Banking & Financial

Services

White Paper

Reconciliation Utility for OTC

derivatives
BFS Thought Leadership
About the
Authors

Ramakoteswara Rao T
Ramakoteswara Rao T has over 15 years of experience working in the
manufacturing, retail, banking and capital market domains. He has
worked with customers across the US and Europe. Rao's key focus areas
include large program management, wealth management and related
industry initiatives. Rao holds a master's degree in mechanical
engineering from IIT, Madras.

Ganesh Padmanabhan
Ganesh has seven years of experience in IT solutions and consulting for
the capital markets domain. He has worked with leading market
infrastructure firms on various initiatives. Ganesh holds a master's
degree in business administration from the S. P. Jain Center of
Management, Singapore.
In the wake of the financial crisis of 2008, both buy and sell side firms are
still grappling with multiple challenges including declining revenues, low
margins, heightened risk sensitivity and greater regulatory scrutiny. To
comply with rapidly evolving regulations, banks are re- focusing their efforts
on centralization of key operational processes to lower costs (replacing
CapEx to OpEx model) and achieve tighter risk control.

The demand for reconciliation and exception management systems (to

reduce operational risks) is mainly driven by the perceived risk associated
with evolving instruments of operation in the rapidly growing capital
markets industry. Reducing operational risks and adopting suitable run-the-
bank (RTB) initiatives is the top priority for most banks, and is considered as
the critical driver behind investing in reconciliation processes. Further, utility
based models have been proven to work well for various functions across
the trade lifecycle.

This paper reviews the opportunity to build the 'Reconciliation-Utility-in-a-

Box' model, catering to banks' demands, with twin focus on reducing costs
and improving efficiency for the Over the Counter (OTC) derivatives trade
reconciliation process.
Conten
ts

1. Introduction 5
Current OTC Trade reconciliation 6
process Challenges in OTC 6
derivatives reconciliation Emerging 8
options 9
Currently available reconciliation 1
solutions 0
2. Centralized Reconciliation 1
Utility 3
3. Conclusion 1
3
4. References
Introduction
Seven years after the financial crisis of 2008, both buy and sell side firms are still grappling
with multiple challenges including declining revenues, low margins, heightened risk sensitivity
and greater regulatory scrutiny. To comply with rapidly evolving regulations, banks are re-
focusing their effort on centralization of key operational processes to lower costs and achieve
tighter risk control. There is a clear imperative to reduce costly and labor intensive
reconciliation operations by replacing the existing capital expenditure (CapEx) model with an
operating expense (OpEx) model, typically through outsourcing.
The demand for reconciliation and exception management systems (to reduce operational
risks) is mainly driven by the risk associated with evolving instruments of operation in the
capital markets industry. The rapid growth of the global capital markets industry has been
characterized by:
n Global rise in trade volumes and exceptions
n Increase in instrument complexity
n Derivatives usage post-trade and collateral management
n Multisided reconciliation: novation
n Increased regulatory oversight as well as investor demand for transparency
n Reduction in Total Cost of Ownership (TCO) and development of shared reconciliation services
Reducing operational risks and adopting suitable run-the-bank (RTB) initiatives is the top
priority for most banks, and is considered as the critical driver behind investing in
reconciliation processes. Strategies adopted by different market participants include:
nReactive reconciliations: Initiated only when mark-to-market (MTM) calls or independent
amount calls do not agree
nProactive reconciliations: Regularly scheduled reconciliations, with frequency driven by credit
quality, dispute history, trade volume, and counterparty type
Generally, large dealers tend to reconcile a higher percentage of trades (especially
outstanding trades) on a daily basis using multilateral vendor platforms. Also, a large
percentage of trades are executed 'by dealers with other dealers'. Reconciliation operations of
large firms are performed in silos, either by asset classes, geographies or business divisions.
The majority of asset managers continue to reconcile trades using trade files and spread
sheets provided by their counterparties.
Over the years, utility based models have been tested and proven to work well and are used
for various functions across the trade lifecycle such as central counter party clearing. From our
understanding, many large banks and investment management firms are looking at adopting
a centralized utility model for reconciliations and cost basis reporting.
This paper reviews the opportunity to build the 'Reconciliation-Utility-in-a-Box' model, catering
to evolving demands, with a twin focus on reducing costs and improving efficiency for the
Over the Counter (OTC) derivatives trade reconciliation process.
Current OTC trade reconciliation process
In the current scenario in institutional trading, most fund management firms insist that
custodian banks add sufficient controls to facilitate reconciliation between their fund
managers and broker-dealers. Currently, custodians perform OTC reconciliation through trade
confirmation between asset managers and broker dealers, whereas asset managers perform
reconciliation separately with broker dealers and custodians. As a result, 10 percent of the
trade falls in the reconciliation cycle due to different valuation methods with different time
intervals adopted by investment managers, broker dealers and custodians, which are
important for collateral management. Counterparty risk management demands not only an
agreement on portfolios and valuations, but also an alignment of collateral positions.
Disagreement on these collateral balances can dramatically affect exposure calculations,
leading to further disputes and risk management failures.
Model1 depicts the two prevalent
Table Description
models used in the reconciliation process:
Unilateral One firm performs the reconciliation and sends results to its counterparty
for investigation.

