Financial reconciliation | A primer
This page is designed to be a primer for those who are new to financial reconciliation. If this describes you, then read on! If, however, you are an experienced reconciliation professional, please see some of our more recent blog posts such as:
- Rethinking batches: an agile way to process trades within the t+1 timeframe
- Agile, not fragile: how to automate the business without breaking your control framework
- How no-code data solutions can bring agility without headaches
When you hear the phrase ‘financial reconciliation’, it’s probably being used to describe what might be better termed ‘bank reconciliation’ or ‘account reconciliation’ – that is, the accounting process that marries your business’s ledger entries to your bank statements or other source documents.
But in fact, the term covers so much more than balance sheet substantiation. It really comes into its own in the context of financial institutions – perhaps you’re a bank reconciling payments between accounts, or a broker reconciling between your systems across the trade lifecycle. In each case, you’re engaging in financial reconciliation.
How that reconciliation looks will differ depending on the type of institution you work for. Smaller businesses often rely on a manual reconciliation process, with a person or team preparing and reconciling datasets without a technological solution. Larger businesses with more complex data, however, will probably need an automated reconciliation solution.
This blog has been written to give you a solid overview of what financial reconciliation is, both in the context of larger and smaller firms. Here’s what we’ll cover:
- A financial reconciliation definition
- The importance of financial reconciliation
- What the financial reconciliation process looks like
- How financial firms carry out reconciliations
- The challenges of financial reconciliations
- Financial reconciliation types
- How often you should carry out financial reconciliations
What is financial reconciliation?
Financial reconciliation is a process that ensures data is the same in two or more places at once. This data might be the cash amounts you use for accounting, but also includes things like trade details and the data needed for regulatory reporting.
Whenever you need to ensure data accuracy in your business, you’ll need to carry out financial reconciliation – whether you’re reconciling internal data or to external data.
The importance of financial reconciliation
Financial reconciliation is crucial to successful operations. Every business in the world – from the guy who did your kitchen tiles to Apple or Walmart – has to reconcile their data, to ensure that it’s an accurate representation of what took place and to know when remedial action is needed.
If you’re a sole trader, reconciling your received payments against your invoice records tells you when you need to chase a client. If you’re running a business, you’ll need to reconcile your accounts to make sure that nothing funny’s going on in your ledger or bank accounts, before filing your returns.
And if you’re a financial firm, things get even more complex. With mission-critical data, there are all sorts of reconciliations you’ll need to do as part of your everyday operations – not to mention the audits and fines you risk if things don’t match up. So let’s take a more detailed look at the importance of financial reconciliation.
Greater data quality
At first glance, this might seem self-evident – any business’s data obviously needs to be clean, complete and correct for a range of reasons, some of which we’ll go into below. But in financial markets, the whole system relies on everyone’s trading data being complete, accurate and timely. If it’s not, problems mount up – settlement and reporting could be affected. Robust financial reconciliation can help you avoid unnecessary regulatory and public scrutiny, not to mention fines.
As a financial firm, your day-to-day business relies heavily on reconciliation. Say you’re a small or medium-sized broker processing equity trades. You could end up dealing with your client, an execution broker, an exchange, a custody business and a securities depository. All of those transactions need to be reconciled. A strong financial reconciliation system will make sure that you can do your job efficiently.
Reconciliation is vital in mitigating the risks that come with operating in a heavily regulated space like financial services. Say you’re not reconciling your trades with the detail or frequency demanded by your regulator, or you’re using a manual system. You end up with more work, and increase reputational, counterparty and market risk, which could make you liable for losses. Find the right reconciliation solution, and you’re part of the way toward making sure that never happens.
You need to be able to prove to your regulators and customers that you have the proper controls in place for your business. The right financial reconciliation software is key here. It will ensure that your reconciliation processes are transparent from start to finish, that you can manage permissions, and that you can see exactly who’s taken what action, when.
Useful, accurate reporting
You’ll need to report on your trading or accounts data for a range of reasons, to regulators and customers as well as internal stakeholders. Reconciling your financial data properly not only ensures that your reports are accurate, but can also help take some of the weight out of the complex transaction reporting that’s part and parcel of operating in the capital markets.
The financial reconciliation process
Now that we’ve covered what financial reconciliation is and why it’s important, let’s take a look at what’s involved at each step of the financial reconciliation process.
The first step of financial reconciliation is gathering all the data that you need to reconcile. If you’re a financial firm, this might be data regarding trades, positions, fees, commission and dates, for example. You’ll get some of this from records in your business’s systems. The rest will be from your counterparties and other intermediaries – brokers, banks, clearing houses, repositories and so on. It’ll likely come in a range of different file types and formats, which leads us neatly onto the next step.
