United States: Swaps End-User Update - What End-Users Need To Know About Portfolio Reconciliation

Last Updated: January 20 2014
Article by John S. Servidio, Karl M. Strait and Kevin K. Chen

In 2014, swap dealers will contact end-users to engage in swap portfolio reconciliations. End-users should understand:

  1. Why portfolio reconciliation is required under the Dodd-Frank rules, as well as by the European Market Infrastructure Regulation;
  2. What portfolio reconciliation is; and
  3. What end-users need to do for portfolio reconciliation.

Why portfolio reconciliation?

Portfolio reconciliation is required under the Dodd-Frank ("DF") swap documentation rules (the "DF Swap Documentation Rules") and the European Market Infrastructure Regulation ("EMIR") risk mitigation techniques (the "EMIR RMTs"). Portfolio reconciliation is intended to mitigate overall risk associated with uncleared swaps by proactively identifying and resolving mismatches in material terms and valuations. The DF Swap Documentation Rules require every swap dealer to "establish, maintain, and follow written policies and procedures reasonably designed to ensure that it engages in portfolio reconciliation ... for all swaps [entered into with its counterparties]." In order for a swap dealer to engage in portfolio reconciliation, the rules require that:

  1. A swap dealer must agree in writing with each of its counterparties on the terms of the portfolio reconciliation;
  2. Reconciliations may be performed on a bilateral basis or by one or more third-party service providers agreed to in writing by the parties;
  3. Reconciliations with end-users must be performed no less than quarterly for a swap portfolio that includes more than 100 swaps at any time during a calendar quarter, or annually for a swap portfolio that includes no more than 100 swaps at any time during a calendar year;
  4. Discrepancies in the material terms or a valuation (of 10 percent or more) of any swap should be resolved in a timely fashion; and
  5. For a swap with an end-user, a swap dealer must promptly report any valuation difference greater than $20 million to the Commodity Futures Trading Commission ("CFTC") if not resolved within five business days.

The CFTC has determined that the EMIR RMTs for portfolio reconciliation are comparable to the DF Swap Documentation Rules for portfolio reconciliation and that swap dealers located in the EU will be deemed to have complied with the CFTC's portfolio reconciliation rules if they comply with the EMIR RMTs for portfolio reconciliation.

What is portfolio reconciliation?

The DF Swap Documentation Rules define portfolio reconciliationas any process by which the two parties to one or more swaps:

  1. Exchange the terms of all swaps in the swap portfolio between the counterparties;
  2. Exchange each counterparty's valuation of each swap in the swap portfolio between the counterparties as of the close of business on the immediately preceding business day; and
  3. Resolve any discrepancy in material terms and valuations.

Portfolio reconciliation can be performed in a variety of ways, including by an exchange of portfolio data between the parties or a one-way delivery of portfolio data by a swap dealer to be reviewed by the end-user. When parties have large portfolios, the parties often agree to have their respective portfolio data reconciled by a third-party service provider. The service provider will match the material terms and valuations of the outstanding swaps between the swap dealer and the counterparty and identify any discrepancies in the portfolio data. After the service provider performs the reconciliation, it will return the results to the parties. When the parties have smaller portfolios, the parties often agree that the swap dealer will deliver its portfolio data to the end-user for review. The end-user will then either affirm or object to the material terms and valuations delivered by the swap dealer. Regardless of the portfolio reconciliation process agreed to by the parties, the parties must work to resolve any discrepancies in a timely fashion.

What do end-users need to do?

The ISDA March 2013 DF Protocol ("DF Protocol 2.0") enables market participants to agree on a process for portfolio reconciliation (see Schedule 4 of the Supplement for DF Protocol 2.0). End-users should adhere to DF Protocol 2.0 if they have not already done so. In Part III, Section 3 of the Questionnaire for DF Protocol 2.0 (or any equivalent bilateral agreement), an end-user can:

  1. Agree to engage in portfolio reconciliation with its swap dealer counterparty, by answering "Yes" in Part III, Section 3(a);
  2. Elect whether to exchange portfolio data with its swap dealer counterparty, by answering "Exchange," or to receive and review portfolio data in a one-way delivery from its swap dealer counterparty, by answering "Receive," in Part III, Section 3(b); and
  3. Elect whether to reconcile material terms against information previously reported to a swap data repository, by answering "Yes" or "No" in Part III, Section 3(c).

The parties also can agree, outside DF Protocol 2.0, to deliver their respective portfolio data to be reconciled by a third-party service provider. This requires onboarding to a third-party service provider's operations platform, but may be more efficient for larger swap portfolios.

Additionally, end-users that trade with swap dealers, or financial counterparties, located in the EU can adhere to the ISDA 2013 EMIR Portfolio Reconciliation, Dispute Resolution and Disclosure Protocol (the "EMIR Protocol") and/or a comparable "top-up" agreement in addition to DF Protocol 2.0. Similar to DF Protocol 2.0, the EMIR Protocol enables market participants to agree on a process for portfolio reconciliation under the EMIR RMTs. A "top-up" agreement is a bilateral agreement equivalent to the EMIR Protocol that may be used by counterparties that have already adhered to DF Protocol 2.0 but need to top-up their existing documentation to comply with the EMIR RMTs.

From time-to-time, depending on the size of their swap portfolios, end-users should expect their swap dealers to contact them in order to perform portfolio reconciliations. Swap dealers will typically send an email or letter to the address(es) provided in the notice section of DF Protocol 2.0. The notice will often include details for the exchange or review of portfolio data, an offer to use a third-party service provider to perform the reconciliation, and contact information for resolving any discrepancies with the swap dealer.

Portfolio reconciliation may be new to many end-users in 2014, but after completing the appropriate documentation and working with their swap dealers to resolve any discrepancies, end-users can benefit from reduced overall risk and fewer disputes with their swap dealers.

A copy of the CFTC's Swap Documentation Rules is available here, and a copy of the regulatory technical standards for the EMIR RMTs is available here.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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