A common challenge for Asset Managers, Fund Administrators & Middle Office investment book of record (IBOR) providers is how to ensure that Contract For Difference (CFD) resets as presented by the prime broker are correct. This article provides a brief outline of the various approaches and recommendations.
A CFD has many of the characteristics of a future but with key complications such as Dividends, Withholding Tax, Financing and CFDs do not have expiration dates.
Equity Resets: A CFD can be setup as bullet or to reset more frequently.
- Settled at the end of the contract with a single payment. PB can request ad-hoc reset.
- Operationally efficient.
Monthly Resets: Many advantages for preforming monthly CFD Equity resets such as:
- Gains/Losses become realised
- Interest and income dividend income is received as cash and cash interest
- Dividend expense is paid out of cash
If the option of monthly Equity resets is applied and agreed in PBs terms, than some key controls should be completed to validate the Prime Brokers postings and lend to the smooth settlement of the cashflows.
- Review standard trade parameters such as notional reviewed. (Agree with PBs in advance if Corporate Actions are to be included)
- Reset dates to be agreed. For cross currency CFDs the reset date is determined by the underlying equity currency settlement convention.
- Settlement date is determined by the settlement currency of the CFD. Agree with PBs in advance regarding holidays, if Following or Modified will be used.
- Pre agree with PB what price is to be used for the Equity reset eg COB BBG price.
Every CFD generates a CFD financing charge. Financing charges are accrued daily and settled monthly. Financing on unwinds can be settled on close out of the trade (Intra month) or deferred to month end financing. It’s important that CFD financing is correctly attributed to interest received, interest paid, or stock borrow costs in Fund accounting systems to maintain accurate disclosure in the financial statements.
Independent verification of CFD financing:
It is important to understand that there is no Market standard for CFD financing calculation. Prime Brokers may use slightly different methodologies. Independent calculation of finance accruals should be performed to verify brokers figures. Financing replication should be completed using the methodology that was mutually agreed in the terms document.
In order to perform the independent replication, you will require several parameters such as Spread (Broker fee), Day count convention (This is dependent on currency. If it is a commonwealth currency apply A/365 and for others it’s A/360), Benchmark rate (To be obtained from an Independent source (Bloomberg)) and Notional (Market/Cost). Note figures may not always match exactly and we may see a small variance due to sources used for rates etc, but you will gain greater confidence that the PB calculation is accurate for CFD Financing.
The main benefits from completing an independent calculation are:
- Each Equity and Financing reset as presented by your prime broker is correct & accuracy of the NAV / income price per unit
- Accurate tax calculations where applicable
- Monitor and track PB behaviour
- Accurate cash balances & cash ladders
- Better informed when selecting Prime Brokers and agreeing terms as you can select calculations in your favour
Having considered the benefits there is no argument that an independent verification is beneficial to all parties but how can we ensure the accruals are in line and all parties are kept in check and no one is over/under charged?
We have found that by reconciling versus the prime broker across each individual key data component of the calculation i.e. index, spread etc. on a daily basis across every instrument this will ensure that when the CFD is reset and the finance interest settled both parties will be in line or within suitable mutually agreed low tolerances. For firms transacting CFDs with multiple prime brokers and higher volumes, this service capability provides the firms oversight and control with improved transparency for independent finance replication, comparison and reduced counterparty dispute resolution.