Portfolio reconciliation provides a means of ensuring that parties' books and records remain synchronised and that effects of trade events, such as novations, amendments and other activities, are accurately captured (ISDA's Recommended Practices for Portfolio Reconciliation).
Commission Implementing Decision (EU) 2017/1857 of 13 October 2017 on the recognition of the legal, supervisory and enforcement arrangements of the United States of America for derivatives transactions supervised by the Commodity Futures Trading Commission as equivalent to certain requirements of Article 11 of Regulation (EU) No 648/2012 of the European Parliament and Council on OTC derivatives, central counterparties and trade repositories
Pursuant to the regulatory technical standards (Commission Delegated Regulation (EU) No 149/2013 of 19 December 2012 supplementing Regulation (EU) No 648/2012 of the European Parliament and of the Council with regard to regulatory technical standards on indirect clearing arrangements, the clearing obligation, the public register, access to a trading venue, non-financial counterparties, and risk mitigation techniques for OTC derivatives contracts not cleared by a CCP - ‘Commission Delegated Regulation on Clearing Thresholds’ or ‘RTS’)) there is an obligation imposed on financial counterpartiss and non-financial counterparties to an OTC derivative contract to agree in writing or other equivalent electronic means with each of counterparties on the arrangements under which portfolios will be reconciled.
Such agreement must be reached before entering into the OTC derivative contract, which is specific to EMIR while, for instance, the US CFTC rules do not specify the timing of agreement regarding portfolio reconciliation.
EMIR Regulation in Article 11(1) requires that financial counterparties and non-financial counterparties that enter into an OTC derivative contract not cleared by a CCP, must have, exercising due diligence, appropriate procedures and arrangements in place to measure, monitor and mitigate operational risk and counterparty credit risk, including at least formalised processes which are robust, resilient and auditable in order to reconcile portfolios.
The said requirement applies equally to:
- financial counterparties and
- non-financial counterparties (irrespective of whether they exceed the clearing threshold or not).
Purpose and object of portfolio reconciliation
The main purpose of the portfolio reconciliation is to identify at an early stage any discrepancy in a material term of the OTC derivative contract, including its valuation.
The portfolio reconciliation must cover key trade terms that identify each particular OTC derivative contract and must include at least the valuation attributed to each contract arising from the requirement to mark-to-market (or to-model where applicable).
Thus the key trade terms that identify each particular OTC derivative contract that must be acknowledged while portfolios are reconciled, may be specified as follows:
- the valuation attributed to each contract in accordance with Article 11(2) of EMIR,
- the effective date,
- the scheduled maturity date,
- any payment or settlement dates,
- the notional value of the contract,
- currency of the transaction,
- the underlying instrument,
- the position of the counterparties,
- the business day convention,
- any relevant fixed or floating rates of the OTC derivative contract,
- any other relevant details to identify each particular OTC derivative contract as provided for in Article 13 of RTS.
When it comes to practical instruments for fulfilling EMIR portfolio reconciliation requirements, for instance ISDA master agreement standard envisioned two alternate methods: "Exchange of Portfolio Data" and "One-Way Delivery of Portfolio Data".
They differ mainly in the level of activity of the parties to the agreement in executing the portfolio reconciliation, where under the former scenario both parties initiate the procedure, while under the latter only the one.
Required frequencies for portfolio reconciliation
IOSCO Risk Mitigation Standards for Non-centrally Cleared OTC Derivatives FR01/2015 of 28 January 2015 contain a general clause stipulating portfolio reconciliation needs to be carried out "at regular intervals".
EMIR is more prescriptive in that regard as it lays down the minimum frequencies at which the parties should reconcile portfolios.
For a non-financial counterparty below the clearing threshold portfolio reconciliation is required to be performed once per quarter when the counterparties have more than 100 OTC derivative contracts outstanding with each other at any time during the quarter and once per year when the relevant number is 100 or less (for other specific reconciliation frequencies see box).
Mindful of the fact that for financial counterparties and NFC+ significantly higher reconciliation frequencies apply, in case of OTC derivative contracts between NFC- and FC, the lower range reconciliation frequency is allowed.
This is also actual for reconciliation between NFC– and NFC+.
The practical effect of the new requirements is, however, that the firms will have to carefully count their outstanding contracts not to overlook the relevant reconciliation thresholds.
It is also noteworthy that, as opposite to earlier versions of the draft RTS, the definitive text requires the relevant frequencies for portfolio reconciliation be measured "at any time" during, respectively, the week, quarter etc.
