Thought Magazine

OTC Reporting and Reconciliation

Of all the provisions contained within the Dodd-Frank Act, the European Market Infrastructure Regulation (EMIR) and similar regulations that have been applied across the globe, the new reporting requirements are amongst the most far-reaching and represent a significant challenge for the over-the-counter (OTC) derivatives market. After the mandated reporting start dates, firms must report to a trade repository the details of all derivatives contracts they conclude, modify or terminate. This obligation applies in respect of both cleared and bilateral derivatives contracts. As a result of the inherent challenges and operational risks involved in meeting these new regulatory reporting requirements, many institutions will be required to implement additional risk mitigation steps to enhance their existing operational controls and procedures.

"Many institutions will be required to implement additional risk mitigation steps to enhance their existing operational controls and procedures."

New regulatory reporting requirements

In view of the complexity of the reporting reforms, initial industry efforts have focused on ensuring that institutions understand their regulatory requirements primarily in relation to who needs to report, what needs to be reported, to whom, how and by when. Both regulations require the establishment of repositories (known as swap data repositories under Dodd-Frank and trade repositories under EMIR) that will store the required data on behalf of regulators. Both Dodd-Frank and EMIR mandate the reporting of significant volumes of data associated with executed trade, holding both the buy- and sell-side to the trade responsible for ensuring that the reporting parties have all the required data to complete their reporting obligation.1 However, there are significant differences between the two regulatory reporting requirements in relation to who is obligated to report. Under Dodd-Frank only one counterparty to the trade has the reporting obligation, and this lies predominantly with the sell-side or derivatives clearing organisations (DCO) and, in time, swap execution facilities (SEF) and derivatives contract markets (DCM). In contrast, under EMIR both counterparties to the trade have a reporting obligation and therefore buy-side institutions will find themselves responsible for this new regulatory reporting. In addition, under EMIR, exchange-traded derivatives (ETDs) are considered in scope. For many impacted firms, meeting the reporting requirements, specifically those under EMIR, will present significant operational challenges. Given the above, it is essential that institutions understand which regulatory jurisdictions they and their trades fall under and the different regulatory reporting rules that apply.

Trade repository reporting landscape

Although both Dodd-Frank and EMIR allow reporting responsibilities to be delegated, each counterparty to the trade remains accountable to its own regulator for the accuracy and completeness of the trade repository’s record.2 The importance of this is underlined by the fact that the data held by trade repositories will be a regulatory record and will also, in part, be made publicly available in an aggregated format either by access to a trade repository (as is the potential in EMIR) or via a swaps report3 (Dodd-Frank), which will be published by the CFTC in the spring of 2013.

Given the operational complexity and current industry uncertainty in relation to delivering the EMIR-mandated reporting requirements, much of the industry efforts have focused on delivery of the European reporting regulation.

For EMIR, many institutions may aim to delegate reporting responsibilities to their trading counterpart. Alternatively, given the need to ensure accuracy, institutions may decide to seek third-party reporting solutions or carry out the reporting themselves even where they are not the mandated reporting party.

None of the above options are without their own challenges. The ability to delegate remains uncertain as broker-dealers continue to explore whether to offer this service. Even where delegation is offered, viewing the work required to pass data onto the delegated party for onward reporting may prompt firms to decide that they are better placed reporting the data directly to the trade repository themselves. Much will also depend on whether all or some of the broker-dealer community will offer reporting services.

These challenges are compounded by existing uncertainty in regard to understanding how certain regulations are to be applied and what the consequences are for non-compliance. Of note is the need within EMIR for both parties to the trade to report their view of the mark-to-market. How this is achieved and whether delegation is an option continues to be explored and has yet to be determined.

The number of trade repositories currently in existence or in the process of registering also presents another level of complexity. EMIR explicitly encourages a multiplicity of trade repositories creating a reconciliation and control challenge as well as risk of duplication and fragmentation. Unless buy-side firms are able to guarantee that all their trades, irrespective of which trading counterparty they use, are reported to a single trade repository, they may need to establish relationships with multiple trade repositories, potentially across jurisdictions, to gain a complete view of their total portfolio.

