collateral: transforming counterparty risk into legal and operational risks robert mcwilliam head of...
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Collateral: Transforming
Counterparty Risk into Legal and
Operational Risks
Robert McWilliam
Head of Counterparty Exposure Management
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5 Years Ago…..
Collateral reduced credit losses during Asia, Russia
and Hedge Fund ‘crisis’ in 1997/98
ISDA estimated $200bn collateral assets
9 ISDA Collateral opinions
High thresholds linked to credit worthiness
Calendar driven or mtm margin calls
Weekly/monthly margin frequency
Single product margining
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ISDA 1999 Collateral Review
Reduction in time frames associated with call cycle
and substitutions
Revised dispute resolution procedure
Broadening of scope to include reconciliation and
exchange of information
Simplification of definitions and language
Simplification of document architecture
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While collateral reduces credit risk, it simultaneously increases other risks to which banks are exposed, such as legal, operational, liquidity and market risk. Therefore, it is imperative that banks employ robust procedures and processes to control these risks.
The New Basel Capital Accord , January 2001
Basel II
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Funding Corp bonds, Equity Govt Bonds
Industry Opinions BespokeLegal
High ThresholdInfrequent Calls
Zero ThresholdDaily Calls
Operations
Documentation GMRA, ISDA Client Driven
Portfolio Passive Active
Settlement Govt Bonds, Cash Corp Bonds, Equity
Low Cost High CostRisk
Legal and Operational Risks
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Is the Collateral Yours to Keep?
Perfection and enforcement risk for pledges
Re-characterisation risk for title transfer
Uncertainty under conflicts of law rules as to
which law applies
Vulnerability to third parties
Enforceability of “top-up” deliveries
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ISDA Collateral Agreements
Operational Provisions
Legal Provisions
Definitions
Elections Supplement
New York Pledge
English Transfer
English Deed
Japanese Pledge/Loan
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Time Frames
3 day call cycle: Value - Notify - Settle
Contrast FX Margin, Repo markets
2 day substitution: Deliver - Return
Double-up credit risk overnight
Market practice may differ from CSA terms
Increased legal risk??
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CSA Para 4 - Dispute Resolution
(1) Disputing party to notify other party by close of business on the LBD following the date that the demand is received
(2) transfer the undisputed amount
(3) parties to consult in an attempt to resolve the dispute
(4) if they fail by the Resolution Time, then:(i) Valuation Agent to seek 4 actual mid-market quotes
(ii) recalculate collateral value pursuant to 11(e)(ii)
Following recalculations, Valuation Agent will notify each party not later than Notification Time on LBD following Resolution Time
Failure to make the required transfer results in an Event of Default under ISDA Master Section 5(a)(i) ‘Failure to Pay or Deliver’ subject to a standard 3 day cure period.
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Reconciliation
Agreement terms
Thresholds, Rating triggers, Collateral eligibility and haircuts
Population matching confirmations
Valuation differences:
OTC transactions cashflows, rates, curves, vol smile…
Collateral assets coupons, prices, pre-payments
Settlement and custody
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AGREEMENT DATA
CUSTOMER REFERENCE DATA
COUNTERPARTY DATA
STATIC DATA
COLLATERAL ASSET DATA
TRANSACTION DATA
MARKET DATA
Collateral System
Data Requirements
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Portfolio Risks
Liquidity and volatility
Collateral eligibility and haircuts not sensitive to market
Concentration
Within portfolio and across the firm
Correlation of your counterpart with:
Issuer of collateral asset; “two-party pay” risk
Market events
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CUSTODY
DATA MANAGEMENT
CONFIRMATIONS
PAYMENTS
RISK & LEGAL
FINANCIAL CONTROL
TRADING DESK
Margin Team
Communications Centre
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Funding Active re-use, cross product margining
EU Collateral Directive, Hague ConventionLegal
Continued investment in systems and peopleCentral Counterparties, Outsourcing
Operations
Documentation ISDA Margin Provisions 2001, GMRA 2000
Portfolio Wider collateral acceptance
Settlement Consolidation of platforms
Changes in Market EnvironmentRisk
Trends in Collateral Use
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Collateral Market - Today
$719bn collateral assets
70% cash, 13% govt bonds, 17% other
38,500 collateral agreements
54% Americas, 24% Europe, 10% Caribbean
26% banks, 22% investors, 19% hedge funds, 17% corporate
50% fixed income derivative exposure collateralised
70% support Repo, 33% FXMargin, 28% Sec Lending
33 ISDA collateral opinions
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And the Future….
Collateral is much more widely used
New entrants; insurance/pension funds, corporate, emerging markets
Tighter credit terms; zero threshold, daily calls
Risk based margining across wider product range
Improvement in collateral risk management
More highly skilled practitionersimproved business process
Better technology support
ISDA initiatives: Electronic Date Interchange, Asset Definitions, Guideline update, revised CSA, Law reform…
New tools to manage counterparty risk: CDS, Tear-ups, Third Parties