Collateral: Transforming Counterparty Risk into Legal and Operational Risks

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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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Basel II
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
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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
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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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Data Requirements
STATIC DATA
MARKET DATA
COUNTERPARTY DATA
TRANSACTION DATA
Collateral System
AGREEMENT DATA
COLLATERAL ASSET DATA
CUSTOMER REFERENCE DATA
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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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Communications Centre
PAYMENTS
TRADING DESK
CONFIRMATIONS
FINANCIAL CONTROL
Margin Team
CUSTODY
RISK LEGAL
DATA MANAGEMENT
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Trends in Collateral Use
Changes in Market Environment
Risk
EU Collateral Directive, Hague Convention
Legal
Documentation
ISDA Margin Provisions 2001, GMRA 2000
Continued investment in systems and
people Central Counterparties, Outsourcing
Operations
Settlement
Consolidation of platforms
Portfolio
Wider collateral acceptance
Funding
Active re-use, cross product margining
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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 practitioners improved
  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