Professional Documents
Culture Documents
OTC Derivatives: The Challenge of Deriving Clear Benefits
OTC Derivatives: The Challenge of Deriving Clear Benefits
Contributing editors
Florence Fontan, Head of European affairs, BNP Paribas Securities Services
David Beatrix, Business development - market and financing services, BNP Paribas Securities Services
Mark Armstrong, Legal European regulatory affairs, BNP Paribas Corporate and Investment Banking
Nicolas Mehta, Head of OTC derivatives documentation, policy and development, BNP Paribas Corporate
and Investment Banking
Additional contribution
Jeremie Pellet, Head of regulatory affairs, BNP Paribas Corporate and Investment Banking
Florent Benhamou, Market risk products, BNP Paribas Securities Services
Cyril Ettori, Head of market and counterparty risk analysis, BNP Paribas Securities Services
Eric Roussel, Head of product management, trade and market solutions, BNP Paribas Securities Services
Special thanks
Jonathan Duff, Communications manager, BNP Paribas Securities Services
Mark Hillman, Head of marketing and communications, BNP Paribas Securities Services
Table of
contents
06 Executive summary
08 Part 1: Overview of the regulatory initiatives
affecting OTC derivatives
10 1.1 Dodd-Frank Act and EMIR: similar but
different
42 Next steps
48 Glossary
52 Contacts
Executive
Summary
Over the years, over-the-counter (OTC) derivatives have
given institutional and corporate investors a flexible tool for
hedging a large range of risks. The swap market has grown
very large. Then the 2008 financial crisis occurred and
critics accused the OTC derivatives markets of triggering and
amplifying the crisis due to the swap market’s sheer size.
7
Part 1:
Overview of the regulatory
initiatives affecting OTC
derivatives
9
Part 1: Overview of the regulatory initiatives affecting OTC derivatives
Notably, draft MiFIR (ie, the proposed amendments to MiFID will take
the form of a directive and a regulation) will cover pre- and post-
trade transparency requirements for OTC derivatives transactions
and the non-equity markets, and the mandatory trading of OTC
derivatives on organised trading facilities (OTFs) or derivatives
trading venues (DTVs). A draft legislative proposal on the latter is
expected from the European Commission in late October 2011.
IIn Europe, EMIR is still under negotiation at the European Parliament. It is expected to be finalised before the
end of 2011. EMIR is a European regulation, not a directive. This means it will pass directly into national law
without a period of national transposition by each EU member state. Despite this fast-track approach, however,
EMIR is not expected to come into force before the end of 2012 at the earliest as the European Commission,
with the support of ESMA and other European regulators, needs to adopt almost 30 technical standards.
In mid June 2011, the CFTC and SEC took actions that will likely defer most of the Dodd-Frank Act
requirements regulating swaps and security-based swaps. Temporary relief will give market participants
until the first quarter of 2012 to comply—the initial date was to have been July 2011. To date, the
SEC and CFTC have issued very few final rules, including how they even define the term ‘swap’.
Dodd-Frank Act CFTC temporary Initial deadline Title VII Rulemaking Rules effective
signed exempt relief for rule making deadline date
21 July 14 June 16 July 1st Quarter 4th Quarter
Rule making by
US CFTC and SEC
(Dodd-Frank)
31st Dec
2010 2011 2012 G20
Deadline
12
Acts and regulations: transatlantic differences
Clearing • Mandatory clearing of ‘eligible’ derivative contracts for • Clearing obligation applies to anyone who enters into a
trades entered into between financial counterparties and derivative subject to the clearing obligation; applies to trades
obligation third country entities (including those which would be between US and non-US counterparties
exempted if EU entities) • In general, the rules do not apply to derivatives trades
• Two ways to determine clearing eligibility: (a) ‘Bottom- that do not have a direct impact/connection with US
up’: CCP request and (b) ‘Top-down’: ESMA in consultation commerce (eg Foreign CCP, Foreign counterparty probably
with the ESRB (incentivise EU CCPs to clear; use of non-EU excluded)
CCPs) • Mandatory clearing of swaps determined by the CFTC (for
• Criteria: “swaps”) and SEC (for “security based swaps”) as eligible
(1) systemic risk reduction provided a central clearing house exists
(2) liquidity of contracts • Criteria: differ from the EU; for example, the US regulators
(3) availability of pricing information are required to take into account the effect on competition,
(4) ability of the CCP to handle contract volumes including clearing costs
(5) level of client protection provided by the CCP • CFTC can also restrict trading in non-cleared contracts
• EMSA to define details in secondary legislation by 30 and stay the application of the clearing obligation
June 2012
Non-cleared • Bilateral trading of non-cleared trades possible, provided • Stricter oversight of swap dealers and major swap
general risk management measures are in place (eg participants, including registration with the CFTC, BCR,
trades mitigation of operational and credit risk, including position limits and stricter capital and margin requirements
requirements for electronic confirmation, portfolio • Customised trades may trade OTC, but must be reported to
reconciliation, daily mark to market of outstanding a trade repository and likely to be subject to higher capital
contracts, segregated exchange of collateral ‘or’ appropri- and margin charges
ate holding of capital)
• Transactions between financial and non-financial
• Capital requirements directive (CRD) IV likely to impose counterparties not exempt from the margin requirements,
higher capital charges for non-cleared trades and 1-3% risk but regulators have indicated that these provisions should
weighting for CCP exposures not apply to end-users