In light of this complex and evolving but still embryonic reporting landscape, institutions may elect to undertake direct reconciliations of their records to those of the trade repository, which ensures that regardless of the reporting mechanism, any errors or omissions are promptly identified for remediation.

Risk mitigation landscape

Both Dodd-Frank and EMIR stipulate that institutions must establish procedures and processes to identify, record and monitor disputes in relation to portfolio reconciliation for bilateral trades against the trading counterparty. This is in addition to similar controls for disputes relating to the trade valuation and the exchange of collateral.

Whilst the regulations do direct trade repositories to undertake portfolio reconciliations, they do not explicitly state that institutions (such as buy-side institutions) must reconcile to trade repositories. However, it is important to note that the creation of trade repositories establishes a new, primary risk management tool for the regulators, which elevates the accuracy and completeness of the trade repository record to sit alongside that of the counterparty and a firm’s own books and records.

To ensure that they have an appropriate level of control on what is being held with the trade repository, many institutions will seek to develop risk mitigation processes that incorporate a portfolio reconciliation function with the relevant trade repositories. Buy-side institutions can effectively do this in one of three ways, by:

  1. Undertaking a direct (in-house) portfolio reconciliation to a trade repository
     
  2. Relying on their trading counterparties to:

    1. report correctly and
       
    2. undertake a timely, complete and accurate portfolio reconciliation with the trade repository
       
  3. Outsourcing this portfolio reconciliation function to a third party

Direct reconciliation

Some institutions will prefer to undertake a direct portfolio reconciliation with the trade repository themselves. However, this option does not come without its own challenges.

Operations and technology managers will need to find capacity from teams that may already be tasked with building the next generation of OTC trading and clearing solutions. Institutions may potentially need to de-prioritize existing or proposed projects or increase their resource depth and budgets. Even where a portfolio reconciliation platform already exists, many institutions will need to assess whether this platform can accommodate additional portfolio reconciliations or whether a new technology solution is required. In addition, institutions will have to determine which trade repositories they wish to reconcile against. To decide, they will need to understand to which trade repository they or the delegated party is reporting.

Reliance on a trading counterparty

Where a portfolio reconciliation to the trade repository is already being undertaken by an institution’s trading counterparty or counterparties, buy-side institutions may conclude that their counterparty’s controls are sufficient to ensure an appropriate level of comfort with regard to the trade repository record. To a large extent, the viability of this option will be driven by the completeness and visibility of the portfolio reconciliation and the implementation of an effective oversight model. The key to this will be whether the institution’s trading counterparty or counterparties are also the reporting party, and whether they (i) are prepared to reconcile values that are unique to just the buy-side (as will be the case under EMIR), and (ii) give buy-side firms access to the reconciliation files and provide a mechanism in which disputes can be identified and resolved.

Outsourcing

Alternatively, institutions may decide that outsourcing presents the best opportunity to significantly reduce the inherent operational risks, complexity and costs associated with establishing and maintaining in-house portfolio reconciliation solutions. By outsourcing portfolio reconciliation, institutions can benefit from:

  • Reduced costs—access to a scalable, variable, cost-based trade repository reconciliation system; this eliminates institutions’ commitment to the present and future costs associated with portfolio reconciliation functions  
  • Greater control, flexibility and speed—the ability to adapt their trade repository reconciliation system based on rapidly changing market conditions, providing a level of continuity in operations  
  • An increased focus on their core capabilities

In selecting an outsource partner, institutions must also ensure that the service provider is able to deliver an integrated portfolio reconciliation solution that includes both a validation of the trading counterparty portfolio record and the trade repository record.

Whichever trade repository reconciliation model institutions select, they will need to be satisfied that the process offers an economic, robust, transparent and future-proof solution. As stated, the model will also need to be developed alongside parallel trade reconciliation requirements, primarily versus the clearing broker, the bilateral counterparty and, where appropriate, the service provider and any existing internal reconciliations, optimally leveraging industry-wide infrastructure that has been developed to meet regulatory requirements that allow for operational efficiencies.

"Given the operational complexity and current industry uncertainty in relation to delivering the EMIR-mandated reporting requirements, much of the industry efforts have focused on delivery of the European reporting regulation."