Bilateral Parties deliver their files to a vendor-service which performs the

reconciliation and publishes the results. Access to results is given to
subscribers. Non-subscribers can be given read-only access for review

Table 1: Prevalent Reconciliation Models (Source: TCS Research)

In today's scenario, different methods work for different categories.

Major broker dealers use single bilateral solutions while buy-side firms
use specialized technology which is generally unilateral and results in an
increase in bespoke reports. Due to the need to manage different
processes, these activities also become resource-intensive.
Challenges in OTC derivatives reconciliation
The current OTC derivatives reconciliation process needs enhancements
to address the following aspects:
n Continued prevalence of manual processing
n Lack of standard file formats and data standards
n Inconsistency in frequency of reconciliation
n Multiple tolerance thresholds
n Lack of substantial overlap between position and collateral
reconciliation
Many firms incur a high fixed cost to expand the operations team for
these reconciliations. Industry analysts indicate that operations teams
spend 20 to 30 percent of their time on reconciliation due to the
International Swaps and Derivatives Association (ISDA), , Portfolio-Reconciliation- 6
process' inherent complexities. Major broker dealers staff their
1

Feasibility Study, 2009

reconciliation teams at the rate of approximately one full-time
equivalent (FTE) per 49,800 trades. Other banks staff their operations
Table 2 depicts the operation cost for
reconciliation. Cost of Reconciliation

Reconciliati FTE Salary / FTE Total Cost /

on (000s $) Year (000s $)
Frequency
Monthly 2 80 160
Weekly 4 80 320
Daily 8 80 640

Table 2: Operation Cost for Reconciliation (Source: TCS Research)

Today, OTC derivative trades are not properly reconciled; both in terms of collateral
management and position reconciliation. Inadequate reconciliation processes can affect the
profitability of OTC products, pushing the issue higher up the priority list for the firms. Due to
the increasing number of OTC derivative trades, many firms are now looking to contract with
a service provider for a systematic long term solution.
Table 3 lists the challenges faced in OTC trade reconciliation.
Challenges Description
Regulatory and n Increased push for greater transparency of OTC derivative products
compliance n Compliance requirements on exception management and reporting
pressure
Greater volumes on hedge funds, proprietary trading of complex non-standard
n