• Secondary rule-making will define capital and margin
requirements
Reporting • Financial counterparties and non-financial counterparties • Each swap, either cleared or uncleared, shall be reported
that exceed an information threshold are subject to the to a registered Swap Data Repository “as soon as technologi-
reporting obligation of OTC derivatives contracts to Trade cally practicable” after time of trade execution (appropriate
Repositories, no later than the working day following the delay will apply for “block trades”)
execution, clearing, or modification of the contract • Responsibility of reporting uncleared swaps to SDR will
• Possibility for a counterparty to report OTC derivatives depend on a hierarchy of counterparty types
contracts on behalf of another counterparty • Uncleared derivatives existing at enactment generally
• When a trade repository is registered by ESMA for reporting must be reported to a registered trade repository or the
a particular type of OTC derivative, all those derivatives relevant regulator, under rules that must be adopted by
previously entered into shall be reported to that repository October 2011, within 30 days of the final rules or other time
within 120 days period specified in the rules
Timeline • Draft Regulation in the co-decision procedure and under • CFTC/SEC to draft secondary regulations pursuant to
review by the European Parliament and Member States statutorily prescribed deadlines
• For the Regulation to come into effect, both Parliament and • General effective date is 360 days after date of enactment
member states need to jointly negotiate and agree a single (21 July 2010), but rulemaking is likely to extend beyond this
text (expected for end 2011) period
• ESMA to draft technical standards by 30 June 2012 • Most rules will provide opportunity for public comments for
• Technical standards need to be adopted by the Commission 30 days (some rules 45-60 days)
to be legally effective
• Regulation has direct effect (unlike a directive) and requires
no implementing legislation – would enter into force 20 days
after official publication (anticipated end of 2012 but could be
earlier if politically expedient)
• CCPs that have an existing national authorisation would
have two years to obtain authorisation
• Other provisions do not take effect until implementing
regulatory standards are adopted (eg information and
clearing thresholds for non-financial counterparties)
• EMIR generally unclear on the non-application of the new
requirements to existing trades (‘grandfathering’ provision)
13
Part 1: Overview of the regulatory initiatives affecting OTC derivatives
Beyond EMIR and Dodd-Frank, the industry has witnessed mounting regulatory pressure
for more independent, sophisticated and frequent valuation. Which investors are most
affected? Which jurisdictions have the most detailed provisions?
Asset management
Since January 2009 (Ucits III 4th amendment), European asset
managers are required to use independent valuation sources
for all positions. The financial crisis of 2008 prompted some
countries to move ahead on their own without waiting for the
European Regulation to evolve. In France, the Autorité des
Marchés Financiers (AMF) published its own instructions as early
as 9th December 2008. Asset managers must now have internal
pricing capabilities for valuing the ‘term financial instruments’
(comprising OTC derivatives) they hold in their portfolios.
The use of OTC derivatives has spread widely since Ucits III
included them among eligible securities. The trend has even led
the European commission to create the term ‘sophisticated Ucits’
to designate these funds with innovative investment strategies. As
a result, the above requirements for independent, sophisticated
and more frequent pricing of OTC derivatives are having an impact
on very large areas of the investment community. Since its third
version, Ucits has become Europe’s flagship investment vehicle,
spreading globally as a brand. So the question of how to value OTC
derivatives interests more than just European asset managers.
Asset managers in Asia or hedge funds trying to use Ucits vehicles
to attract institutional investors are directly concerned.
14
Insurance
Insurance companies operating in Europe face slightly different
issues regarding OTC derivatives. The Solvency II legislation
places risk management at the heart of their operations. It
imposes an approach based on cash flow, requiring consistent
valuation of assets and liabilities and computation of stress-
tested values to obtain the Solvency Capital Requirement
(SCR) and Minimum Capital requirement (MCR).
Solvency II in a nutshell
The European directive Solvency II must be applied from the 1 January 2014, by all insurance companies
based in Europe. It has the first objective to place risk management at the heart of all insurance companies,
imposing a cash-flow based approach, and harmonising insurance sector practices. The second objective
is to protect policyholders through robust and comprehensive risk management practice.
Pillar I, quantitative requirement on capital computation, has the most important impact in
terms of OTC valuation and reporting capabilities. It aims to make the market consistent in
terms of valuation of assets and liabilities and the computation of their stressed values to
obtain the Solvency Capital Requirement (SCR) and Minimum Capital requirement (MCR)
Pillar II, supervisor review, aims at better organisation of- and more operational
and governance controls over- investment management
Pillar III, disclosures: a comprehensive reporting approach to the regulator, the company board and the investors
Solvency II requirements also impact asset managers, in particular because Pillar I imposes on insurance
companies look-through reporting capabilities to analyse their underlying portfolio of funds. This results
in increasing pressure on asset managers to bring further transparency to their allocation.
