Financial Markets Operations Management (34 page)
Read Financial Markets Operations Management Online
Authors: Keith Dickinson
Unlike ETDs and cleared OTCDs, where a CCP assumes the credit risk through novation and calls initial margin plus variation margin as appropriate, bilaterally cleared OTCDs expose both buyer and seller to credit risk throughout the duration of the contract. A 30-year, bilaterally cleared interest rate swap (IRS) would have a 30-year credit exposure.
If we consider a single IRS transaction, on the trade date the value of the floating leg would equal the value of the fixed leg. Thereafter, one leg would be worth more or less than the other, thus creating an exposure for one of the counterparties. Consider a seven-year interest rate swap on a notional amount of GBP 20 million, as shown in
Table 9.19
. You will observe that the NPVs differ.
TABLE 9.19
Interest rate swap
| Interest Rate Swap | Terms | |
| Notional amount | GBP 20,000,000 | |
| Duration | 7 years | |
| Fixed rate payer | Client | @ 1.5% payable annually |
| Floating rate receiver | Big Bank | 6-month LIBOR |
| Net present value of fixed interest payments | GBP 1,946,691 | |
| Net present value of floating interest receipts | GBP 2,124.937 |
In the example above, if the client paid/delivered assets to Big Bank with a value of GBP 178,246, then there would be no exposure from one party to the other. We refer to this payment or delivery as
collateral
, and collateral is used as a risk-management tool in order to reduce counterparty risk across many different activities, including the non-centrally cleared OTC derivatives business.
According to the ISDA Margin Survey 2014,
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90.2% of all non-centrally cleared (i.e. bilateral) transactions were subjected to collateral agreements of one form or another (Credit Support Annexes, margin provisions or other types of agreement). Just 9.8% were not subjected to any agreement of any type.
Collateral consists of cash and securities, with cash being the largest proportion. The breakdown of collateral received and delivered, as noted in the ISDA Margin Survey 2014, was as shown in
Table 9.21
.
TABLE 9.21
ISDA Margin Survey 2014
| Collateral Type | Received 2014 (2013) | Delivered 2014 (2013) |
| Cash | 74.9% (79.5%) | 78.3% (78.7%) |
| Government securities | 14.8% (11.6%) | 18.2% (18.4%) |
| Other securities | 10.3% (8.9%) | 3.4% (2.9%) |
At any moment in time, any two counterparties will have an exposure to each other, with the exposed party calling for collateral to mitigate any credit risk. Whilst it might be prudent to move collateral on a daily basis, it will certainly be an operational burden to do so. In order to overcome this, arrangements can be made so that collateral is only moved under pre-specified conditions.
When two parties enter into an agreement (Credit Support Annex), they will agree either that one party deposits an initial margin with the other party or assigns a percentage of the total trade notional to the other party. This is known as an
independent amount
.
For example, Party “A” might deliver USD 5 million of collateral to Party “B” (initial margin). Alternatively, Party “A” might assign, say, 8% of the total trade notional amount to Party “B”. If the amount was USD 50 million, then the IA would be USD 4 million.
How would both parties decide who had to pay the IM or IA to whom? Credit analysis will reveal which party is the most credit risky in relation to its counterparty. If Party “A” was rated BB+ and Party “B” AAA, the latter would be more likely to be exposed and would call for IM or an IA to be assigned.
A threshold is one example of a collateral parameter and represents the amount of unsecured exposure that is allowed by either party before collateral is called. The amount of threshold would be agreed based on credit exposure analysis by both parties.
An MTA is the amount of collateral that is required before any collateral is delivered. For example, if the MTA is USD 1 million and the required collateral is, say, USD 800,000, then no delivery will be made. However, should the required collateral increase to USD 1,240,000, then a delivery would take place.
To avoid making payments for odd amounts, both parties can agree to round amounts up or down to, say, the nearest USD 100,000. If we take the example in the Minimum Transfer Amount section above, the required collateral delivery of USD 1,240,000 would be rounded down to USD 1,200,000.
In September 2013, the Basel Committee on Banking Supervision (BCBS) and the Board of the International Organization of Securities Commissioner (IOSCO) jointly published a policy framework that established minimum standards for margin requirements for non-centrally cleared OTCDs.
The requirement to exchange initial margin with a threshold of up to EUR 50 million will commence from 1 December 2015 and the requirement to exchange variation margin will become effective on the same date.
