Removing the Risk From OTC Derivatives Reconciliation
AMF seeks standardization in communications among funds, brokers, custodians
May 18, 2009
The Asset Managers Forum is moving to standardize the way that fund managers, broker-dealers and custodian banks reconcile post-trade positions and collateral requirements for over-the-counter derivatives.
At a conference last week, the Asset Managers Forum's (AMF) derivatives committee elaborated on a set of recommendations that it issued in a March white paper. The goal of the best practices is to reduce the credit, counterparty and operational risks inherent in the largely manual communications among buy- and sell-side firms and their service providers.
"Pension plans and other institutional clients need to know their exposure with multiple fund managers and are asking custodian banks to put sufficient controls in place to reconcile between their fund managers and broker-dealer," said Michael Burg, AVP at Bank of New York Mellon Corp., at the New York conference. "Our objective is to protect them from errors and gain transparency over the OTC transaction process."
Along with BNY Mellon, the AMF derivatives committee's three-way reconciliation working group, which was created last year, includes representatives from Brown Brothers Harriman, JP Morgan Chase & Co., and State Street Corp.; investment management firms Putnam Investments, Promark Global Advisors and Lord Abbett & Co.; and trade management servicer Omgeo and interbank messaging consortium Swift.
Currently, there is a lack of uniform data formats and market practices for reconciling OTC derivative trades. Spreadsheets and PDF files are common, noted panelists, and even when automated approaches are taken, they present plenty of inconsistencies.
Custodians also face limitations in accessing data from brokers that are not clients. "The information provided by broker-dealers varies and is incomplete in some cases," said Cherie Graham, director of derivatives product management for Brown Brothers Harriman, in an interview. The Boston-based custodian's OTC derivatives reconciliation team compares on a daily basis the trade notifications it receives from asset managers with information from dozens of brokers.
"Each broker-dealer may have a different reconciliation system," noted Neil Burke, executive director of Morgan Stanley. "But if we standardize data attributes, it will become a lot easier to do the process over time."
Bad Breaks
Asset managers reconcile separately with their brokers and custodians. Position discrepancies--or breaks--often arise when each party uses a different cutoff time, or when trades are booked at different times. In reconciling market valuations, breaks can occur when the fund manager and broker-dealer don't use the same times to create their curves; the custodian bank, in turn, may be using a third-party valuation provider.
In its March report, the AMF, which estimates that 10 percent of OTC trades have breaks, urged investment managers, brokers and custodians to reconcile positions and market valuations daily, or at least weekly. All parties do not have to reconcile at the same frequency, noted the AMF, adding that firms that opt for daily position reconciliation should use end-of-day data.
After a break is resolved by the custodian bank, a report should be sent to the asset manager or its end client. According to the AMF, which is part of the Securities Industry & Financial Markets Association, all breaks should be addressed by the investment manager by the end of the business day in which they were discovered.
"Standardization is still an evolving process," said Neil Kelleher, executive director of Goldman Sachs in London. "The 16 largest broker-dealers are reconciling with each other but we need to align that with asset managers and custodian banks. We also need to get the information to the front-office trading and confirmation desks, product managers and settlement executives."