Regulatory provision for OTC derivatives valuation is not new but it is now reaching a critical
point. This is particularly true in Europe, which is adding layers of provisions and requirements
at both the European and national levels. While EU legislation seems to be taking the lead,
the impact is already worldwide, especially for asset managers. Indeed, whether the need
arises from having to respect Ucits requirements or to help their insurance clients comply
with Solvency II, the pressure is on asset managers to fully understand the details and
intricacies of the new legislation.
15
Part 2:
The impact on investment
managers’ operations,
financing needs and risk
exposure
17
Part 2: The impact on investment managers’ operations, financing needs and risk policies
Differing approaches in the EU and the US have fostered the adoption of different clearing of
OTC derivatives. What is the impact on documentation and how should investors approach it?
Europe
The EU approach is in essence a ‘principal’ model.
18
Designation notice given by the clearing member to the
executing broker relating to the specific client in question
Clearing fees and other auxiliary matters (as relevant) are set out in a
side letter.
United States
The US model, on the other hand, is an extension of the ‘futures’
model: a futures commission merchant (FCM), acting as agent and guarantor of
the client’s margin and other obligations to the clearing house, ‘faces’ the CCP.
The documentation would be a customer account agreement (developed from
the form used for existing listed derivative transactions) with an addendum
addressing specific issues in relation to cleared OTC derivatives. These might
include termination and close-out mechanisms, and any ‘porting’ arrangements.
Since these are likely to be standard for all CCPs, one agreement
should suffice (though there may also need to be CCP-specific
appendices). Clearing fees and interest rates on cash margin are
set out in a separate side letter. In addition, there is an Execution
Agreement (similar to a give-up documentation suite) which can be
either bilateral (client and executing broker) or, subject to CMC rule-
making in this regard, trilateral (client and executing broker and FCM).
(Focus on LCH.Clearnet SwapClear IRS, ICE Clear Credit and CME IRS)
19
Part 2: The impact on investment managers’ operations, financing needs and risk policies
Contract label Purpose Signing parties
Execution or Client Executing Clearer CCP
or Clearing? Broker
ISDA (including CSA) Execution X X
It seems fair to say that the clearing industry could benefit from further
standardisation of documentation.
Adopting central clearing for eligible OTC trades will be a burden for all institutional investors.
While most participants expect to make their operations more efficient in the coming years,
looming regulatory deadlines will exert significant pressure sooner or later. Which operating
model will be needed? How similar will OTC clearing processes look to the familiar futures
commission merchant (FCM) model or the general clearing member (GCM) model?
The diagram below illustrates the existing set-up for Chicago Mercantile
Exchange (IRS & CDS contracts) and the target for SwapClear (IRS
contracts.) Note that institutional investors will be required to
interact with swap execution facilities and affirmation platforms.
20
1 Step 1: Execution and choice of CCP
• The block trade is executed on a SEF (Swap Execution Executing Swap Execution Facility Client
Facility) by both parties (the Executing Broker and the broker 1
Client), including the choice of the CCP Execution
Front choice of CCP Front
• The block trade is transferred to an Affirmation Platform Office Office
2 Step 2: Affirmation, allocation and choice of futures
commission merchant (FCM) Affirmation Platform
• The Executing Broker (EB) alleges the block trade (and 2
selects an FCM if not self-cleared) Middle Affirmation Trade
• The Client affirms the block trade, allocates the trade Office Allocation Support
to “Unique Client ID” (e.g.funds) and selects one or choice of FCM
several FCM(s)
• The trade is submitted for clearing to the CCP 3
3 Step 3: Clearing Consent Clearing
Risk Risk
• A Clearing Consent Request is sent by the CCP to the consent
clearing members (Client FCM and EB FCM) Give up Give up
• The clearing members give their
Clearing Consents Give-up CCP
4 Step 4: Intraday Clearing 4 Novation
• The CCP runs its risk filters EB (self- Clearing
• After risk filters are passed, the novation and cleared)
or 5 FCM
confirmation of the trade occur simultaneously and a
clearing notification is sent to Client FCM, EB FCM and FCM (EB) Post-trade (Client)
processing
the Affirmation Platform
• Transaction is allocated in FCM Position Accounts
(PA) held by the CCP (for Clients: 1 PA per “Unique Trade Repository
Client ID”= legal entity)
5 Step 5: Post-trade processing Notes:
• Netting On SwapClear, allocation will potentially be possible post
• Reporting: the trade is integrated by the CCP into the clearing (TBC)
appropriate Trade Repository On CME, Clearing Consent can be automated through a Risk
• Reconcilliation Filter engine parameterised by the clearing member
• Margining and payments
Execution platforms
While the exact definition and mandatory obligations of SEFs are
still being worked out, the Dodd-Frank Act mandates that all clear-
able swaps be executed on SEFs. MiFID 2 will likely include a similar
provision for Europe. We expect it to set out an obligation to deal on
‘organized trading facilities’ (OTFs). Existing platforms like Bloomberg,
Tradeweb, and Market Axess are all seeking have the SEF ‘label’. They
need it to comply with US regulations and to attract liquidity on their
systems.
