Portfolio Reconciliation

When the terms or valuations of a trade differ between counterparties, the amounts of collateral called and delivered drift apart. In OTC derivatives, reconciliation is the work of finding and fixing these gaps before collateral is called and delivered and before disputes are reported to the authorities.

Why it exists

A derivative continues after it is signed, until maturity, and its valuation moves every day. Each counterparty keeps its own record of the trade, so an input error or a difference in how the valuation is calculated makes the two firms' numbers drift apart. Portfolio reconciliation is the process of finding and fixing these gaps on a regular basis. When the US Commodity Futures Trading Commission (CFTC) published its rule in 2012, it described reconciliation as a post-trade processing and risk management technique. It has three aims. They are to find and fix discrepancies in trade terms between execution and maturity, to make sure that all terms are confirmed, and to find and fix valuation discrepancies. It can also help find discrepancies in collateral valuation¹.

Reconciliation happens at a different time from a trade confirmation, which compares terms after execution. A confirmation is exchanged after the trade is executed. For swaps between swap dealers and major swap participants, US rules require the confirmation to be exchanged by the end of the first business day after the execution date². Reconciliation is repeated for all trades with a counterparty for as long as the trades are outstanding.

A valuation discrepancy leads to a discrepancy in the amount of variation margin. Disputes over the terms in confirmations and disputes over valuations that affect margin payments have long been significant problems in the over-the-counter derivatives market. The CFTC regards reconciliation as an effective way to find and resolve these disputes, and expects regular reconciliation to prevent most of them from arising³. The work of calling and delivering collateral is covered in Collateral Operations.

What is compared, and in what order

Reconciliation exchanges the material terms of the trades and the valuation of each trade. The CFTC rule defines reconciliation as a process in which two parties do three things: exchange the material terms of all swaps between them, exchange the valuation of each swap as of the close of business on the previous business day, and resolve discrepancies in terms and valuations. In the rule, a valuation is the current market value or net present value of a swap⁴. In the EU, the delegated regulation (149/2013) under the European Market Infrastructure Regulation (EMIR) covers the key trade terms that identify each contract and says the reconciliation includes at least the valuation of each contract⁵.

In the order the rules set out, the flow is as follows.

1. The counterparties agree in writing on how reconciliation will be done. In the EU, they agree before entering into the contract⁶⁷.
2. They exchange the material terms of the trades and the valuations as of the close of business on the previous business day.
3. Each firm compares its own record with the other's and finds discrepancies in terms and valuations.
4. They resolve the discrepancies. The deadlines for resolution are set separately in the US and the EU.

A worked example

Consider a hypothetical example in which Firm O and Bank P have three interest rate swaps. With only three trades, the minimum frequency under the rules, as the table in the Frequency and scope section shows, is once a quarter or once a year depending on the two firms' categories. In this example, assume that the two firms reconcile every business day and exchange valuations as of the close of business on the previous business day. Valuations are from Firm O's point of view: a plus is an amount Firm O receives, and a minus is an amount it pays. Assume that collateral is exchanged as variation margin equal to the net valuation, and that there is no threshold or minimum transfer amount. Except for trade C, the two firms' records for the three trades match.

The two totals differ by 5 million yen. Comparing the terms, only trade C has a different notional amount. If everything else about trade C is the same, and the valuation method and inputs are the same, the valuation is proportional to the notional amount. Multiplying Firm O's valuation of 50 million yen by the ratio of 9 billion yen to 10 billion yen gives 50 × 9 ÷ 10 = 45 million yen, which matches Bank P's valuation. The difference in valuation is explained by the difference in the recorded notional amount.

Suppose the two firms review the trade confirmation and find that the notional amount is 10 billion yen and that Bank P had entered 9 billion yen. When Bank P corrects its record, its valuation of trade C becomes 50 million yen, and both firms' totals match at +130 million yen.