This amendment resolves earlier ambiguities, when and how often the portfolio size should be measured.
Considering, as was said above that the frequency of portfolio reconciliation depends on the status of the counterparty (FC, NFC+ or NFC-) and on the number of outstanding contracts the counterparties have with each other, it is noteworthy that those two elements may change in time and therefore modify the frequency of the portfolio reconciliation requirement.
At this point an ambiguity arose, at which frequency should the status of the counterparty and the number of outstanding contracts be reassessed.
In that regard the European financial regulator ESMA has explained that the frequency of the portfolio reconciliation requirements should be reassessed at each portfolio reconciliation date. If for example a NFC- is subject to a quarterly reconciliation with Counterparty X and performs the first portfolio reconciliation on 15 December 2013, the date of the next portfolio reconciliation should be: 15 March 2014 (quarterly requirement) if the NFC- is still a NFC- on 15 December 2013, and if the number of its outstanding contracts with Counterparty X was above 100 at any time in the previous reconciliation period, i.e. from 15 September 2013 to 15 December 2013.
Article 13 of the Commission Delegated Regulation on Clearing Thresholds
1. Financial and non-financial counterparties to an OTC derivative contract shall agree in writing or other equivalent electronic means with each of their counterparties on the arrangements under which portfolios shall be reconciled. Such agreement shall be reached before entering into the OTC derivative contract.
2. Portfolio reconciliation shall be performed by the counterparties to the OTC derivative contracts with each other or by a qualified third party duly mandated to this effect by a counter party. The portfolio reconciliation shall cover key trade terms that identify each particular OTC derivative contract and shall include at least the valuation attributed to each contract in accordance with Article 11(2) of Regulation (EU) No 648/2012.
3. In order to identify at an early stage any discrepancy in a material term of the OTC derivative contract, including its valuation, the portfolio reconciliation shall be performed:
(a) for a financial counterparty or a non-financial counterparty referred to in Article 10 of Regulation (EU) No 648/2012:
(i) each business day when the counterparties have 500 or more OTC derivative contracts outstanding with each other;
(ii) once per week when the counterparties have between 51 and 499 OTC derivative contracts outstanding with each other at any time during the week;
(iii) once per quarter when the counterparties have 50 or less OTC derivative contracts outstanding with each other at any time during the quarter;
(b) for a non-financial counterparty not referred to in Article 10 of Regulation (EU) No 648/2012:
(i) once per quarter when the counterparties have more than 100 OTC derivative contracts outstanding with each other at any time during the quarter;
(ii) once per year when the counterparties have 100 or less OTC derivative contracts outstanding with each other.
Scope of the responsibility for the reconciliation requirements
Some ambiguities relate to the scope of the responsibility for the reconciliation requirements where a counterparty does not provide its data for reconciliation.
This case may typically concern smaller non-financial counterparties but it is also noteworthy that definitions of 'financial counterparty' and 'non-financial counterparty' under EMIR are limited to EU entities and appear, therefore, not to cover transactions between EU entities and non-EU entities.
This leads to legal uncertainty in respect of the extra-territorial application of the all risk mitigation requirements, including portfolio reconciliation.
In that way the EU counterparty, be it financial or non-financial may be particularly exposed to risk that the other party to the transaction, being non-EU counterparty, refuses to co-operate in meeting the deadlines for timely confirmation.
Similar difficulties with enforcing portfolio reconciliation requirements may be encountered in relation to transactions between financial counterparties and non-financial counterparties on the one hand and:
- counterparties in the EU that are not classified as financial counterparties or non-financial counterparties e.g. natural persons and sovereign entities which are not 'undertakings' and which are not subject to obligations under Article 11;
- certain particular counterparties listed in Article 1(4) and (5) of EMIR who are exempt from obligations under Article 11.
It was therefore suggested that a negative affirmation process could efficiently be used when dealing with such circumstances.
If the counterparty returns a portfolio, the reconciliation will be carried out, but if the counterparty does not return a portfolio (within a suitable timeframe), it will be deemed to have agreed with the data sent to it for the purposes of the reconciliation.
Such arrangements would of course have to be subject to an appropriate contractual framework between the parties.
ESMA in its Questions and Answers on EMIR as updated on 5 August 2013 observed that Article 11 of EMIR, which provides the basis of these requirements, applies wherever at least one counterparty is established within the EU.