21
Part 2: The impact on investment managers’ operations, financing needs and risk policies
In the US, the Dodd-Frank Act states that cleared swaps other than
’large notional swaps’ (ie block trades) must be reported ’as soon
as technologically practicable’ after the time of trade execution.
While the definition of the entity responsible for reporting cleared swaps
is still under debate, the responsibility for the reporting of non-cleared
swaps to the Swap Data Repositories falls on the counterparty which
has the highest rank in a hierarchy of counterparty types*. This should
solve part of the reporting issues for financial and non-financial entities.
22
Fixed income products and especially credit derivatives
have historically been the asset classes moving fastest
towards ‘electronification’. The trend gained momentum in
the past decade as operational risk grew in tandem with the
booming market. Today almost all credit derivative trades
are confirmed electronically in the DTCC from both the sell
and buy sides. DTCC even built a ‘Global Repository for OTC
Credit Derivatives’ within its Trade Information Warehouse.
This was achieved by adding ‘copper’ records to the existing
‘gold’ records (legally binding transactions confirmed
electronically). The ‘copper’ records are single-sided, non-legally
binding transactions, and comprise more bespoke contract
submissions that are not eligible for electronic confirmation.
23
Part 2: The impact on investment managers’ operations, financing needs and risk policies
Converging regulations are pushing institutional investors to value their assets, in particular
OTC derivatives, in an independent, more sophisticated and more frequent manner. Are asset
managers and corporates prepared to meet this challenge and what issues should they be
considering?
Let’s take the example of pricing for Interest Rate Swaps. Here the
timing of the reference data snapshot may vary from one CCP to
another, so discrepancies will arise. In this case, internal valuation
could solve the problem by harmonising all prices on a single curve.
24
different methodologies and market data for cleared and non-
cleared trades could render the entire strategy less efficient.
In-house OTC valuation resources must also be fast. Ucits IV, EMIR
and other upcoming regulations will require daily computation.
Production, controls and reporting must all operate efficiently
for an in-house system to work with the required frequency.
25
Part 2: The impact on investment managers’ operations, financing needs and risk policies
Moreover the credit crunch in 2008 highlighted the need for valuation
methodologies to account for the nature of collateral (if any) that
applies to OTC transactions dealt under a Credit Support Annex (or
equivalent collateral agreement). Thus discounting methodologies
that take into account overnight interest rate swaps (OIS) spreads
are increasingly popular and are progressively replacing the LIBOR-
based methodologies. Central counterparties themselves are moving
to OIS discounting methodologies in their swap-clearing activities.
Regulation and evolving market practices will require a profound rethink of the valuation
processes and systems for pricing OTC derivatives. Pricing from CCPs will help but will not
suffice. Sourcing alternative prices and adopting the sell-side pricing methodologies is the
way forward. Yet, given the complex nature of the instruments, those who buy and sell OTC
derivatives are probably better off delegating those increasingly complicated tasks to exter-
nal partners.
From a collateral management perspective, the introduction of central clearing will give rise
to ‘portfolio bifurcation’. Once cleared, OTC trades will refer to clearing agreements, while
bilateral OTC trades will continue to refer to ISDA Credit Support Annexes (or local jurisdiction
collateral agreements). What will be the impact on collateral management operations and
which areas should be looked at?
26
This will have a substantial impact on the way back offices work.
They will now need clearers’ reports to perform tasks they used to
handle independently, such as processing upfront fees, swap coupon
payments, position reconciliations, clearing-fee payments and credit
event processing on CDSs. Yet they will also continue to process
non-cleared trades as they do under the current OTC model.
27
Part 2: The impact on investment managers’ operations, financing needs and risk policies
Portfolio compression
The complexity of the different cleared and non-cleared OTC processes and the growth in
processing volumes will strain existing back-office and collateral-management systems.
Serious system and procedure upgrading will be required. For these reasons, outsourcing
the collateral operations to a specialist provider who benefits from economies of scale will
appeal to institutional investors. As a general observation, the custodian who keeps the assets
safe is also best-placed to keep collateral safe and to provide collateral agent services.
28
Choosing a clearing broker
While institutional investors are not expected to connect directly to CCPs, they will need
to find a way to interact with a clearer who is connected to the CCPs on their behalf. What
selection criteria should investors use?
The institutional investor should choose a clearing broker that can tick all of these boxes.
In practice, only a few players will be able fulfil all these criteria. Furthermore, the clearer
should be part of an organisation that can provide key additional services, such as collateral
financing and protection, as we explore in sections 2.2 and 2.3.