Understanding the risks

Whilst many questions remain in relation to the OTC derivatives reporting landscape, it is increasingly critical for institutions that trade OTC derivatives to understand the consequential risks associated with the new reporting requirements. Effective risk mitigation solutions can then be implemented that are integrated with institutions’ current and future portfolio reconciliation requirements. Without an effective risk mitigation overlay across their OTC derivatives operating model, institutions may be exposed to an increased likelihood of incorrect, incomplete, duplicative or failed reporting.

 

Dodd-Frank and EMIR Contrasts

Beyond a shared G20 high level commitment that mandates the reporting of both cleared and bilateral OTC derivatives trades to a trade repository, significant differences exist between the terminology, technical detail and asset scope of Dodd-Frank and EMIR.

Within Dodd-Frank, trade repositories are known as swap data repositories, whilst the EMIR continues with the trade repository terminology. In the EMIR, ETDs are considered in-scope, whereas in Dodd-Frank they are not. In addition, under Dodd-Frank the identification of the reporting party is reasonably clear and prescriptive—as a general rule, the more senior party to the trade (subject to the designation as defined by the regulator) will be the designated reporting party. Otherwise, if of equal standing, the parties must elect between them who reports. In contrast, the EMIR permits both parties to be the reporting party for some of the data. The EMIR also allows the reporting to be delegated to the trading counterparty or a third party.

Reportable data within Dodd-Frank (based on CFTC terminology) is defined as swap creation data and swap continuation data. This will include (but not be limited to) information relating to the primary economic terms (meaning all terms of the swap matched or affirmed by trading counterparties in verifying the swap at or shortly after the time of execution); confirmation data (all of the terms of a swap matched and agreed upon by the counterparties in confirming the swap); valuation data (the daily mark/mid-market mark of the swap); and continuation data (reportable life cycle event data is required to ensure that the trade repository record remains current and accurate—this will include assignments, novations and full or partial terminations).

The SEC proposed rule does not use the above terminology. Instead it references the terms to be reported (in real time and additional information that is to be reported within set time frames) on execution and the need to report life-cycle events if these result in a change to previously reported information. The SEC proposed rules do not currently require reporting of valuations; instead, they require that the data elements necessary for a person (i.e., a third party) to determine the market.

Under EMIR, reportable data is defined as counterparty data and common data. Counterparty data will include, but not be limited to, the reporting of a series of identifiers (counterparty, broker, reporting entity, clearing member, beneficiary), counterparty data (name, domicile, corporate sector, financial or nonfinancial nature); data relating to the context of the trade (confirmation of whether the trade is directly linked to commercial activity or treasury financing, trading capacity); clearing data; valuation data (mark-to-market value, valuation date, valuation time, valuation type); collateral data (confirmation that the position is collateralised, calculation method, value and currency).

Common data will include data specific to the contract type (product ID, underlying data, notional currency, delivery currency); generic transaction data (trade ID, reference number, price/rate, quantity), asset specific transaction data; and report modification data.

On the latter point, reporting for Dodd-Frank commenced on January 1, 2013. Reporting for EMIR is projected to start in the third quarter of 2013, currently September 23, 2013.4


1Under CFTC rules, both buy and sell-side have a regulatory responsibility to ensure that an SEF, DCM or DCO has all required information to meet the reporting rules. Under SEC rules (which are yet to be finalised), it is expected, based on the proposed rules, that the responsibility for ensuring the reporting party has all the required data to report will remain with sell-side only.

2Under CFTC, the reporting obligation transfers to the SEF or DCM for swaps executed on facility and to the DCO for cleared swaps. This is not the case under proposed SEC rules as responsibility remains with the reporting counterparty. Typically, third parties such as affirmation/ confirmation platforms are being used as delegated agents for reporting under CFTC rules.

3CFTC Release: PR6412-12, “CFTC Issues Proposed Swaps Report for Public Comment,” November 14, 2012, www.cftc.govWeblinking practices.

4EMIR Indicative Timeline, update 28-Feb-13, www.esma.europa.euWeblinking practices.

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Thought, Q2 2013

Author

Alvaro Zambrano Saez

Alvaro Zambrano Saez
Senior Prodcut Manager of Global Investment Operations Services
 

 
 

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