Act, have implemented distinct, but broadly similar requirements.

The requirements apply to all derivatives users and all uncleared trades, but the frequency of the reconciliations depends on both the customer type and size of portfolio. On both sides of the Atlantic, trades between dealers will have to be reconciled daily, weekly or quarterly. In Europe, this standard applies to all financial institutions as well as any non-financial institution that is subject to a clearing requirement, which will include some relatively small firms – and this population is likely to find the rules most onerous...

In summary, the relatively short implementation timetable for the reconciliation requirements – partly a result of delays in clarifying their scope – may lead regulated firms to rush through changes to the way they source and manage their reconciliation processes. That could be dangerous. The authors would urge firms to pause, take a deep breath and then approach the issue in a more considered way, with a clear understanding of the desired outcome.

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