Collateral: Transforming Counterparty Risk into Legal and Operational Risks Robert McWilliam Head of Counterparty Exposure Management
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
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
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
Risk Low Cost High Cost Industry Opinions Bespoke Legal Documentation GMRA, ISDA Client Driven High Threshold Infrequent Calls Zero Threshold Daily Calls Operations Settlement Govt Bonds, Cash Corp Bonds, Equity Portfolio Passive Active Funding Corp bonds, Equity Govt Bonds Legal and Operational Risks
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
New York Pledge English Transfer English Deed Japanese Pledge/Loan Operational Provisions Legal Provisions Definitions Elections Supplement ISDA Collateral Agreements
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??
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.
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
Data Requirements STATIC DATA MARKET DATA COUNTERPARTY DATA TRANSACTION DATA Collateral System AGREEMENT DATA COLLATERAL ASSET DATA CUSTOMER REFERENCE DATA
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
Communications Centre PAYMENTS TRADING DESK CONFIRMATIONS FINANCIAL CONTROL Margin Team CUSTODY RISK & LEGAL DATA MANAGEMENT
Trends in Collateral Use Risk Changes in Market Environment EU Collateral Directive, Hague Convention Legal Documentation ISDA Margin Provisions 2001, GMRA 2000 Operations Continued investment in systems and people Central Counterparties, Outsourcing Settlement Consolidation of platforms Portfolio Wider collateral acceptance Funding Active re-use, cross product margining
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
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