29
Part 2: The impact on investment managers’ operations, financing needs and risk policies
The advent of cleared OTCs with competing CCPs and the splitting of portfolios between
cleared and non-cleared contracts will increase the complexity of collateral management
procedures. It also implies the following funding challenges:
Higher collateral costs due to the generalisation of initial margin
requirements and systematic same-day collateralisation (T+0
instead of T+1 for the OTC contract still un-cleared)
Lostbenefits of exposure netting at portfolio level. Eligible trades executed
with a counterparty will be transferred to a clearer, under a clearing contract.
Non-eligible trades will remain bilateral, under a collateral agreement.
Fragmentation of the collateral requirements across multiple clearers and bilateral
counterparties
As a result, the continued use of OTC contracts will generate higher funding require-
ments for corporations, pension funds and asset managers. All this while liquidity remains
scarce.
How much bigger will collateral funding requirements be?
Beyond collateral optimisation procedures, what options should institutional investors
consider?
30
ISDA Margin Survey 2011 Growth of collateral agreements reported by respondents as of year end, 1999-2010
200,000 Key:
reported agreements
150,000
Collateral agreements reported by respondents
100,000
50,000
0
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
ISDA Margin Survey 2011: Growth in value of total reported and estimated collateral, 2000-2010 (USD billions)
4,000 Key
Reported
Estimated
3,500
3,000
Value of total and estimated collateral (USD billions)
2,500
2,000
1,500
1,000
500
0
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
31
Part 2: The impact on investment managers’ operations, financing needs and risk policies
Swap Dealer Swap Dealer Swap Dealer/Major Swap Swap Dealer/Major Swap Participant
Transaction to to Participant to
parties Swap Dealer Major Swap to Non financial entity
Participant financial entity
Mandatory collateral Mandatory collateral Mandatory collateral
• 99% 10 days Initial Margin • 99% 10 days Initial Margin • Initial Margin, Variation Margin and
Margin or Alternative method threshold at discretion
requirement or Alternative method
• Variation Margin • Variation Margin
• Zero threshold • Zero threshold except for
• 100 000 USD MTA certain types of financial
entities (under comment
sollicitation)
In practice, especially outside the US, clearers will have the option
to adopt a more flexible approach. This is very likely when it comes
to large investors or at least significant clients, whose business is
strategic enough for the clearer to decide not to adopt the CCPs’
restrictive criteria. In such cases, clearers would post the full
collateral called by the CCP on behalf of its client but not request
the corresponding amount from the latter. The adoption of such
arrangement is likely to remain limited to a handful of key names
and only few investors will be in a position to benefit from it.
32
maturity. Moreover they tend to be fully invested with large pools of
securities and little cash and the eligibility restrictions on variation
margin will mean raising cash through collateral transformation.
This heightens the impact on performance and returns.
Examples of initial margin requirements by CCPs on IRSs and CDSs (single trades)
Some of the world’s leading CCPs have been quick to size the
opportunity. In the US, ICE Clear Credit has already expanded its
substantial business clearing credit default swaps to the inter-
dealer market. In Europe, ICE Clear Europe, Eurex and Clearnet
SA have also cleared CDS trades. ICE Clear Europe, with dealers
firmly behind it, has processed almost 95% of Europe’s inter-dealer
volume. CME is looking to handle interest rate swap (IRS) clearing,
and SwapClear, part of LCH.Clearnet Ltd, is eyeing the US market.
33
Part 2: The impact on investment managers’ operations, financing needs and risk policies
Tension is expected around the question of collateral sourcing. In a situation of scarce liquidity,
stricter eligibility rules and increased amounts of collateral locked in with CCPs, not all
institutions will be treated equally. As often in competitive markets, the laws of natural
selection will apply: large counterparties will be able to take advantage of their size to grow
bigger, and smaller institutions will find it harder to obtain the flexibility they need.
34
A model in which the CCP calculates margins required to OTC
clearers at each final client level is likely to emerge. There is
one other possibility: regulations may authorise an OTC clearer
to net positions against the CCPs across all its clients. This last
model, inspired from the listed derivatives world, may not be
the one preferred by the regulators as it would not guarantee
the portability principles and the segregation of margins of a
clearer’s client in case another client of that clearer defaults.
However positive the netting effect, and putting aside the benefits
of proper management of back-loading, institutional investors will
look for additional sources to reduce their funding requirements.
OTC clearers who can also act as custodians will be able to bring
that additional level of sourcing, using transformation solutions.
Because they have access to the client’s full range of assets, custodians
can measure a client’s liquidity and credit profile at any moment.
There is no need to pre-fund a collateral account, adding needed
flexibility to the process. We expect institutional investors to turn
towards OTC clearers who can also act as custodians to maximise the
benefits of collateral transformation. It helps that many custodians
already have financing, securities lending or repo capability.
35
Part 2: The impact on investment managers’ operations, financing needs and risk policies
Backloading
Indeed, the first cleared trade will depend on an enforcement date of the
regulations, regardless of the client’s general hedging strategy. This first
cleared trade, on a stand-alone basis, may imply significant collateral
requirements. To avoid this, the client could decide to backload part of
its portfolio to achieve a delta-neutral position and the netting effect.
The volumes of collateral required will increase and at the same time a growing portion will
be tied up in CCPs, thus making resource even scarcer. In this context, investors will have to
optimise three main options:
1 Choose a set-up with far fewer clearers than executing brokers so as to maximise the
netting effect
2 Seek clearers who can work with custodians and help transform collateral
3 Work with a collateral agent to achieve maximum collateral optimisation
Astute backloading management will also help reduce collateral needs in the short term.
36
2.3 A new paradigm for counterparty risk
Market reforms will raise new risks. Institutional investors will encounter risk from executing
brokers in their role as counterparty. There will also be heightened risk from CCPs and, to
a lesser extent, clearers. What segregation model should investors favour and what is the
best compromise between protection and operational efficiency?
Client 1
initial margins
Clearing member clients Clearing member clients
omnibus account omnibus account
Client 2
initial margins
37
Part 2: The impact on investment managers’ operations, financing needs and risk policies
Clients’ assets are held in the same omnibus account, but collateral
is legally attributable to each customer’s contracts. That collateral
is on loan to a customer, and is treated as belonging to the customer
at the CCP level, but as a debt at the clearing member level.
And the CCP could only use the clearing member clients’ assets if all
other clearing member default funds and its own capital have been used
38
However, non-defaulting clients’ collateral is only at risk in very large
defaults, when other clearing member default funds are needed.
The LSOC and Waterfall Models offer much more protection than the
Baseline Model. They are similar operationally in that all collateral
between the clearer and the CCP flows into a single omnibus
structure. However, they demand different levels of effort by the CCP
to guarantee client segregation and portability when defaults occur.
39
Part 2: The impact on investment managers’ operations, financing needs and risk policies
The buy-side will assess the risk of its OTC bilateral counterparties the
way it always has. And not all OTC trades will be eligible for central
clearing. An OTC clearer may be entitled to additional margin from its
final client. That will depend on the clearer’s credit risk assessment of
its clients. The client may also be called upon to provide the clearer
with a buffer to cover CCP intraday margin call requirements.
Last but not least, CCP clearing may go a long way toward protecting
OTC derivatives markets from systemic risk. This hardly means,
however, that systemic risk should merely be passed along to central
counterparties. Central counterparties must be properly regulated.
Their eligibility must depend on their proven ability to manage
risk for products that are sufficiently standardised and liquid.
Regulation should help promote the balance between mutualisation of risk and asset protection.
It should also take account of the OTC market’s distinct characteristics, notably that it is less
liquid than the market for listed derivatives. The point is to offer clients and their clearing
members the flexibility to choose the model that suits them best. While corporates and
institutional investors must look at the choice of model from their own perspective, LSOC
seems to strike the right balance between operational simplicity and client margin protection.
Regulations are increasingly pushing for monitoring counterparty risk in real time. In parallel,
the co-existence of cleared and non-cleared OTC derivatives is increasing the number of
counterparties to deal with.
What approach should institutional investors adopt?
40
institutional investors, not only banks, have now to take risk
management very seriously. Practically, this means computing
and monitoring counterparty risk exposure in real time.
41
Next
steps
Faced with such wide-ranging changes in the structure of the OTC
derivatives market, institutional investors now need to focus on a
large number of issues. These fall within three areas: operational,
funding and counterparty risk, as shown in the table below.
Impacts Actions
Operational Documentation • Signing new set of documentation for cleared OTCs with
clearing broker
• Signing a collateral agreement
Connecting to SEFs • Build a technical connection to new or existing execution
platforms, or enter into relationship with a dealing desk
that has links with the execution platforms, to search for
best execution
• Register as a market participant, completing the legal
documentation required by both the platforms and the
regulators
Connecting to affirmation/ • Build a connection to existing affirmation platforms
confirmation platforms • Review the operational model and process
• Consider using an external service provider to manage
the entire scope of connection and process the trades on
behalf of institutional investors
Connecting to trade • Connect to trade repositories depending on the regulation
repositories
Back-office adaptation • Define a policy on the interfacing with clearers
• Define the internal distribution of data to relevant
departments
• Adapt back office, accounting and collateral infrastructure
and organisation
• Connect to trade repositories depending on the regulation
OTC derivatives valuation • Counter-check CCP prices, using robust valuation process
and independent sources
• For complex instruments, delegate to 3rd party middle-
office providers
• Use Credit Value Adjustment pricing process at portfolio
level, prior to trade execution
Collateral management • Review the clearer’s reporting/ask for customisation
set-up • Adapt collateral management infrastructure and
organization
• Implement a portfolio reconciliation process
• Adapt the dispute procedures to the Dispute Resolution
Convention and Market Polling Procedure
• Increase STP level with counterparties and custodians
• For big portfolios, define a portfolio compression strategy
Clearer selection • Evaluate credit rating
• Check quality of relationship
• Check operational expertise
• Negotiate fees and cost structure
• Negotiate risk policy (intraday margining and credit
limits)
Funding Clearer selection, • Choose a set-up with fewer clearers than executing
collateral optimisation and brokers so as to maximise the netting effect
transformation • Seek clearers who can work with custodians and help
transform collateral
• Work with a collateral agent to achieve maximum
collateral optimisation
Counterparty Collateral protection • Define the best collateral segregation structures with
risk clearers and third-party custodians
Counterparty risk • Adapt counterparty risk processes to the portfolio
measurement bifurcation, with differentiated treatment of cleared OTC
derivatives
43
About
BNP Paribas
45
About BNP Paribas
Present across Europe through all its business lines, the Group
has four domestic retail banking markets in France, Italy,
Belgium and Luxembourg. It has one of the largest international
networks with operations in more than 80 countries and
205,300 employees, including 162,500 in Europe, 15,200
in North America and 12,500 in Asia (30 June 2011).