Therefore, where an EU counterparty is transacting with a third country entity, the EU counterparty would be required to ensure that the requirements for portfolio reconciliation are met for the relevant portfolio and/or transactions even though the third country entity would not itself be subject to EMIR.
However, if the third country entity is established in a jurisdiction for which the Commission has adopted an implementing act (under Article 13 of EMIR), the counterparties could comply with equivalent rules in the third country.
The clarification on the above issue of negative affirmation can currently be found in the regulatory guidance of ESMA, which has explained as follows:
"The processes under which a counterparty is deemed to have perform portfolio reconciliation after a fixed deadline has expired would be compliant provided that both counterparties have agreed in advance to perform portfolio reconciliation by this process".
The said stance of ESMA may be of importance to firms that are unable to compel their counterparties to provide their portfolio data to perform reconciliation.
However, regulated entities must as always be prepared to demonstrate that good faith and commercially reasonable efforts have been made to procure the cooperation of their counterparies with respect to the relevant EMIR requirements.
Further remarks on the scope of counterparty responsibility involved with the portfolio reconciation can be found here (as the said considerations are to some extent common with the clearing thresholds' nuances).
Parties wishing to implement EMIR portfolio requirements into their contractual documentation have at their disposal at least two master agreements:
- the ISDA 2013 Portfolio Reconciliation, Dispute Resolution and Disclosure Protocol published by the International Swaps and Derivatives Association, Inc. (the "ISDA Protocol"), and
- EFET's form of EMIR Risk Mitigation Techniques Agreement (the ERMTA).
The divergences between these standards when it comes to the portfolio reconciliation procedures are rather of minor significance: while the ISDA Protocol permits both parties to be Portfolio Data Receiving Entities (in the contractual sense), and should this be the case, provides that the parties will agree a suitable process for reconciling portfolio data, the ERMTA, as a bilateral agreement opposed to a protocol, places a prohibition on allowing both parties being Portfolio Data Receiving Entities.
If neither party is content to send portfolio data, the parties will need to agree a suitable alternative process for reconciling portfolio data that meets their needs.
As EFET underlines in its Guidance Notes, it is intended that the core obligations under both the ISDA Protocol and the ERMTA are to apply to transactions that are subject to the applicable EMIR obligations, including where those transactions are not documented under an ISDA Master Agreement (in the case of the ISDA Protocol) or an EFET General Agreement (in the case of the ERMTA).
Obligations imposed on each Party are dependent upon determining whether a particular Party is sending Portfolio Data or receiving Portfolio Data (terms capitalised defined in ERMTA).
Under ERMTA each Party to an outstanding EMIR Relevant Transaction must designate in the corresponding section of the Election Sheet whether it is a Portfolio Data Sending Entity or a Portfolio Data Receiving Entity.
ERMTA specifies alternative procedures on occasions where only one Party becomes a Portfolio Data Sending Entity and where both Parties are such entities.
Each Party may change its designation as either a Portfolio Data Sending Entity or Portfolio Data Receiving Entity, as originally selected in the Election Sheet only with the written agreement of the other Party.
A change of a Party's designation is, however, not permitted, if the result would be that both Parties are Portfolio Data Receiving Entities.
The frequency with which Data Reconciliation is performed by the Parties may be changed under ERMTA to a greater or lesser frequency by one Party sending a notice to the other Party, in writing, with supporting evidence as to why that Party considers the frequency of Data Reconciliation should be changed.
The Parties to the ERMTA are free to agree explicit dates for each frequency, for example, the day of the week in the case of a weekly Date Reconciliation, or a specific date in the case of quarterly or yearly Data Reconciliation.
ERMTA contains also specific provisions regulating portfolio reconciliation being processed with the use of Agents and Third Party Service Providers.
Describing responsibility for portfolio reconciliation it is useful to mention that under ERMTA as well as ISDA Protocol failure to comply with contractual portfolio reconciliation requirements does not represent an event of default, termination event or material reason (without prejudice to rights and remedies provided by law).
The possibility to include the above standards into other than ISDA and EFET legal documentation may seem a convenient and swift way to cope with EMIR portfolio reconciliation burdens (as well as other EMIR risk mitigation techniques). However, as is also reserved in the EFET's and ISDA's responsibility clauses, market participant is solely responsible for EMIR compliance as well as for safeguarding its own interests.
Interesting and useful feature of ERMTA is that parties may choose to apply its terms to transactions that are not EMIR-relevant transactions and to transactions, in respect of which there is some doubt as to whether or not they are embraced by EMIR risk mitigation requirements.
