UNDERSTANDING COLLATERAL FOR OTC DERIVATIVES

Christopher Moores

FOREX ASSOCIATION OF INDIA Seminar on the Credit Support Annex 6th April 2013
STRICTLY PRIVATE AND CONFIDENTIAL

English_General

UNDERSTANDING COLLATERAL FOR OTC DERIVATIVES

J.P. Morgan is a marketing name for investment banking businesses of JPMorgan Chase & Co. and its subsidiaries worldwide. Securities, syndicated loan arranging, financial advisory and other investment banking activities are performed by a combination of J.P. Morgan Securities LLC, J.P. Morgan Limited, J.P. Morgan Securities Ltd. and the appropriately licensed subsidiaries of JPMorgan Chase & Co. in EMEA and Asia-Pacific, and lending, derivatives and other commercial banking activities are performed by JPMorgan Chase Bank, N.A. J.P. Morgan deal team members may be employees of any of the foregoing entities.

FOREX ASSOCIATION OF INDIA

Agenda

OTC Derivatives Collateral - Introduction and Basics

OTC Derivatives Collateral - Legal Concepts and Agreement Parameters

DERIVATIVES

OTC Derivatives Collateral - Collateral Assets

18

OTC Derivatives Collateral - The Operational Process

21

UNDERSTANDING COLLATERAL FOR OTC

FOREX ASSOCIATION OF INDIA

Collateral Risk Management - Risk Mitigation and Transformation

Clients
UNDERSTANDING COLLATERAL FOR OTC DERIVATIVES

Sales & Trading

Liquidity

Collateral Operations (Service)

Collateral Risk Mgmt

Credit

Legal

FOREX ASSOCIATION OF INDIA

What is Collateral?

Collateral Assets of quantifiable value, delivered by one party for the benefit of a second party, pursuant to a formal legal agreement between the two, with the intention of providing the second party with recourse to those assets in the event of default of the first party, in the expectation that the liquidated value of the assets will defray any loss suffered by the second party.

UNDERSTANDING COLLATERAL FOR OTC DERIVATIVES

Portfolio Collateralisation A credit enhancement mechanism used to reduce or mitigate credit risk Limits the credit exposure of both parties across a diversified portfolio of derivatives - typically all products covered by the ISDA Master Agreement The net market value of the portfolio is reviewed (usually on a daily basis), and if necessary, the Out-of-the-money party transfers collateral to the In-the-money party Documented under the ISDA Credit Support Annex

FOREX ASSOCIATION OF INDIA

Executive Summary
Collateral is the most effective risk mitigation tool for derivative transactions

1
UNDERSTANDING COLLATERAL FOR OTC DERIVATIVES

What is collateral and why is it beneficial?

Risk mitigation tool which offers mutual protection

It allows each party to receive cash/securities as guarantee of payment of the Mark-to-Market (MTM) of a derivative Collateral protects each party against a default of the other, reducing the risk of entering into derivatives Reduced counterparty risk means enhanced capacity to trade greater volume, complexity and tenor. Lower capital requirements and lower trading costs for both parties

Added benefits

How is a collateral relationship established and what are the key parameters?

ISDA + Credit Support Annex (CSA)

All the terms of the collateral relationship are agreed in the Credit Support Annex (CSA), which is an attachment to the ISDA Master Agreement There are a number of key collateral terms that are flexible and subject to negotiation between the parties

How does collateral work mechanically?

Who calls for collateral and when?