Once you’ve brought all of your data together, you’ll need to normalise it. This involves making sure that all records are in a similar format, and that any redundancies (or duplicates) are removed. This will leave you with a standardised, efficient set of data that’s easier to reconcile. If you don’t normalise data – for example, if you have one set of dates in UK format, and another in US – you’ll run into errors that you could have easily avoided.
After you’ve prepared your data, you’re ready to start matching – checking that the two or more sets of data reconcile against each other where necessary. This step of the process can be particularly challenging when dealing with financial data, due to the quantity and complexity of that data. Matching is therefore often automated using a matching engine, a key part of any financial reconciliation solution. The best engines will use ‘fuzzy matching’ to recognise where records are similar, if not exactly the same, and let you decide whether or not they constitute an exception.
You’re probably going to run into data errors – also called ‘breaks’ or ‘exceptions’ – no matter how rigorously you’ve carried out each of the preceding three steps. They’re to be expected, particularly if you’re working with larger data sets. Whenever your data doesn’t meet the rules you’ve set, an exception is created. You can then look more closely at that record to discover the problem and propose a solution. The best reconciliation systems can even group and categorise these exceptions automatically, depending on the type of break, meaning that the most significant exceptions can be escalated immediately.
Once you know what caused your exception, you need to fix it. Your exception may have been caused by something as simple as a discrepancy in format – perhaps something slipped through the net at the normalisation stage. If so, you can carry out a normalisation exercise again to solve the issue. However, there may be a genuine break between two records that should match. You’ll need to investigate these with your stakeholders and counterparties.
How do financial firms carry out their reconciliations?
Financial firms have a variety of options when it comes to choosing how to carry out their reconciliations. Which reconciliation model is right for you depends on a range of factors like the nature of your data, the timeframe in which you need to reconcile and the complexity of the reconciliations.
To help you decide, let’s take a look at four different ways that financial firms carry out their reconciliations.
If you’re reconciling two sets of data yourself using a simple tool like Microsoft Excel, you’re carrying out manual reconciliation. While it sounds basic, this sort of process is quick to implement and cost-effective, and can work well for smaller businesses with simple reconciliations to carry out. Especially if those reconciliations aren’t likely to change in nature over time.
However, if you need to carry out complex reconciliations between more than two sets of data, or if your datasets are particularly large, you’ll want to consider a different solution. Your efficiency may be affected by a manual system’s lack of automation, or over-reliance on one key user. And with Excel offering no audit trail or detailed reporting, demonstrating compliance can be tough.
In-house developed solutions
If you’re a large or medium-sized business with the right resources in-house, you may look at building your own reconciliation solution. Since you’ll have complete control over the design, you’ll be able to build something that’s great for solving your specific reconciliation problems – with none of the other features you may not need, but that come as standard in off-the-shelf packages.
Should your needs expand beyond your initial use cases, though, your in-house solution will need development to remain fit for purpose. This can put undue strain on the teams needed to make the updates, becoming unsustainable in the long term and making it difficult to keep up with changing business and regulatory requirements.
Having third-party software installed on your business’s servers is a common reconciliation solution, and could solve the majority of your reconciliation challenges. These systems have a large user base, and offer reliable support packages and ongoing development. You may even be able to customise the interface and report types without intervention from your provider. Though any significant changes to the reconciliation setup are likely to need additional development and potentially incur extra consultancy costs from the provider.
The key cons here are you’ll pay a lot for an on-premise solution to be installed, and more for ongoing maintenance. You’ll need to devote time, people and money to deploy upgrades or adapt the software to new use cases or input data formats. While on-premise software is well-supported at first, its high cost and low adaptability mean that it’s likely to be left behind in favour of cloud-based solutions.
Use a cloud-based reconciliation platform and you can get going immediately without having to install a solution on your in-house servers. As a result, you can deploy cloud solutions far more quickly and at a much lower cost than on-premise software.
These platforms are regularly updated, so there’s no need for time-consuming major upgrades, and you’ll often benefit more quickly from the latest advances in reconciliation technology – such as machine learning or no-code capabilities.
Cloud-based reconciliation solutions use the same code base across customers, which is great for standardisation, simplification and best practice. The potential downside to that, is you may not get as many customisation opportunities – whether related to the interface or data output.
As you’ve no doubt guessed, financial reconciliation comes with a host of challenges. The good news is that none of them are insurmountable. In fact, at Duco we’re set up to help you overcome them.
You can find out some of the challenges you’ll face when reconciling below. To find out how you can get on top of these with Duco, why not watch a demo of our platform in action?