If the discrepancy is left in place, the variation margin amounts differ. Bank P delivers 125 million yen to Firm O, based on its own calculation. Firm O should receive 130 million yen, so it is 5 million yen short. The counterparty credit risk for that amount is not covered by collateral. In the opposite case, if Bank P had entered trade C as 11 billion yen, its valuation of trade C would be 50 × 11 ÷ 10 = 55 million yen, and the total would be 135 million yen. Bank P would deliver 5 million yen too much, and Firm O would hold that much extra. In either direction, if reconciliation finds the cause and the record is corrected, the two firms' collateral amounts match.

Figure description

The figure shows Firm O and Bank P exchanging terms and valuations, and delivering collateral when they differ. The amount under each box is the notional amount of trade C that each firm recorded: 10 billion yen at Firm O and 9 billion yen entered at Bank P. If the discrepancy is not corrected, Bank P delivers 125 million yen, based on its own calculation, as variation margin, and Firm O receives 5 million yen less than the 130 million yen from its own calculation.

Frequency and scope

US and EU rules set a minimum reconciliation frequency according to the number of trades with a counterparty. The US rule mainly applies to swap dealers and major swap participants. The EU rule applies to financial counterparties and to non-financial counterparties.

Under US rules, the numbers in this table are counted for each swap portfolio. The weekly category depends on the number of trades on any business day in that week. The quarterly and annual categories depend on the number at any time in that quarter or year¹⁰. EU rules classify by the number of outstanding OTC derivative contracts with the counterparty¹¹.

Consider a hypothetical example in which only the number of trades differs. Applying the table, for example: when there are 60 trades between swap dealers in the US, or between financial counterparties in the EU, the minimum is once a week. If the number reaches 500, it is every business day. At 40, it is once a quarter. In the US, when the counterparty is neither a swap dealer nor a major swap participant and there are 80 trades, the minimum is once a year.

Swaps cleared by a clearing organization are outside the scope of reconciliation under US rules¹². In 2012, the CFTC explained that a clearing organization holds the definitive record of the trade and determines a binding daily valuation, so cleared swaps do not need reconciliation. The same document expected that, as clearing is mandated and bilateral trades decline, the reconciliation burden would also become lighter¹³.

Resolving discrepancies and the dispute process

What happens after a discrepancy is found (dispute resolution in reconciliation) is set out as follows in the US and the EU. Here, discrepancies in trade terms are separated from discrepancies in valuations.

US rules require swap dealers and major swap participants to do the following. When the counterparty is in the same category, a discrepancy in material terms is resolved immediately¹⁴. For valuation discrepancies, the firm sets and follows written policies and procedures reasonably designed to resolve them as soon as possible, and in any event within five business days. These policies and procedures also decide how the firm will comply with the variation margin rules until the discrepancy is resolved¹⁴. If an individual dispute is not resolved within five business days, the firm does not violate the rule as long as it has followed its policies and procedures¹⁵. When the counterparty is not in the same category, the firm sets procedures to resolve discrepancies in terms and valuations in a timely fashion¹⁶.

A valuation difference of less than 10% of the higher valuation need not be deemed a discrepancy. The CFTC explained that it drew the 10% line to make clear which disputes must be resolved¹⁷. For example, if the higher valuation is 100 million yen, a lower valuation of 90 million yen or less is treated as a discrepancy. In the previous section, the difference for trade C is 5 million yen, exactly 10% of the higher valuation of 50 million yen. It is not "less than 10%," so it is treated as a discrepancy. The line is applied to the valuation of each swap, not to the difference in the totals.

Large disputes that cannot be resolved are also reported to the authorities. In the US, when a valuation dispute of more than USD 20 million (or the equivalent in another currency) remains unresolved for three business days if the counterparty is a swap dealer or a major swap participant, or five business days otherwise, the firm promptly notifies the authorities¹⁸.

EU rules require counterparties to agree, when they enter into a contract, on detailed procedures to identify, record, and monitor disputes. These cover disputes over the recognition or valuation of a contract and disputes over the exchange of collateral. They also agree on procedures to resolve disputes in a timely manner, and on a specific process for disputes not resolved within five business days¹⁹. A financial counterparty reports to its competent authority a dispute for an amount higher than EUR 15 million that remains outstanding for at least 15 business days²⁰.

Who reconciles

Reconciliation can be done by the counterparties directly or by a qualified third party. US rules say that, between swap dealers and major swap participants, the counterparties or a qualified third party do it. When the counterparty is anyone else, the counterparties do it, or a third party chosen by written agreement of both²¹. EU rules say the counterparties do it, or a qualified third party delegated by one of the counterparties⁵. In the US, how a third party is chosen is part of the written agreement when the counterparty is neither a swap dealer nor a major swap participant⁶. The names, scope, and operators of the services that provide reconciliation are covered in Post-Trade Efficiency Services.

What this page does not cover

The reconciliation requirements in Japanese rules are not covered on this page. The differences from the current text of the EU delegated regulation are not covered on this page. Comparisons of individual providers are not covered on this page.

Notes

1. CFTC, 77 FR 55904 (September 11, 2012), the opening paragraph of "E. Portfolio Reconciliation—§ 23.502". ↩

2. 17 CFR 23.501(a)(1). The deadline when the counterparty is not a swap dealer or a major swap participant is set separately in (a)(2) and (a)(3). ↩

3. The same document, the last paragraph of "1. Statutory Basis for Portfolio Reconciliation" and the first paragraph of the Commission's response to comments in "2. General Comments to Portfolio Reconciliation". ↩

4. 17 CFR 23.500(i) (Portfolio reconciliation) and (m) (Valuation). Material terms are defined in 23.500(g) as the minimum primary economic terms in Appendix 1 to the same subpart. ↩

5. Delegated Regulation (EU) No 149/2013, Article 13(2). Source: the original text as published in 2013 (legislation.gov.uk, Original (As adopted by EU)). ↩ ↩²

6. 17 CFR 23.502(a)(1) and (b)(1). (b)(1) provides that the choice of a third-party service provider is also part of the agreement. ↩ ↩²

7. Delegated Regulation (EU) No 149/2013, Article 13(1) (agreement in writing or by an equivalent electronic means, made before entering into the contract). ↩

8. Delegated Regulation (EU) No 149/2013, Article 15(1)(a). ↩

9. 17 CFR 23.502(e) (reconciliation records consistent with 23.202(a)(3)(iii) are kept in accordance with 23.203). ↩

10. 17 CFR 23.502(a)(3)(i)–(iii) and (b)(3)(i)–(ii). ↩

11. Delegated Regulation (EU) No 149/2013, Article 13(3)(a)(i)–(iii) and (b)(i)–(ii). ↩

12. 17 CFR 23.502(d). ↩

13. CFTC, 77 FR 55904, "E. Portfolio Reconciliation—§ 23.502", the first paragraph of the Commission's response to comments in "2. General Comments to Portfolio Reconciliation—§ 23.502". ↩

14. 17 CFR 23.502(a)(4) (material terms) and (a)(5) (valuations; written policies and procedures, and compliance with the variation margin rules). Paragraph (a) applies to swaps where the counterparty is also a swap dealer or a major swap participant. ↩ ↩²

15. CFTC, 77 FR 55904, the Commission's response to comments in "11. Resolution of Valuation Disputes in Portfolio Reconciliation—§ 23.502(a)(5) & (b)(4)". ↩

16. 17 CFR 23.502(b)(4) ("in a timely fashion"). ↩

17. 17 CFR 23.502(a)(5), last sentence, and (b)(4), last sentence. CFTC, 77 FR 55904, the paragraph on the 10% line in "11. Resolution of Valuation Disputes in Portfolio Reconciliation". ↩

18. 17 CFR 23.502(c)(1) and (2). ↩

19. Delegated Regulation (EU) No 149/2013, Article 15(1)(a) and (b). ↩

20. Delegated Regulation (EU) No 149/2013, Article 15(2). ↩

21. 17 CFR 23.502(a)(2) and (b)(2). ↩