If you refer back to
Tables 9.16
,
9.17
and
9.18
in Section 9.5.5, you will have noticed that some of the items listed in the “Action Required” column were in italic typeface. This was to denote that these actions should occur once or several times throughout the term of the transaction. Operations staff must be constantly aware of the possibility that external events can and do have an impact on open transactions. These include:
- Interest rate resets on interest rate swaps;
- Corporate action events on underlying assets such as equities and bonds;
- Exercise events on futures and options (exercise might be optional or automatic);
- Foreign exchange rates;
- Public holidays and non-business days (a working day in one market might be a non-working day in another);
- Trigger events, such as bankruptcy, that might result in an obligation with predefined characteristics being delivered against a credit default swap contract.
Reconciliation covers two areas:
- Cash (nostro) reconciliation:
We cover this topic in Chapter 14. - Portfolio reconciliation:
Matching all trades (and resolving reconciliation breaks) between two separate counterparties.
Organisations are expected to reconcile their portfolios of bilateral OTCD transactions with each of their counterparties. The objective is to make sure that the portfolio contents of both counterparties agree as of any particular date. Furthermore, portfolio reconciliation helps to ensure that collateral disputes do not occur and, if they do, to allow the collateral function to investigate.
Due to the non-standardised nature of OTCD transaction details, both counterparties need to establish reconciliation procedures to ensure that they have a consistent set of information on
which to perform a reconciliation. The ISDA published the minimum field requirements in its
Minimum Market Standards for Collateralised Portfolio Reconciliation
in January 2010.
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The minimum fields contained in a data file should include those shown in
Table 9.22
.
TABLE 9.22
Portfolio reconciliation minimum data requirements
| Field | Description |
| Your legal entity name | Your name (and legal entity identifier â LEI). |
| Counterparty legal entity name | Counterparty's name (and LEI). |
| Your trade ID | Your trade ID should be recognisable by your counterparty. |
| Counterparty trade ID | Counterparty's trade ID should be recognisable by you. |
| Group IDs (if multi-leg) | Common ID that enables a counterparty to relate a set of multiple bookings back to a single trade ID. |
| External match ID | An externally applied ID for trades confirmed electronically. |
| Product ID/name | This includes an asset class and product, e.g.
|
| Dates | Trade date/start date/end date/exercise date. |
| Mark-to-market (MTM) | Revaluation price and currency. |
| Current notional/quantity | Original and current notional amount or quantity. |
| Trade currency | Initial currency of the transaction and settlement currency if applicable. |
Source:
ISDA Minimum Market Standards (2010).
Reconciliation breaks might be due to timing issues (one party transmits its portfolio before its counterparty has a chance to transmit its own) or there might be genuine breaks where there are trade booking differences or valuation differences.
There are two main types of derivative: exchange-traded derivatives and OTC derivatives. We can subdivide derivatives into their underlying asset classes:
- Credit derivatives;
- Equity derivatives;
- Interest rate derivatives;
- FX derivatives;
- Energy, commodities and developing products;
- Structured products and others.
ETD products are transparent to the industry, highly standardised and designed by the appropriate exchange. ETD transactions are dealt on-exchange and cleared through a central counterparty (CCP) which novates each transaction. This novation replaces the original counterparty risk exposures with bilateral exposures between the CCP and each counterparty. In order to manage this risk, CCPs charge their clearing members initial and variation margin (in addition to other financial buffers).
By contrast, OTCD products were tailored to suit the counterparties, traditionally opaque, complex and often complicated. Transactions were executed off-exchange by bilateral agreements between buyer and seller. Transactions were processed/managed by the two counterparties to any transaction and may or may not have been collateralised.
OTCDs were therefore regarded by the regulators as being highly risky, especially as transactions were not usually reported to the regulators. This situation has been changing over recent years and especially after the 2007 global financial crisis and the collapse of several market participants, most notably Lehman Brothers. We now have a situation where the OTCD is changing:
- Transactions should be dealt on a trading platform (bilateral negotiation still occurs). This is making the OTCD look like an ETD.
- All transactions must be reported to a trade repository which holds the “golden copy” of each transaction.
- All OTCD transactions should be cleared centrally. This works well for the more standardised type of OTCD â types that the CCPs are comfortable handling. The more complex, complicated OTCDs are still processed by the counterparties concerned. This is making the OTCD look like an ETD.
- OTCD transactions that are non-centrally cleared (i.e. bilaterally cleared) are mostly collateralised, with cash and government securities being the predominant class of collateral.
- Counterparties are expected to reconcile their portfolios with each other on a regular basis.
The changes in the OTC derivatives business are very much “work in progress” and regular progress reports are published by the Financial Stability Board on its website (
www. financialstabilityboard.org/list/fsb_publications/index.htm
). The latest progress report § 7 was published on 8 April 2014.