The party who is In-The-Money on each Collateral Valuation Date has the right (not the obligation) to make a Collateral Call on the other party. There are ways to reduce the operational burden on parties

FOREX ASSOCIATION OF INDIA

The Basics: Credit Exposure (i)

Typically a Bank Dealer stands in the middle between two counterparties

Pay Floating Pay Fixed

Counterparty
UNDERSTANDING COLLATERAL FOR OTC DERIVATIVES

A
Receive Floating Interest Rate Swap MTM is zero at inception
Let us assume now that interest rates fall

Bank
Receive Fixed

Counterparty B

Interest Rate Swap MTM is zero at inception

Counterparty A

Pay Fixed

Pay Floating

Bank
Receive Floating Receive Fixed

Counterparty B

Bank is out-of-the-money MTM = negative $10m

Bank is in-the-money MTM = positive $10m

FOREX ASSOCIATION OF INDIA

The Basics: Credit Exposure (ii)

Let us assume that Counterparty B defaults at that particular moment in time

Counterparty
UNDERSTANDING COLLATERAL FOR OTC DERIVATIVES

Pay Fixed

Pay Floating

A
Receive Floating

Bank
Receive Fixed

Counterparty B

Bank is out-of-the-money MTM = negative $10m

the Bank is then left with just one side, where it is out-of-the-money

Bank is in-the-money MTM = positive $10m

Counterparty A

Pay Fixed

Bank will no longer receive the payment of $10m from Counterparty B, but will still have to honour the $10m payment to Counterparty A

Bank
Receive Floating

That means that Bank loses $10m upon default of Counterparty B. That is our Credit Exposure to Counterparty B as of today

Bank is out-of-the-money MTM = negative $10m

FOREX ASSOCIATION OF INDIA

Collateral in more depth

Collateral Reduces Credit Exposure Collateralisation protects

Derivatives generate Credit Exposure

Exposure Credit Limit / appetite

If our counterparty defaults half way down the life of the trade

Without Collateral

UNDERSTANDING COLLATERAL FOR OTC DERIVATIVES

Loss
Time Time

Collateralisation reduces Credit Exposure, allowing for: Significant Credit Risk reduction More trades under the same credit appetite More complex structures / longer tenors, etc. With Collateral in place, your new exposure curve appears as follows:
Exposure Without Collateral Credit Limit / appetite With Collateral Time

With Collateral With Collateral Time

Reduced Credit Exposure also means.

Better Credit Pricing (Lower CVA): because the level of expected exposure is lower, so are the costs of hedging that exposure in the CDS market Lower Capital Requirements for the same Derivatives portfolio

FOREX ASSOCIATION OF INDIA

Agenda

OTC Derivatives Collateral - Introduction and Basics

OTC Derivatives Collateral - Legal Concepts and Agreement Parameters

DERIVATIVES

OTC Derivatives Collateral - Collateral Assets

18

OTC Derivatives Collateral - The Operational Process

21

UNDERSTANDING COLLATERAL FOR OTC

FOREX ASSOCIATION OF INDIA

Collateral Agreements: The Credit Support Annex (CSA)

Title Transfer CSA Security Interest (Pledge) CSA

Ownership of the Collateral moves (transfers) from the Collateral poster to the Collateral receiver following each Collateral call This facilitates rehypothecation (re-use of collateral received under one agreement to post it under a different agreement). This re-use can avoid sourcing costs and provide liquidity Preferred approach in many jurisdictions, however dependent on close-out netting and can be subject to recharacterisation Most common version: English Law CSA

Title/Ownership of the Collateral stays with the Collateral poster, even though the assets typically move between the parties Rehypothecation is more difficult, as explicit consent required from the legal owner of the Collateral. This may increase funding costs and reduce liquidity In some jurisdictions procedural requirements applicable to the creation and perfection of security interests reduce legal confidence Most common version: NY Law CSA

UNDERSTANDING COLLATERAL FOR OTC DERIVATIVES

Important

Both types practically work in the same way from an operational / mechanical point of view: one party calls and the other delivers the Collateral, which physically changes hands The main difference between the two is the Legal concept underlying the collateral moves Some jurisdictions might recognise the validity of one type but not the other. Banks and Dealers typically establish Collateral and Netting Confidence Factors by jurisdiction and counterparty types.

FOREX ASSOCIATION OF INDIA

What happens upon Bankruptcy of a Counterparty?

Key driver: Country of Incorporation

ISDA+CSA
UNDERSTANDING COLLATERAL FOR OTC DERIVATIVES

(English Law)

UK Incorporated Bank

Derivative trading

Indian Bank Incorporated in India

Let us assume that a UK Bank is trading with an Indian Bank under an English Law ISDA & CSA If the Indian Bank goes bankrupt, courts in India will deal with the bankruptcy proceedings and decide what needs to happen with the banks assets and liabilities according to Indian Law It is therefore crucial that the validity of that particular ISDA agreement is fully recognised by Indian Law If the English Law ISDA+CSA agreement (in particular the Close-Out Netting provisions and the Collateral Title Transfer concept) are not fully recognised under the Indian insolvency proceedings, the impact on resulting exposure and loss could be very large indeed

FOREX ASSOCIATION OF INDIA

10

Parameters in a Collateral Agreement

General (usually a given)

Title Transfer / Security Interest

UNDERSTANDING COLLATERAL FOR OTC DERIVATIVES

Specific Terms (usually the object of negotiation between the parties)

Acceptable Collateral Assets and Haircuts Thresholds Minimum Transfer Amount (MTA ) and Rounding Valuation Frequency Independent Amounts Valuation Agent Interest Rates

FOREX ASSOCIATION OF INDIA

11

Threshold
Threshold = Unsecured Exposure

MTM

$5m
UNDERSTANDING COLLATERAL FOR OTC DERIVATIVES

The Threshold is the level that the MTM needs to reach before a party can make a Collateral Call Threshold For example, if the Threshold is $5m, until the MTM reaches $5m, no collateral calls will be made. Once that level is reached, the party who makes the collateral call, will only be able to call for the excess

t
No Collateral Calls would be made until this point in time Once the threshold level is surpassed, calls are made only on the amount above that level (i.e. if the MTM is $7m and the threshold is $5m, a collateral call is made for $2m only) Therefore the threshold is the level of unsecured exposure that one party takes towards the other (and in case of default it is potentially the loss level as well) Collateral

Threshold

FOREX ASSOCIATION OF INDIA

12

Minimum Transfer Amount (i)

Minimum Transfer Amount

MTM

Once the Threshold level has been surpassed, the Minimum Transfer Amount (MTA) comes into play Threshold The MTA is the minimum swing (in Mark to Market terms and with respect to the last time that collateral was moved) that is required for a Collateral call to be triggered An easy way to think about it is the minimum size of a Collateral Call: no Collateral calls can be made for lower amounts than the MTA

$5m
UNDERSTANDING COLLATERAL FOR OTC DERIVATIVES

t
Example

Assume a CSA with the following terms: Threshold = $5m MTA = $1m When will a Collateral call take place?

MTM
Day 1 MTM = $2m

Day 3 MTM = $5.5m

Day 5 MTM = $7m

Day 2 MTM = $1m

Day 4 MTM = $4m

FOREX ASSOCIATION OF INDIA

13

Minimum Transfer Amount (ii)

Threshold = $5m , MTA = $0

MTM
Collateral

A low MTA allows us to react very quickly to small changes in MTM but the $5m threshold means that we will never be able to call for the first $5m of exposure

$5m
UNDERSTANDING COLLATERAL FOR OTC DERIVATIVES

We will never be able to call for these $5m

t
Threshold = $0m , MTA = $5

MTM $5m
Collateral

Until the MTM reaches $5m, both arrangements yield the same result (no collateral calls) but as soon as the MTM is over that level, we will be able to call for the full exposure although we will have to wait for the MTM to move by another $5m to call again

FOREX ASSOCIATION OF INDIA

14

Interest Rate Payable on Cash Collateral Balance

The party who posts Cash collateral receives an Interest Rate based remuneration on the balance posted

Independent Amounts

Collateral ($)

Counterparty
UNDERSTANDING COLLATERAL FOR OTC DERIVATIVES

Bank Collateral

Interest (Fed Funds O/N)

Deposit

Interest rate

Fed Funds O/N rate

Funding ($)

Counterpartys Bank / Custodian Treasury Desk

Bank Treasury Desk

Fed Funds (for USD), EONIA (for Euros), SONIA (for Sterling) , MIBOR (for INR), OIS Rates This happens regardless of the CSA type (Title Transfer / Security Interest) Negative spread to OIS rates are rarely agreed Negative Rates? Flooring?

FOREX ASSOCIATION OF INDIA

15

Other Parameters in a CSA

Valuation Frequency

Independent Amounts

Valuation Agent

UNDERSTANDING COLLATERAL FOR OTC DERIVATIVES

The Valuation Frequency is simply how often both parties will look at the MTM and perform the Collateral Calculations If the valuation frequency is weekly or monthly, no Collateral Calls take place in between (Discuss Adhoc rights) The valuation frequency does not necessarily have to be equal to frequency of the calls (i.e. the valuation frequency might be daily, for example, but if the MTM does not move by a large enough amount, there will not be a daily collateral call)

Upfront collateral amounts that are only applicable to particular trades (i.e. when selling options, for example) These are generally negotiated on a case by case basis when trading each product Always included in Bank/Dealer Collateral Agreements with Hedge Funds

The valuation agent is responsible for making the Collateral requirement calculations As per standard, the valuation agent is the party making the demand A party acting as a sole valuation agent, will typically provide its Counterparty with a (daily) statement regardless of whether they are calling for collateral or not. Otherwise, a statement will typically only be sent when a party is calling

FOREX ASSOCIATION OF INDIA

16

Considerations
Considerations Parameters When to use them and how

How much unsecured appetite does Credit have for this counterparty?
UNDERSTANDING COLLATERAL FOR OTC DERIVATIVES

Threshold

If Credit Appetite is high for the cpty, you might be comfortable with some unsecured threshold Sometimes your counterparty will not be concerned about your creditworthiness or might not want to receive collateral from you The counterparty will be a natural holder of some assets, while it might be difficult for them to handle other asset types The more volatile your portfolio is, the more frequently you will want to be able to call for collateral The lower the MTA, the more often you will be able to call for collateral Clients who are not used / are unable to handle collateral might ask you to be the Valuation agent under the CSA You can establish special measures to further minimize credit risk
17

What is your counterpartys Credit appetite to you? What collateral assets is the Counterparty likely to be posting? How volatile is your derivative portfolio likely to be with them?

Unilateral / bilateral CSA

Eligible collateral assets

Valuation frequency

How big in terms of MTM?

Minimum Transfer Amount

How geared-up is your counterparty to handle collateral? Would you like additional security measures?
FOREX ASSOCIATION OF INDIA

Valuation agent

Independent Amounts, same-day cash delivery

Agenda

OTC Derivatives Collateral - Introduction and Basics

OTC Derivatives Collateral - Legal Concepts and Agreement Parameters

DERIVATIVES

OTC Derivatives Collateral - Collateral Assets

18

OTC Derivatives Collateral - The Operational Process

21

UNDERSTANDING COLLATERAL FOR OTC

FOREX ASSOCIATION OF INDIA

18

Requirements of Collateral Assets

Key step in the Collateral Process is the Valuation of the Collateral Pool

Liquid - Cash and Cash equivalents Easily Transferable Observable daily prices
UNDERSTANDING COLLATERAL FOR OTC DERIVATIVES

Do Not consider: Hold ing Collateral Assets until maturity Marking Collateral to model
Examples to avoid

Structured Notes Typical situation: Bank/Dealer sells a structured note to a Client The Client is also a derivative counterparty under a CSA, and they want to post the note they just bought from the Bank /Dealer as Collateral under the CSA

CDO Tranches, Some ABS Securities, Some Fund Units Assets with limited liquidity / small market may not trade often enough to have a daily quoted price Some Fund Units are only redeemable during just one specific day of the week/month

