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Importance of Valuations – and All Other Inputs - in OTC Derivatives Collateral Management. Scott Linden Derivatives Collateral Management Services . Agenda. Derivatives Collateral Management Overview Data Inputs and Management Identification of Valuation Issues Global Trends Conclusion.

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importance of valuations and all other inputs in otc derivatives collateral management

Importance of Valuations – and All Other Inputs - in OTC Derivatives Collateral Management

Scott Linden

Derivatives Collateral Management Services

agenda
Agenda
  • Derivatives Collateral Management Overview
  • Data Inputs and Management
  • Identification of Valuation Issues
  • Global Trends
  • Conclusion
overview of derivatives collateral management process
Overview of Derivatives Collateral Management Process
  • Collateral - a Rapidly Growing Credit Risk Mitigation Tool
    • Consistent with overall growth in OTC derivatives trading
    • Collateral in use – increased from $719 billion year end 2002 to $1.3 trillion at year end 2005
    • Growth in collateral agreements – increased from 38,500 in 2002 to 110,000 at year-end 2005
    • Growth in collateralized exposure – increased from 30% in 2002 to 60% in 2005
    • Reasons beyond trading growth –
      • Corporate credit shocks have lead to increased collateralization
      • Increased derivatives trading by asset managers and other new entrants
    • Results have led to an expansion well beyond the historic dealer to dealer and dealer to hedge fund collateral relationships

Source: ISDA Margin Survey 2006

overview of derivatives collateral management process1
Overview of Derivatives Collateral Management Process
  • Legal Framework
    • ISDA Master Agreement – netting agreement in event of default across OTC products
    • Credit Support Annex (New York or English law) – contains negotiated margin and collateral terms
      • Bilateral or Unilateral
      • Credit Threshold
      • Minimum Transfer Amount
      • Eligible Collateral, Haircuts, Interest Rates on Cash
      • Initial Margin Requirements
      • Valuation and Settlement Timing
overview of derivatives collateral management process2
Overview of Derivatives Collateral Management Process

Illustration of the Derivatives Margin Call Process

Portfolio

Valuation

Communication

Collateral

Valuation

Verification

Collateral

Requirement

Calculation

Movement of

Collateral

T

T + 1

T + 2

T

T + 1

T + 1

Source: ISDA Margin Survey 2006

data and information inputs
Data and Information Inputs
  • Missing, incorrect, or mishandled data from the many inputs can lead to missed or incorrect margin calls.
  • Areas Information
  • Legal ISDA agreements and CSAs
  • Credit Ratings and margin terms
  • Trade Support Trades and valuations
  • Custodian Services Security positions and pricing
  • Treasury Services Interest rates
management of data and margin process
Management of Data and Margin Process

Minimum In-House Support Requirements

  • Derivatives trade valuations
  • Derivatives trade warehouse
  • Collateral holdings and pricing
  • CSA term warehouse
  • Collateral calculation engine and
  • Operational resources
identification of valuation differences
Identification of Valuation Differences
  • Margin Dispute – But where is the problem?
    • Market Practice – calling party reconciles, disputing party provides trade report
    • Reconciliation Tools – all require manual formatting/manipulation over numerous iterations
    • Problems with reconciliations – “many to many”, trade types, novations, resets, unwinds, terminations
    • End Result - highlight population differences for further investigation or valuation differences for discussion with counterparty
  • Periodic Reconciliations – ISDA recommends at least annually
  • Monthly MTM Validation – Adopted byHedge funds and asset managers
global trends impacting collateral process
Global Trends Impacting Collateral Process
  • Market Utilities – Deriv/serv electronic confirmation, ISDA Novation Protocol, DTCC Trade Information Warehouse
  • Independent Service Providers – Many provide easy links to DTCC for buyside firms
  • Prime Brokerage-like Services – Improved reporting of derivatives valuations – web based, customized, etc. - allows for more frequent reconciliation/validation
  • The Next Big Thing - Market Innovation – LLCDs, CDS on MBS/ABS… ?
conclusions
Conclusions ?
  • Positive trends in market should lead to cleaner populations between counterparties. Valuation differences will be easier to identify – and resolve.
  • But -
    • Will lofty goals of DTCC Trade Information Warehouse – “golden” copy of trade with standard valuation across products with link to settlements and collateral - be realized?
    • Will funding of post trade process improvements remain high?
    • Will ISDA Collateral Clearing House ever materialize?
    • Will market innovation and growth outpace processing related utilities and innovation?