February 7, 2011

Question: When is a galaxy not a galaxy? Why, when your data is disputed, of course! Last month, a team of astronomers reported in the journal Nature what they believe to be the oldest galaxy in the universe; an object so distant and faint that its light travelled 13.2 billion years before a few rays were captured as a ghostly image by the Hubble Space Telescope. If confirmed, this would be an extraordinary discovery, and would mean we are capable of peering back to a time when the universe was but a mere cosmic infant. But wait! Not so fast! Or as they say in astronomy, Hold your Horse Head Nebula! Some are disputing the find, and point out that the team originally identified three such candidates for “oldest galaxy in the universe,” before withdrawing their research and staking this new claim. It seems that what the team really found, staring back at them across the universe, was a healthy dose of skepticism residing in their cosmological peers.

Disputes and disagreements in the sciences are nothing new, and it can take years to review, duplicate and independently verify such claims (if ever at all!) When it comes to your derivatives though, you don’t have a light year to confirm a calculation, verify a value or parse a payment notice! This needs to be done inside a unit of time far shorter, certainly within a calculation period, and typically within only a day or two. It turns out that your contract documents are the key to this process, and allow us to reconcile discrepancies in your derivative contracts in a far more reasonable amount of time.

Confirmations. Getting the economic details of a derivative transaction documented correctly in a trade confirmation can be a challenge. Your relationship bank may have a respectably low error rate on confirmations, but it doesn’t matter when their “one in a million” error turns out to be on your confirmation! When you first enter a trade, Chatham Financial will gladly review your trade confirmation against the trade details, as transacted, in our system. In reviewing so many confirmations across so many clients, we commonly encounter errors that you may never see, including incorrect conventions on resets, calculations, payments and maturity dates, as well as incorrect index look?backs, day count conventions and holiday cities. We have even seen dates written in European format (DD/MM/YYYY) instead of U.S. format (MM/DD/YYYY), which has a tendency to impact your hedged risk and contract value, and rarely for the better! Although many discrepancies appear minor, they do make a difference in pricing and need to be resolved before you approve the confirmation.

Payment Notices. Even after differences on the confirmation are reconciled, payment notices are still occasionally observed with calculation errors. Your first payment notice should be thoroughly scrutinized and compared with our system calculated amounts to be sure. Chatham will troubleshoot the payment amount with your bank on your behalf, sharing and comparing our calculation to identify the exact reason for an errant amount. Residual errors can be found in rates, dates and resets. We have seen some banks agree to conventions that their systems can not actually support, such as rounding conventions (i.e., rounding the rate 1/32nd of 1%). We have also seen banks not follow standard ISDA reset conventions, not specifying or remaining “silent” on the resets, then following calculations instead of payment conventions, contrary to ISDA definitions. Although we do not generally see problems linger on the same trade over multiple periods, it is still wise to quickly compare subsequent payment notices to our calculated values for peace of mind.

Valuations. So your trade confirmation has been corrected and payment notices now routinely arrive with correct payment amounts. All that’s left to do is sit back and relax and hey…what the?…why is my valuation on Chatham’s website different than my bank’s? Chatham provides independent valuations on your derivative instruments, and it is not uncommon for our values to differ from your bank’s values. One reason may be the time stamp. Chatham values your trades at 4PM EST daily, and different banks use different times for end of day valuations. Another difference can be where trade values are actually reported, which can be at bid, mid or ask pricing. Your counterparty may also discount the structure using a different index or tweak its forward curve construction (adjusting for the introduction of cash rates, futures and swap rates, for example), both of which will have an impact on your derivatives valuations. Most differences are considered minor, but a large difference in value should be investigated promptly. If you are in a trading relationship where you post collateral based on changes in derivative valuations, and the latest valuation is off considerably, you will want to follow procedures for posting the undisputed amount (the portion for which you have no good faith dispute) while you reconcile the balance. As with confirmations and payment notices, Chatham can help you troubleshoot your derivative valuations with your bank as well.

At Chatham we tend to have an obsession with accuracy because the details really, really matter in tangible ways. This is why every transaction goes through our input check, confirmation check, and double check process, and all discrepancies are immediately investigated. Most of the time, our obsession with accuracy goes unnoticed. Occasionally, banks input details incorrectly or we have a big event like a Lehman bankruptcy and then our clients are glad that we were obsessive about checking and insisting that documents were signed and completed. We don’t claim to be error free (we try!) but in a vast majority of discrepancies, Chatham’s robust process will identify and reconcile errors that others miss, and leave you with accurate and timely payment amounts and valuations.

If you have questions on your derivative confirmations, payment notices or valuations, give us a call! Chatham can help you see deeper into the derivatives space than ever before and you won’t need telescope time or a National Science Foundation grant to do it!

Tags: