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Reconciliation Explained

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What is Reconciliation?

According to dictionary.com, “Reconciliation is the process of two people or groups in a conflict agreeing to make amends or come to a truce.”.

So what does reconciliation have to do with financial services? Let’s talk about a sub-area of financial services – investment management – to give us some perspective.

Suppose whenever you spend even a single dollar on a day, you write down the expense in your notepad or on your phone. If you are a bit tech-savvy, you might use an app for this. Let’s assume that you use both cash as well as your credit card(s) to buy coffee, pay for the cab etc. At the end of the day, whatever transactions that you have written in your notepad/phone should tally with the cash in your wallet and your unbilled credit card statement. Now, what if your mind is somewhere else while buying your coffee at Starbucks and you forget to make an entry into your ledger (i.e. notepad/phone). Worst still, instead of entering $6.00 for that coffee, you accidentally punched in $600 (i.e. forget to put the decimal point). It won’t make much difference to your life actually. But what if the same mistake was made by your investment manager (an entity to whom you have given your hard-earned money to put in the markets), who deals with thousands of transactions each running into thousands or millions of dollars? What if this investment manager sells some stocks from your fund to someone else to receive cash on your behalf, but the buyer of the stocks makes some mistake (instead of punching in “I bought 1000 shares of Apple”, he punches in “I bought 10 shares of Apple”) and transfers less cash to your account? As you can imagine, there will be a huge dispute between your investment manager and the buyer of your Apple stocks. If the investment manager is not careful enough, there will be a dispute between you and your investment manager later!

Let’s complicate things a bit.

Your investment manager has 100 traders working out of New York, London and Hong Kong. They deal with assets (including stocks) that are traded in different currencies such as USD, EUR, GBP etc. They all operate in different time zones, use multiple custodians (custodians are like banks that hold securities such as shares instead of cash). They all use different IT systems to send/receive data internally along with the outside world. Of the 20 IT systems in use (some of which were built decades ago), one of them breaks down and no one comes to know about it. Batch processes will crash or spew out incorrect data. Or maybe one of the traders selected “JPY” instead of “GBP” from a dropdown menu on the screen while entering his trade (similar to how you wrote your expenses in your notepad). Bad data will travel throughout the system making someone unhappy (mostly you).

Wouldn't it be a good idea to pull out data from each and every internal IT system as well as IT systems of other parties, such as the guy to whom your manager sold the Apple shares and your custodian, at the end of each day to check if all agree to what has been traded? This happens in reality and is called reconciliation.


Why is reconciliation such a headache?

As a rule, the bigger an investment management firm becomes, the more complex transactions it will get an opportunity to do. A small investment manager, with just 3-4 guys, might just deal in stocks in their country (many exceptions are there, notably hedge funds). But bigger investment managers will deal with multiple assets such as stocks, bonds, complex derivatives etc., in multiple currencies using multiple brokers, custodians, fund administrators etc. As they grow, they start maintaining multiple technology platforms, most of which cannot communicate with each other in real time. Using APIs hasn’t really caught up in this world yet!

They get data feeds from multiple sources with conflicting data sometimes. For example, imagine that the investment manager invests in a few shares of a company that trades on two exchanges. At the end of the day, the last traded price for both the exchanges might be slightly different by a few cents. Although both the prices are correct, which one should I use? What if half of the IT systems use the price from exchange 1 and the other half uses from exchange 2? The “recon” process (abbreviation for reconciliation) will have to get all the systems to agree to one price.

In fact, there is a concept of IBOR (Investment Book of Records) and ABOR (Accounting Book of Records). IBOR refers to the investment data used to supply accurate information to the front office (sales and trading) in support of an investment management process. Examples of the data that goes into creating IBOR are prices of securities, intraday positions, securities that he is allowed to trade that day etc. ABOR, on the other hand, refers to the data used by the back-office team to perform functions like reporting to the authorities, calculating the portfolio values, calculating the net asset values (i.e., figure out what the price of a security should be), making sure that the numbers reported by the custodian (such as quantity of shares) is the same as the internal numbers etc.

Now, IBOR and ABOR should theoretically be in sync always, but they are not. This is due to poor integration of technology systems, manual entry errors etc.

Recon happens at two levels:

  1. Internally – example, between the IT system that is used by the front office traders and IT systems used by the back office team
  2. Externally – example, between the data shared by the counterparty (the entity whom you sold your Apple shares to) and the data recorded by our systems
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Reconciliation happens for MANY items (data points) such as daily cash, balances, dividends, positions, counterparty exposure etc.

Also, each investment manager will deal with other multiple investment managers, multiple clients, geographies, custodians, portfolios, currencies, subscription requests, redemptions requests etc.


Reconciliation between investment manager and custodian

It must be clear that the reconciliation process is the foundation of a manager’s data integrity.

Let’s talk about a specific example that will help you understand why recon is important with external systems. The front-office guys working at the investment manager are the ones who deal with clients. They are in charge of taking orders from the clients, executing them and then reporting their performance. On the other hand, the back-office team is responsible for making sure that their custodian accounts and banks have the correct amount of securities and cash.

Imagine that the systems of the front office and back office are not in sync. You, as the customer, calls up the front office team and ask them what your portfolio is worth today. They say, as per their systems, your portfolio is worth $X. You are happy and ask the front office guy to sell all your shares in anticipation of receiving $X. However, after two days, the back-office guys say that you will receive $Y, which is less than $X. You will be angry at your investment manager of course.

Now you may ask why the balance with the back-office would be different from that of the front-office. Although we live in the world of autonomous cars, financial institutions’ technology systems live in the dinosaur era. When you buy or sell shares, you don’t get the possession of your shares or cash instantaneously. It takes days (T+1, T+2, T+3…) to “settle” the trade. Yes, they are that slow. Hence, the systems get yet another opportunity to go out of sync!

What would a “good” reconciliation system look like?

Some attributes that are required for a good recon system are:

  • Some rule-based structure is required. For example, a “price break” generally leads to a “position break”. What does this mean? If you buy 1000 shares of Apply at $X EACH but because of some communication gap with your counterparty, it records it as 1000 shares of Apple at $Y, your recon system should show a “price break” because the per unit price (of $X and $Y) do not match. Also, since position is simply equal to {price * quantity}, the “position amount” will be different too. A good recon system should be able to highlight that the “position break” (i.e., mismatch in position amount) is actually because of a “price break”
  • Should allow you to set acceptable tolerance levels. For a trade of a million dollars, if there is a mismatch of $2, it does not matter. $2 is just a rounding error which can be ignored. If we do not define tolerance limits, the back-office team will end up working 24X7!
  • The system should be fast to give out the output quickly enough so that the humans can make the phone calls/shoot emails to figure out the common ground before the trading starts the next day.
  • Reporting capabilities – Management loves fancy dashboards.
  • Some ability to prioritize the breaks and assign them to the humans (back-office team also called “operations”)
  • Audit trail – all the changes made to the data in the IT system should be recorded so that it can be pulled out for investigation later.
  • Ability to work on multiple file formats such as XLS, TXT, CSV, XML etc. and provide an easy to configure user experience.
  • Recently, few recon players have started claiming that the rules are being optimized using AI

Bottomline

Reconciliation is a hugely labor-intensive task even with the use of IT systems. Some existing players, who are already well entrenched in the network of financial services technology systems, have started delivering recon systems that use AI algorithms to better detect “breaks”. Recon is indeed one of the most important operations in the finance world. Trades worth trillions of dollars are reconciled daily


This content is accurate and true to the best of the author’s knowledge and is not meant to substitute for formal and individualized advice from a qualified professional.

© 2022 Shalabh

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