Non standardized derivatives

products n Accounting difficulty due to increase of new products such as index swaps

n Increased difficulty in matching of trade IDs on non-Markit Wire trades

Cost efficiency nDuplication of trade details, and inconsistency in both timing of files and frequency of
reconciliation increase processing times and reduce processing capacity, resulting in
multi-way reconciliations

n Increased volumes of cross border settlements and trading for OTC derivatives
Cross border increase corresponding complexity of transactions, emphasizing the need for quick
trading and efficient process
n Increase in number and diversity of counterparties

n Increase in collateralized OTC derivatives transactions that extend beyond the

historic dealer-to- dealer and dealer-to-hedge fund relationships

Collateralization n Cross product collateralization is fast becoming a reality as market participants

eliminate the silos within collateral management

n Quest for proactive reconciliation by separation of commoditized product and quick
Speed to market process development through consistent monitoring, reporting, automated
business rules and exception tracking, and resolution

Risk Management n Increased need for mitigation of credit risk exposure

n Reducing systemic risk with accurate operational risk controls

Table 3: Current and Emerging Challenges in OTC trade reconciliations

(Source: TCS Research)

7
Firms need a reconciliation solution that enhances operational control, increases business
efficiency, and ensures regulatory compliance, while managing the transaction lifecycle with
flexibility. Also, the solution should be capable of incorporating the changing needs of back
and front office systems. Over a period of time, basic solutions with rudimentary exception
handling features have evolved into multifaceted, rules-driven reconciliation engines with
impressive flexibility to handle a wide array of reconciliation categoriespositions,
transactions, asset classes and cash. These reconciliation engines are increasingly evolving
into workflow management solutions through incremental upgrades to their exception
management tools.
Emerging options
The technology options available for performing portfolio reconciliations fall into two main
categories, vendor- serviced and in-house solutions.
Many firms have in-house solutions that use spreadsheets and, in some cases, simple
databases to store, organize, view and analyze data. Some asset managers use a specialized
service provider for reconciling with dealers, but use an in-house solution for reconciling with
the custodian. Major broker dealers use a vendor-serviced technology solution for
reconciliation between themselves while other banks and buy-side firms utilize a combination
of different solutions. Different vendor and in-house solutions maintain different trade
matching algorithms and data sets.
Due to the increasing number of OTC derivative trades, many firms are now evaluating the
option of contracting with a service provider for a systematic long term end to end solution
encompassing valuation, collateral management and portfolio reconciliation. Following are
some options that will be available in the future:
Future option 1 Centralized Data Model Using Proprietary Reconciliation Tools
This model utilizes a centralized tool that aggregates data from market sources and allows the
market participants to use their own proprietary technology solution to perform
reconciliations. Though this model uses proprietary reconciliation tools, it results in poor
Broker
quality of reconciliation and inefficient processes. Dealer
Trade
Repository
Figure 1 shows the reconciliation process under the centralized data model using existing
enterprise reconciliation solutions.
Centralized Investme
Tool for nt
Data Recon Manager
Managemen Tool 1
t
Trade Investme
Warehous Recon nt
e Tool Manager
1

Figure 1: Reconciliation process with centralized data

model using existing enterprise recon
solutions (Source: ISDA) 8
Future option 2 - Single Collateral Portfolio Reconciliation Vendor
This model utilizes a central vendor to aggregate data from market sources and performs
collateral reconciliations. The solution is designed to improve efficiencies by providing a
single definitive collateral per bilateral relationship and also helps in avoiding reconciling the
same record more than once. But this model may restrict the market participants in choosing
their own recon model and collateral management solution (instead of unified model).
Figure 2 shows the reconciliation process with a central vendor offering central data
management and reconciliation services

Broker
Trade Dealer
Repository
Centralized
Vendor for Investme
Data nt
Management Manager
& 1
Reconcilation
Trade s Investme
Warehouse nt
Manager
1

Centralized Reconciliation Services

Figure 2: Reconciliation process

with a central vendor
offering central data
management and
reconciliation services
(Source: ISDA)
Currently available reconciliation solutions
Capital market firms can choose any of the following options while implementing a
reconciliation solution:
n Purchase third party vendor software solutions
n Outsource technology and processesBPO
n Develop a customized solution through a shared services model with a technology
service firm n Utilize an on demand utility or application service provider (ASP) model
hosted by a third party Table 4 compares the various reconciliation models:

