The 4 difficulties of ETD and OTC reconciliations

In its simplest form, the aim of a derivatives “Street Side” reconciliation is to create a golden record by matching the internal records for transactions, positions, and financials with the external records of every counterparty across clearinghouses, exchanges or intermediaries. This means loading multiple internal data sources to compare to multiple external data sources, where each counterparty has its own format and naming convention.

Given that derivatives are a global product, a typical bank or broker will be active on over 20 venues through multiple counterparties with the largest ones covering all CCPs for listed and OTC derivatives. The process involves collecting and normalising data from fragmented sources and platforms often with varying symbology, processing the multiple fields of the trade, and then matching it across various functions and operations across the trade cycle. At the same time, trade breaks must be identified and addressed as promptly as possible to ensure that reports sent to clients and regulators are accurate.

This article captures the four broad reasons ETDs and OTC derivatives are more complicated to reconcile than other asset classes.  We’ve called them the four D’s.

Data Quality

• Inconsistency – The most obvious might be naming conventions between internal and external systems whilst transacting with multiple counterparties who’ve all got multiple counterparties of their own.
• Reference – complexity builds up quickly when trying to ‘normalise data from fragmented sources and platforms all using different symbology and coding.
• Human error – Regardless of the sophistication of systems, human error will occur. If trades are entered incorrectly then mismatches or breaks will occur.

Dates

Needless to say, the nature of derivatives contracts presents a significant headache as futures and options have expiry dates – expiry dates add another layer of complexity

• Options contracts that have expired can just disappear causing breaks that aren’t really breaks
• If a break occurs or is discovered after the expiry date, the trade needs to be ‘brought back’
• In some instances, delivery can end up occurring before the expiry date. When this happens, the futures contract gets converted to a physical position creating a mismatch.

Detail

Derivatives tickets simply contain far more detail than other types of transactions.

• Reconciling a derivatives trade may involve reconciling upwards of 25 different data points. This coupled with the issues identified in the data quality point adds further complexity.
• Fees and commission make up a portion of the data points and are difficult to reconcile. There are fees for the brokerage house, the parties involved in the trade, clearing fees, third-party brokerage fees and commission.
• Competitive markets have forced exchanges and brokers to offer volume discounts, rebates, and tiered rate structures adding to the intricacy. It is the responsibility of the brokers to claim discounts and rebates on fees which all play a part in the reconciliation.

Depth and daily balances

Top-level matches mask deeper exceptions. Good automated systems will do bottom-up and top-down reconciliations so that discrepancies below the top level don’t cause issues down the line.  

• Some platforms only reconcile trade and positions. If there is a discrepancy between surrounding the closing price or another individual trade level detail, trade and positions may reconcile but the value will be different
• Calculation of unrealised and realised profit and loss depends on carrying over the rolling values from day to day because even if a position doesn’t change, its value may well do.  Many reconciliations systems just aren’t set up to do this.

Conclusion

Therefore, the relatively straightforward goal is immensely complex in a world in which even mid-sized sell-side firms can process millions of trades per day from disparate sources settling across multiple locations and time zones in multiple currencies across thousands of different instruments.

Moreover, the complexities aren’t diminishing, remaining compliant and minimising risk is always the aim. The challenge for post-trade teams is how to rapidly identify and resolve breaks.

With every break having a sequential knock-on effect, it’s easy to see why addressing these challenges is getting a lot of attention.