Monday, December 21, 2009

ISDA: Derivatives trade matching faces challenges

Original posted on Reuters by Karen Brettel:

Frequent trade matching is touted as one initiative that can help reduce risk in the $450 trillion, privately traded derivatives markets, though a number of challenges may complicate its wider practice, according to an industry study released on Monday.

Concerns about derivatives exposures, and whether collateral posted against the trades would be sufficient to cover losses if a dealer failed, added to stresses in the financial system last year and helped spark runs on banks including Lehman Brothers.

Differences in the way that derivatives trading partners record trades, which may include whether or not a trade was entered into or variations in a trade's size, terms or value, can be risky as they can leave parties with exposures that they are unaware of.

Disputes over trades can also hold up the exchange of an estimated $4 trillion in collateral that is used to back derivatives and mitigate losses in the event of a counterparty failure.

Large derivatives dealers in June adopted daily trade matching of exposures with each other, known as portfolio reconciliation, a practice which now accounts for around 60 percent of derivatives volumes, the study, conducted by trade association the International Swaps and Derivatives Association, found.

ISDA plans to publish documents detailing best practices and minimum market standards by the end of the year to encourage more of the market to undertake the procedure.

Variations in technology used to compare trades portfolios, and concerns over the quality of data used in the systems, however, pose challenges for expanding the practice to the other 40 percent of the market, ISDA said.

To ensure greater use of the practice, a solution is needed to overcome differences in technology and reticence among some participants to make results from reconciliation transparent to their counterparty.

ISDA Portfolio Reconciliation Feasibility Study

Advances Understanding and Promotes Better Collateral Management Practices

NEW YORK, Monday, December 21, 2009 – The International Swaps and Derivatives Association, Inc. (ISDA) today announced the publication of its “Feasibility Study: Extending Collateralized Portfolio Reconciliations”. This publication is intended to enhance understanding of the achievability for wider adoption of portfolio reconciliation discipline across the industry.

“While portfolio reconciliation is clearly a subject of interest in the privately negotiated derivatives industry, actual take-up across the broader community is still relatively nascent,” said Julian Day, Head of Trading Infrastructure, ISDA. “The level of engagement on this topic has been encouraging and productive. To this end, buy-side and sell-side firms will work collaboratively and with vendors to identify solutions to support a wider rollout of portfolio reconciliation during 2010.”

The Study discusses the considerations that exist for expansion of a frequent reconciliation for collateral portfolios beyond the group of 15 major dealers that regularly report progress and commitments relating to industry infrastructure projects ('Fed 15'). The Study has been undertaken by representatives of dealer and buy-side firms under the guidance of the ISDA Collateral Committee.

In July 2008, ISDA and derivatives industry participants made the first of a series of commitments to regulators regarding collateral management, including portfolio reconciliation. These commitments led to significant improvements in market practice towards the goals set by the Counterparty Risk Management Group III (CRMPGIII). Amongst these improvements was the adoption by June 30, 2009 of a daily portfolio reconciliation standard between the Fed 15 dealer firms.

Daily reconciliation between Fed 15 dealers covers an estimated 60% of the global privately negotiated derivatives industry, across all asset classes.

While this is a significant accomplishment in less than a year from the first formal industry commitment, participants are committed to addressing expansion to a broader constituency.

The study can be downloaded here.

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