9
 Third Party Outsourcing Shared Services ASP Model
Software
Model Integrated Product Reconciliation Reconciliation CoE Reconciliation hub /
Suite Factory platform based utility
Silos based on Staffing in low- Clusters of
Operation asset classes / and medium- dedicated Centralized utility
geographies cost locations reconcilers in
major operations
centers
TCO reduction 10 -20% 30 40% 20 30% 60 70%
Flexibility Low Low Medium High
Standardization Low Low Medium High
CAPEX High Medium Medium Low
Productivity Low Medium Medium High
improvements
Economies of scale Low Low High High
Operational risk High High High Low
Quality enhancements Low Low Low High
Degree of automation High Medium Medium High
Regulatory compliance Medium Medium Medium High
Cross border trading Low Low Medium High
support
Speed to market Medium Low Medium High
Source: Internal Research
Table 4: Comparison of various reconciliation models (Source: TCS Research)

From the above analysis, it is evident that a centralized utility model would be
the most apt solution to cater to market demands and address the key issues
and challenges faced by market participants.

Centralized Reconciliation Utility

With the recent changes in the market structure in the OTC derivatives space,
the emergence of new entities such as Swap Execution Facilities (SEF) and
regulation on centralized clearing are aimed at reducing reconciliation effort
and meeting collateral management requirements. However, the existence of
bilateral trades between parties will continue - necessitating additional
reconciliation effort. Despite initiatives such as the Dodd-Frank Act (DFA) and
the European Market Infrastructure Regulation (EMIR), the market will continue
to remain volatile in the short term. Furthermore, with the implementation of
SEF and other requirements such as centralized clearing expected to continue
beyond 2015, there is more scope and opportunity for building a centralized
utility model for reconciliation processes. With several countries in the Asia-
Pacific region trying to develop their own reconciliation frameworks, the 1
introduction of such a model is needed to ensure standardization and a 0
common approach framework similar to the DFA and EMIR in the US and EU
respectively.
The aim of a centralized reconciliation utility model is to reduce operational, counterparty and
credit risks as a result of large manual communications among buy-and sell-side firms and
their service providers. The solution embraces all parties that adopt this reconciliation model
enabling both sides to view the results and work on any inconsistencies.
The driving force behind building and embracing a utility model based reconciliation platform
is achieving higher operational efficiency and cost savings through the following:
n Reducing cost per transaction by eliminating the capital expenditure (CapEx) model (zero
infrastructure costs, license and maintenance costs)
nReducing operating expenses by implementing a shared services model across reconciliation
functions and reducing the number of FTEs required
n Realizing economies of scale across geographies and asset classes
n Standardizing processes and transparencies
n Eliminating redundancies in the reconciliation cycle
n Increasing client satisfaction with improved resolution capabilities
n Ensuring real time information availability and improvement in reconciliation match rates
n Enabling greater operational control by preparing detailed management reports
n Achieving faster resolution of problems through timely identification of exceptions
There is a significant opportunity for service providers to build a utility model to service small
and medium asset management firms. Figure 3 explains the functional elements of a
reconciliation platform on the utility model.

Data Management Business and

/ ETL Matching Rules
Match Engine
(Automation)
Matches Allocation &
Validations Reallocations
Exception Management &
Reporting
Investigatio Workflo
Interfac Client
n& w
managem es Liaison
Resolutio
n ent