46
A leader in the derivatives industry
With a dedicated and experienced team of 100 collateral
management and OTC derivatives reconciliation specialists, together
with best-of-breed technology, BNP Paribas manages one of the
world’s largest collateral flows and number of counterparties.
As member of the International Swaps and Derivatives Association
board and as participant in CCPs for OTC derivatives clearing,
BNP Paribas actively contributes to shaping the industry and is
consistently recognised as an award-winning derivatives house:
Equity Derivatives House of the Year (Risk
Magazine 2009, Euromoney 2010)
Other broker- BNP Paribas Other broker- BNP Paribas Other broker- BNP Paribas
Execution CIB CIB dealers CIB
dealers dealers
Other broker- BNP Paribas Other BNP Paribas Other BNP Paribas
Reporting dealers CIB clearers CIB clearers Securities Services
Joint reporting on cleared trades for clients of
BNP Paribas CIB and Securities Services
Post-trade Trade support BNP Paribas Securities Services BNP Paribas Securities Services
47
Glossary
Backloading
The action of clearing already existing bilateral OTC derivatives positions.
Collateral management
Typically, two parties enter into an OTC transaction under an Agreement
(ISDA framework mainly) that specifies the contractual relationship
between the two parties. As part of this Agreement, a specific document
(Credit Support Annex/Deed under the ISDA framework) stipulates
that some collateral will be exchanged between them to mitigate
counterparty risk. Collateral, in the form of cash or securities, is
mainly exchanged on the basis of the variation in the value of the
exposure between the parties (value of all OTC contracts under the
Agreement). This is often referred to as Variation Margin. In addition,
Independent Amounts can be requested by one of the parties.
Commitment approach
The method used to calculate the exposure of a portfolio by adding
the value of direct positions to the value of the underlying positions
for all derivative transactions associated to the portfolio. For
example, the exposure associated to a CDS for €1 million of stock
translates into an exposure of the same amount - instead of only
the one associated with the collateral posted to take the position.
Excess margin
This represents an additional amount coming on top of the margin
call as established by the CCP or by usual valuation method.
Financial entity
This type of entity, defined in the CFTC proposed rule as of 28 April
2010, is a counterparty that is not a swap dealer or a major swap
participant. A financial entity is: (1) a commodity pool as defined
in Section 1a(5) of the Act, (2) a private fund as defined in Section
202(a) of the Investment Advisors Act of 1940, (3) an employee-
benefit plan as defined in paragraphs (3) and (32) of section 3 of
the Employee Retirement Income and Security Act of 1974, (4) a
person predominantly engaged in activities that are in the business
of banking, or in activities that are financial in nature as defined
in Section 4(k) of the Bank Holding Company Act of 1956, (5) a
person who would be a financial entity described in paragraph
(1) or (2) if his activities were organised under the laws of the
United States or any State thereof; (6) the government of any
foreign country or a political subdivision, agency, or instrumentality
thereof; or (7) any other person the Commission may designate.
49
Glossary
Grandfathering/grandfather clause
A legal term used to describe a situation in which an old rule
continues to apply to some existing situations, while a new rule
will apply to all future situations. It is often used as a verb: to
grandfather means to grant such an exemption. Frequently,
the exemption is limited; it may extend for a set period of
time, or it may be lost under certain circumstances.
Independent Amount
The collateral that is delivered by end-users to dealers to protect them
from credit exposure. It can be any amount that the parties agree,
but it is typically expressed as a fixed currency amount, a percentage
of the notional principal amount, or a computation of value-at-risk.
Independent Amounts can be defined at the level of the portfolio
of transactions between two parties, or can be defined uniquely for
each individual transaction. It can also be zero. (See initial margin.)
50
Margin call
An investor receives a margin call from a broker or clearer
(cleared OTC) if one or more of the securities it has bought
(with borrowed money) decreased in value past a certain
point. The investor is then forced either to deposit more
money in the account or to sell off some of its assets.
