Portfolio reconciliation is a post-trade control in which the two parties to a set of over-the-counter derivative contracts exchange their records of every outstanding trade and compare them. Its purpose is to detect at an early stage any trade that one side has and the other does not, any term that has been booked differently, and any material difference in value, before such differences turn into disputes over collateral or losses on a default.
The practice began as an industry response to collateral disputes during the financial crisis of 2007 to 2009 and has since been made mandatory for uncleared OTC derivatives in the main jurisdictions. The same term is used more loosely in asset management for the comparison of an investment manager's records with those of a custodian, a separate process described under custody account reconciliation.
Why it is required
Bilateral derivatives can remain outstanding for many years, during which they may be amended, partly terminated, transferred to another party or affected by events such as rate resets. Each party records these changes in its own systems. Errors that are not caught when the trade is confirmed can persist unnoticed, and they surface when the two sides calculate different exposures and one disputes a margin call.
When Lehman Brothers failed in 2008, counterparties and administrators found that agreeing which trades existed and what they were worth took a long time. Regulators concluded that firms should be able to produce an agreed view of their bilateral portfolios at short notice, and included portfolio reconciliation among the risk mitigation techniques required for derivatives that are not centrally cleared. Trades cleared through a central counterparty are outside the requirement, because the clearing house holds the single authoritative record.
Regulatory requirements
In the European Union and the United Kingdom, the European Market Infrastructure Regulation requires counterparties to agree in writing, before trading, the arrangements under which they will reconcile portfolios. The minimum frequency depends on the type of counterparty and the number of contracts outstanding between the pair. For financial counterparties and for non-financial counterparties above the clearing threshold, it is:
- Each business day where 500 or more contracts are outstanding between them.
- Once a week where there are between 51 and 499 contracts.
- Once a quarter where there are 50 or fewer.
For non-financial counterparties below the clearing threshold, the frequency is quarterly where more than 100 contracts are outstanding and annual otherwise. The reconciliation must cover the key trade terms and at least the valuation attributed to each contract. Firms must also have procedures for identifying, recording and monitoring disputes, and must report to their regulator disputes above a set amount that remain outstanding for at least fifteen business days.
In the United States, rules of the Commodity Futures Trading Commission adopted under the Dodd-Frank Act impose similar obligations on swap dealers and major swap participants, with comparable daily, weekly and quarterly tiers for portfolios with other dealers and less frequent reconciliation with other counterparties.
How the process works
Each party extracts a file of its live trades with the counterparty as at an agreed date, including identifiers, product type, notional amount, currency, effective and maturity dates, rates and its mark-to-market valuation. The files are exchanged directly or, more commonly, loaded to a shared reconciliation platform that matches them automatically.
The comparison sorts trades into matched, mismatched and unmatched. Unmatched trades, present in only one file, are the most serious, since they suggest a booking that the other side does not recognise, a missed termination or a trade recorded against the wrong legal entity. Mismatches in terms are investigated against the original trade confirmation. Valuation differences within an agreed tolerance are accepted, because each side uses its own models and market data; larger ones are examined for errors in inputs or terms.
Agreed corrections are made in the books of whichever party was wrong, and unresolved items are escalated under the dispute resolution procedure. Most firms adopt the documentation published by the International Swaps and Derivatives Association, which allows counterparties to agree the reconciliation terms by adhering to a protocol rather than negotiating bilaterally. These arrangements operate under the parties' master agreement.
Portfolio reconciliation works alongside other post-trade processes. Timely confirmation establishes the terms at the outset. Collateral reconciliation compares the assets each side believes it has posted and received, and variation margin calculation depends on the agreed portfolio. Where differences in value lead to a disagreement over a call, the matter is handled as a collateral dispute. Trade compression reduces the number of contracts to be reconciled, and regulators require firms to consider it for larger portfolios.
Limitations
The process confirms that two sets of records agree, not that either is correct, and it does not remove differences in valuation that arise from legitimate modelling choices. For firms with many small counterparties, the work of obtaining and loading data is considerable, and delegated arrangements leave the smaller party reliant on the dealer's records. The control is one part of wider derivative lifecycle management.