Figure3: Reconciliation platform on the

utility model

1
1
Coverage: The utility model should cover the following:
Asset Classes: Equities, foreign exchange, interest rate swaps (IRS), credit default swaps
(CDS), commodity derivatives, mortgage backed securities (MBS), debt instruments,
Products: Leveraged trading, repurchase agreements, securities lending agreements, loan
facilities
Event Management: Cash, security dividend, interest payment, premiums, commission
amount, taxes, withholding amounts, fees, payment-in-kind (PIK), escrow events, etc.
Messaging and Delivery Mechanism: The reconciliation platform should be based on the
Financial products Markup Language (FpML), but should also have the capability to
accommodate other standards (for example, other XML, fixed format flat files, spreadsheets)
to drive adoption by both buy and sell side firms. It should also have the ability to support
multiple delivery mechanisms including email, web services, messaging and queuing
applications, file transfer protocol (FTP), and web-based uploads.
Rule Definition and Matching Engine: The matching rules should be configured in a
flexible manner to enable users to define matching criteria, mandatory and optional fields and
specify relative weightages and tolerances. The engine should allow trade matching based on
the defined rules and generate and deliver a unique match ID to the participants for
processing across the life cycle of the trade.
Breaks and Issue Resolution: The platform should enable identification of breaks through
unmatched records and mismatches in trade populations and have the capability to initiate
the work flow management process. However, the party or the counter party will perform
Issue Management and Escalations and the resolution mechanism/method will be recorded for
future John reference.
Exception Management and Reporting: The solution should provide a web portal and a
graphic user interface (GUI), with the ability to sort and filter data for investigating and
submitting queries on trade discrepancies.
The Reconciliation Utility in a Box model should be able to cater to a single client as well as to
multiple clients. The single client model, suitable for clients with global operations, should be
equipped to handle the needs of several business divisions such as retail and institutional
brokerage, prime brokerage, and wealth management etc., to achieve economies of scale.
The multi-tenancy model should aim at supporting small and medium clients with limited
capabilities in reconciliation operations and help them realize cost benefits and improved
quality of service.
Based on considerations such as time-to-market and ease of adaptation by clients, the solution
should offer two options for implementation:
nSoftware as a service (SaaS) model: In this model, the implementation should involve
overhauling of existing reconciliation systems and deploying a customized solution. The
customization should include integration with business rule management products, exception
management and enhancements to workflow management, building interfaces to market data1
2
systems and other inter and intra systems. This model will deliver benefits including reduced
effort and faster time-to-market as the existing process will be re-engineered with minimal
Conclusion
Currently, the market is moving towards a model that demands more frequent portfolio
reconciliation, with daily reconciliation imposing a significant operational burden on
investment management firms. With the evolution of new market practices driven by cost
imperatives, tier1 and tier 2 investment banks and large asset management firms are
constantly trying to improve and streamline their operations while smaller asset
management firms have limited options to align with ever increasing market demand for a
cost-effective reconciliation system.
A centralized utility can go a long way in addressing both these diverse demand segments.
Adopting a centralized utility model delivers multiple benefits including competitive and
flexible pricing frameworks, standardization in reconciliation processes across asset classes
and reduced operating cost. Based on time to market and cost considerations, a firm can opt
for implementing the solution through the SaaS model as compared to the PaaS model.

Referen
ces
1.
2.
www.Omgeo.com (Protocol & Omgeo Cross check)
TriOptima - Post Trade infrastructure for OTC derivative market
3. International Swaps and Derivatives Association (ISDA), Portfolio-Reconciliation-Feasibility Study, 2009
4. JPMC Mitigating Risk with Portfolio Reconciliation, December 2009
5. Algorithmics, OTC Derivatives Portfolio Reconciliation from www.bnymellon.com ,2011
6. Securities technology monitor, Removing the Risk From OTC Derivatives Reconciliation, May 2009
7. Insight into External Integrated Reconciliation and Exception Processing Approach, Head Strong Consulting,
2010
8. DTCC Deriv/SERV LLC from www.dtcc.com
9. EuroClear Collateral Solution Conference 2012
10. European Central Bank, 'OTC derivatives and Post-trading Infrastructures', 2009
11. BFS-white paper Industry Utilities on www.tcs.com, July 2012
12. SunGard Survey Shows Reconciliation Centralization is Top of Banking Agenda to Achieve Both Risk and Cost
Reduction', Press release, Sep 2011.
13. The OTC Derivatives Boom, Five factors that are shaping the future, by John Plansky, Roman Regelman, Charles
Lyman, Booz & Company, 2008

1
3
Contact
For more information about TCS consulting services, contact
bfs.marketing@tcs.com

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