Portfolio reconciliation agents and third party service providers
Both the EU EMIR rules as well as the US CFTC arrangements allow portfolio reconciliation to be performed not only bilaterally but also by a third party.
However, legal responsibility for the whole process remains with the counterparty captured by EMIR.
This rigid stance on legal responsibility for the portfolio reconciliation obligation where the trade takes place with a calculation agent is supported by ESMA regulatory clarification, which has the following wording:
"[c]ounterparties can agree that the calculation agent will be in charge of performing the portfolio reconciliation. In any case, each counterparty remains legally responsible for the portfolio reconciliation obligation".
The industry standards implement the possibility to perform portfolio reconciliation through a settlement agent into legal documentation.
For instance ERMTA standard allows for portfolio reconciation to be made through an affiliate (even without the consent of the counterparty, notification only is required), and, with the other party's consent (such agreement not to be unreasonably withheld or delayed), with the use of duly mandated and qualified third party service provider or other entity not being an affiliate.
Starting date for the portfolio reconciliation requirements
There is also a question regarding the starting date for the portfolio reconciliation requirements. ESMA in its Questions and Answers on EMIR clarified portfolio reconciliation requirements apply to the portfolio of outstanding OTC derivative contracts.
Therefore as the relevant technical standards enter into force on 15 September 2013, the requirements apply to the portfolio of outstanding contracts as of such date.
Thus, for counterparties having to perform their portfolio reconciliation annually, the first one should be made within one year from the entry into force of the RTS on OTC derivatives, i.e. before 15 March 2014.
EMIR and the US CFTC regime applicable to swap dealers and major swap participants (in the meaning of CFTC rules) have been assessed by ESMA as equivalent (final decision thereon being reserved to the European Commission's implementing act).
The process for granting equivalence status to the US reconciliation legal framework has been finalised by the Commission Implementing Decision (EU) 2017/1857 of 13 October 2017 on the recognition of the legal, supervisory and enforcement arrangements of the United States of America for derivatives transactions supervised by the Commodity Futures Trading Commission as equivalent to certain requirements of Article 11 of Regulation (EU) No 648/2012 of the European Parliament and Council on OTC derivatives, central counterparties and trade repositories.
The US counterpart CFTC issued the parallel media report: CFTC Comparability Determination on EU Margin Requirements and a Common Approach on Trading Venues, Release: pr7629-17, October 13, 2017).
Article 1 of the Commission Implementing Decision (EU) 2017/1857 of 13 October 2017 on the recognition of the legal, supervisory and enforcement arrangements of the United States of America for derivatives transactions supervised by the Commodity Futures Trading Commission as equivalent to certain requirements of Article 11 of Regulation (EU) No 648/2012 of the European Parliament and Council on OTC derivatives, central counterparties and trade repositories
For the purposes of Article 13(3) of Regulation (EU) No 648/2012, the legal, supervisory and enforcement arrangements of the United States of America (USA) for operational risk-mitigation techniques that are applied to transactions regulated as ‘swaps’ by the Commodity Futures Trading Commission (CFTC) in accordance with section 721(a)(21) of the Dodd-Frank Act and that are not cleared by a CCP shall be considered as equivalent to the requirements set out in paragraphs 1 and 2 of Article 11 of Regulation (EU) No 648/2012, where at least one of the counterparties to those transactions is established in the USA and registered with the CFTC as a swap dealer or major swap participant.
The reconciliation requirements as a operational risk mitigation technique for OTC derivative contracts not cleared by a CCP are added in a section 4s(i) to the Commodity Exchange Act (CEA) by section 731 of the Dodd-Frank Act and apply to swap dealers and major swap participants, as defined in the CEA.
Consequently, it should be noted that the said Commission Implementing Decision (EU) 2017/1857 of 13 October 2017:
- covers the legal, supervisory and enforcement arrangements regarding reconciliation applicable to swap dealers and major swap participants established in the USA that are authorised and supervised in accordance with the CFTC Regulations;
- does not encompass USA legal, supervisory and enforcement arrangements applicable to persons that are registered with the Securities and Exchange Commission as a security-based swap dealer or a major security-based swap participant pursuant to the Securities Exchange Act of 1934 (15 U.S.C. 78a et seq.).
CFTC Regulations on operational risk mitigation techniques for OTC derivative contracts not cleared by a CCP contain similar obligations to those provided for in Article 11(1) EMIR.