If you’re a financial business, your data will be coming from lots of different third parties – banks, custodians, brokers and so on. The quality of that data, and the level of detail, is going to vary wildly depending on who’s supplied it. So when you come to reconcile, matching can be a huge challenge and take hours of manual work.
Multiple types and formats
There’s no universal standard for data, so you’re going to receive all sorts of different file types from your counterparties. We’ve seen .txt., xls, .csv, .xml, swift, pdf files – you name it, we’ve received it! Across those files, data will be formatted differently depending on the supplier. Normalising that data to get it reconciliation-ready is another massive task.
The world of finance is constantly on the move. New regulatory requirements and industry standards appear with increasing frequency. Innovative new players are entering the market and disrupting traditional processes. To reconcile and report in the ways that regulators and stakeholders demand, you’ll need an agile system that can evolve as quickly as the market does.
At low volumes manual reconciliation is fast and easy to set up, but it quickly becomes cumbersome and expensive at high volumes. It’s also risky. Errors are practically guaranteed when you have to deal with large amounts of data manually. And the risk only increases as complexity grows. Manual reconciliation also doesn’t come with the necessary controls and audit functions that regulators need you to have when dealing with financial data at scale.
If you are using in-house or off-the-shelf legacy technology the pace of change can be very slow, with upgrades requiring major projects and heavy involvement from IT. What happens when your reconciliation software can’t adapt to your latest situation? With the landscape always changing – T+1 in the US meaning faster settlement, for example – you need an agile, flexible reconciliation solution that can keep you ahead of the curve.
Financial reconciliation types
We’ve covered many different aspects of financial reconciliation – what it is, why it’s important, how to do it, and the sorts of challenges it can present. Let’s now go into a little more detail about the different types of financial reconciliation.
Cash account reconciliations
When you carry out cash reconciliation, probably as part of your accounting process, you verify transactions across your financial systems to reconcile cash balances and revenue. Cash reconciliations touch almost every area of your business, and as a result, can create problems for every area of your business when you get them wrong.
Derivatives holdings and activity reconciliations
If you’re a business enabling clients to trade financial derivatives like options or futures, you’ll need to carry out derivatives reconciliation. The complex nature of derivatives – fractional pricing, margin requirements, the clearing process – means data and enrichment challenges. You’ll need your data to be complete and correct, quickly, to manage trading and liquidity, client reporting, and regulatory compliance.
Securities holdings and activity reconciliations
When you trade securities like shares, you’ll need to reconcile your trade and position statements against the details held in your system. This information has an impact on a wide variety of activities like your allocations and fees, fiduciary duties and risk positions. Getting securities reconciliation wrong can result in financial loss and regulatory penalties.
Payments reconciliation compares your internal financial records, like your balance sheet or ledger, to external documents like bank statements to ensure that they match up. When there’s a break, you’ll need to investigate and ensure you’re not losing money or overcharging. With so many different payment providers and source documents, there’s also bound to be discrepancies in data formats that need normalising.
Regulatory reporting reconciliations
Regulators require that reporting data be accurate, complete, and reported in a timely fashion. So even after you’ve completed post-trade reporting, you’re into post-reporting reconciliation: reconciling what you’ve reported on to ensure that what you’ve sent your regulator is correct and complete. And with regulation changing all the time, you’ll need an agile system that can adapt to your regulatory reconciliation needs at a moment’s notice.
How often should you carry out reconciliation?
How often you need to reconcile your financial data depends on a range of factors, namely:
- The types of asset you’re reporting on
- The size of your portfolio
- What sort of firm you are
- How you’re regulated
Let’s look at an example. Suppose you’re an EU-based firm offering derivatives to your clients. You’re regulated by the European Securities and Markets Authority (ESMA), and your business will need to comply with the European Market Infrastructure Regulation (EMIR).
To do that, you’ll need to reconcile your portfolio every business day if you hold over 500 derivative contracts. That goes down to once a week if you have between 51 and 499 contracts, and once per quarter if you have fewer than 50 contracts.
It’s worth noting that these frequencies only apply if you’re a financial or non-financial counterparty referred to in Article 10 of the regulation – but that’s another story. To find out how often your specific business should carry out financial reconciliation, it’s best practice to check the most up-to-date requirements from your regulator.
Are you reconciled with reconciliation?
Congratulations! If you’ve made it this far, you will have seen what financial reconciliation is, its importance, the different ways of carrying out financial reconciliation, and the benefits and drawbacks of each method.
Ready to look for a solution for your business? Find out more about how our cloud-based reconciliation platform can help you solve some of the challenges we’ve just covered.