Portfolio compression
A process that reduces the overall size (notional value) and the number
of line items in credit portfolios, without changing the risk parameters
of the portfolio. The method includes a selection of multiple trades
having equivalent terms and a determination of the net notional
and net coupon. Replacement trades are created, the combined net
notional and combined net coupon of which respectively equal the net
notional and the net coupon of the multiple trades being replaced. A
position-matching method is implemented for portfolio compression.
An implied spread is calculated for each position of a portfolio.
Positions with an implied spread outside desired bounds are corrected.
A buyer and a seller are selected, the buyer having the position with
the highest implied spread value of all net long positions and the
seller of all net short protection positions. The created trade has a
notional value equal to the smaller of the net default exposure and
a spread mirroring the implied spread but with a smaller position.
Transformation solutions
Solutions that allow the substitution of assets not eligible as collateral,
via financing or collateral upgrade, to assets that are eligible as collateral.
Variation margin
Variation margin is paid by clearing members on a daily or
intraday basis in order to reduce the exposure created by carrying
highly risky positions. By demanding variation margin from its
members, clearing organisations are able to maintain a suitable
level of risk and cushions against significant devaluations.
51
Contacts
BNP Paribas Securities Services
Helene Virello, Head of collateral management services
and OTC independent valuation services
Helene.virello@bnpparibas.com
+33 1 57 43 85 24
Gavin.dixon@bnpparibas.com
53
Printed on recycled paper by Edit’O verso - Designed by the graphics department, corporate communications, BNP Paribas Securities Services - September 2011
The services described in this document are offered through a joint venture between BNP Paribas Securities Services
(“Securities Services”), a wholly owned subsidiary of BNP Paribas S.A., and the Global Equities and Commodity Derivatives
and Fixed Income business lines of BNP Paribas S.A. (“BNPP”). BNP Paribas Securities Services is incorporated in France
as a Partnership Limited by Shares and is authorised by the Autorité de Contrôle Prudentiel (the “ACP”) and supervised by
the Autorité des Marchés Financiers (the “AMF”). BNP Paribas S.A. is incorporated in France with limited liability and is
authorised and supervised by the ACP for the conduct of its investment business in France. It is also subject to authorisa-
tion and regulation in other jurisdictions as described further below.
This document is CONFIDENTIAL AND FOR DISCUSSION PURPOSES ONLY and has been prepared for professional investors
by BNPP and Securities Services. This document contains general information only and recipients should note that in
providing this document, BNPP and Securities Services are not providing any financial, legal, tax, regulatory or other type
of advice. This document does not constitute an offer or a solicitation to engage in any trading strategy or to purchase
or sell any financial instruments (“Financial Instruments”). Given its general nature, the information included in this
document does not contain all of the elements that may be relevant for a recipient to make an informed decision in
relation to any strategies or Financial Instruments or services discussed herein. For the avoidance of doubt, the provision
of any information in this document by BNPP and Securities Services does not represent the formation of an agreement
between BNPP, Securities Services and any recipients. Any strategies or Financial Instruments discussed in this document
could involve the use of derivatives, which are complex in nature and may give rise to substantial risks, including the risk
of total loss of any investment. BNPP and Securities Services make no representation as to whether any of the strategies
or Financial Instruments discussed herein may be suitable for recipients’ financial needs or individual circumstances.
Recipients must make their own assessment of the risks inherent in, and the suitability of, any such strategies and/or
Financial Instruments, using such professional advisors as they may require. BNPP and Securities Services accept no liability
for any direct or consequential losses arising from any action taken in connection with the information contained in this
document.
This document is a marketing communication and does not constitute independent research or financial or other advice.
Information contained in this document may have been obtained from third party sources believed to be reliable. BNPP
and Securities Services make no representation, express or implied, that any such third party information is accurate or
complete. Any opinions and/or estimates contained herein constitute the judgment of BNPP and/or Securities Services and
are subject to change without notice. BNPP, Securities Services and their respective subsidiaries and affiliates accept no
liability for any such opinions or estimates or any errors or omissions contained within this document.
This document is prepared for eligible counterparties and professional clients only, is not intended for retails clients and
should not be circulated to any such retail clients (as such terms are defined in the Markets in Financial Instruments
Directive 2004/39/EC). It may not be reproduced (in whole or in part), delivered or otherwise communicated to any other
person without the prior written consent of BNPP and Securities Services. BNP Paribas London Branch (registered office:
10 Harewood Avenue, London NW1 6AA; tel: [44 20] 7595 2000; fax: [44 20] 7595 2555) is authorised and supervised by
the ACP and is authorised and subject to limited regulation by the Financial Services Authority. Details of the extent of our
authorisation and regulation by the Financial Services Authority are available from us on request. BNP Paribas London
Branch is registered in England and Wales under no. FC13447.
www.bnpparibas.com
© BNP Paribas & BNP Paribas Securities Services (2011). All rights reserved.