In particular, Subpart I of Part 23 of the CFTC Regulations contains specific detailed requirements regarding, among others, portfolio reconciliation applicable to OTC derivative contracts not cleared by a CCP.
These requirements are equivalent to the relevant EMIR requirements regarding the frequency and thresholds for portfolio reconciliation match.
The said Commission Decision (EU) 2017/1857 concludes in Recital 9 that in relation to swaps that are under the jurisdiction of the CFTC, as defined in section 1a(47) of the CEA, the CFTC's legal, supervisory and enforcement arrangements applicable to swap dealers and major swap participants are equivalent to the reconciliation requirements set out in the EMIR applicable to OTC derivative contracts not cleared by a CCP, as laid down in Article 11(1) EMIR.
The effect of the above confirmation is that market participants are allowed to comply with only one set of rules and to avoid duplicative or conflicting rules, i.e. where at least one of the counterparties is established in the US, it is deemed to have fulfilled EMIR reconciliation requirements by complying with the requirements set out in the US legal regime.
However, it is noteworthy, the CFTC’s equivalence determination applies only where both the entity and the transaction are otherwise subject to both the CFTC and EU portfolio reconciliation regulations, and not when a swap dealer voluntarily complies with the respective regime.
Article 13 EMIR
Mechanism to avoid duplicative or conflicting rules
1. The Commission shall be assisted by ESMA in monitoring and preparing reports to the European Parliament and to the Council on the international application of principles laid down in Articles 4, 9, 10 and 11, in particular with regard to potential duplicative or conflicting requirements on market participants, and recommend possible action.
2. The Commission may adopt implementing acts declaring that the legal, supervisory and enforcement arrangements of a third country:
(a) are equivalent to the requirements laid down in this Regulation under Articles 4, 9, 10 and 11;
(b) ensure protection of professional secrecy that is equivalent to that set out in this Regulation; and
(c) are being effectively applied and enforced in an equitable and non-distortive manner so as to ensure effective supervision and enforcement in that third country.
Those implementing acts shall be adopted in accordance with the examination procedure referred to in Article 86(2).
3. An implementing act on equivalence as referred to in paragraph 2 shall imply that counterparties entering into a transaction subject to this Regulation shall be deemed to have fulfilled the obligations contained in Articles 4, 9, 10 and 11 where at least one of the counterparties is established in that third country.
4. The Commission shall, in cooperation with ESMA, monitor the effective implementation by third countries, for which an implementing act on equivalence has been adopted, of the requirements equivalent to those laid down in Articles 4, 9, 10 and 11 and regularly report, at least on an annual basis, to the European Parliament and the Council. Where the report reveals an insufficient or inconsistent application of the equivalent requirements by third country authorities, the Commission shall, within 30 calendar days of the presentation of the report, withdraw the recognition as equivalent of the third country legal framework in question. Where an implementing act on equivalence is withdrawn, counterparties shall automatically be subject again to all requirements laid down in this Regulation.
Special treatment for C6 energy derivatives contracts
It is noteworthy that pursuant to MiFID II Directive EMIR portfolio reconciliation requirements will not apply during the 42-month transitional period (counted from the entry into application of the said Directive) to C6 energy derivatives (i.e. physically settled coal and oil traded on an OTF) entered into:
- by non-financial counterparties below EMIR clearing threshold, or
- by non-financial counterparties that will be authorised for the first time as investment firms as from the date of entry into application of the MiFID II.
Practically, for non-financials that have 100 or less OTC derivative contracts outstanding with each other the required frequency of the portfolio reconciliation is only once per year, which does not appear overly burdensome and particularly disrupting business processes carried out so far.
The requirement to agree before entering into the OTC derivative contract on the arrangements under which portfolios will be reconciled practically also would not pose any real difficulty.
Moreover, if the counterparties mandate the said service to the qualified third party, the new EMIR's requirement to reconcile portfolios would not involve too much additional work on the part of non-financial market participants.
Commission Delegated Regulation (EU) No 149/2013 of 19 December 2012 supplementing Regulation (EU) No 648/2012 of the European Parliament and of the Council with regard to regulatory technical standards on indirect clearing arrangements, the clearing obligation, the public register, access to a trading venue, non-financial counterparties, and risk mitigation techniques for OTC derivatives contracts not cleared by a CCP, Article 13
IOSCO Risk Mitigation Standards for Non-centrally Cleared OTC Derivatives FR01/2015 of 28 January 2015