FOREX ASSOCIATION OF INDIA

19

Haircuts / Valuation Percentages

Conclusions

A Haircut, graphically speaking

Market Value of instrument

Mathematically speaking

An example

Haircut UNDERSTANDING COLLATERAL FOR OTC DERIVATIVES Value given to the asset in $ terms
Value we attribute to that asset for collateral purposes

H = 1 year * 2 .32 * CP
Haircut = Average daily Vol for a 1 year period, stressed to 2.32 standard deviations times square root of days in the Cure Period

What you see in CSAs is actually the Valuation Percentage (1 less the Haircut)

The Price of a Bond converges to Par at Maturity

Key Takeaways The higher the Volatility of the asset, the higher the Haircut Price volatility of fixed income instruments decreases with time as they approach maturity and prices converge to par, so for longer maturities you get higher haircuts (therefore lower valuation percentages)

Par

Maturity

FOREX ASSOCIATION OF INDIA

20

Agenda

OTC Derivatives Collateral - Introduction and Basics

OTC Derivatives Collateral - Legal Concepts and Agreement Parameters

DERIVATIVES

OTC Derivatives Collateral - Collateral Assets

18

OTC Derivatives Collateral - The Operational Process

21

UNDERSTANDING COLLATERAL FOR OTC

FOREX ASSOCIATION OF INDIA

21

The Operational Process

UNDERSTANDING COLLATERAL FOR OTC DERIVATIVES

OTC Derivatives Portfolio valuation

Collateral valuation

Collateral requirement calculation

Communication

Verification

Movement of collateral

T+1

T+1

T+1

T+2

FOREX ASSOCIATION OF INDIA

22

Portfolio valuation

T+1 T+1 T+1 T+2

Gather Close of Business (CoB) mark-to-market information for each trade covered by the collateral agreement
UNDERSTANDING COLLATERAL FOR OTC DERIVATIVES

All OTC derivatives covered by the ISDA Master Agreement should be included, as failure to include certain types of product can expose either party to increased risk - avoid the temptation to exclude short term products FX Spot? Trades approaching maturity / settlement on T+1 or T+2 ? Trades novating to central clearing? Discuss CCIL Forward Segment Calculate the aggregate market value of the entire portfolio

FOREX ASSOCIATION OF INDIA

23

Collateral valuation

T+1 T+1 T+1 T+2

Calculate the collateral value of the assets currently posted

UNDERSTANDING COLLATERAL FOR OTC DERIVATIVES

FX timing for Cash if different from the CSA Base Currency Securities Collateral is valued dirty (including accrued coupon) before the appropriate haircut per the agreement is applied

FOREX ASSOCIATION OF INDIA

24

Collateral requirement calculation

T+1 T+1 T+1 T+2

Apply collateral parameters contained within the Credit Support Annex, such as thresholds, upfront amounts etc. to
UNDERSTANDING COLLATERAL FOR OTC DERIVATIVES

determine the MTM exposure to be collateralised The collateral value of assets held / posted is then compared to the exposure amount A collateral requirement figure will be calculated. If this figure is greater than the minimum transfer amount, collateral of sufficient value to cover the requirement (after the application of the appropriate haircut) must be transferred

FOREX ASSOCIATION OF INDIA

25

Communication

T+1 T+1 T+1 T+2

The collateral call information is communicated between parties

UNDERSTANDING COLLATERAL FOR OTC DERIVATIVES

On occasion both parties might present a demand A breakdown of the market values of the individual trades constituting the portfolio is provided to facilitate reconciliation, should the valuations prepared by the two parties differ Communication is typically via email with follow up telephone calls from Operations to Operations Avoid Sales or Relationship coverage involvement

FOREX ASSOCIATION OF INDIA

26

Reconciliation

T+1 T+1 T+1 T+2

Should discrepancies exist between the two parties collateral requirement calculations, the reconciliation process
UNDERSTANDING COLLATERAL FOR OTC DERIVATIVES

must begin The portfolio will be reviewed for obvious discrepancies such as different trade populations, significant differences in valuations of specific trades etc. Industry efforts to proactively reconcile the portfolio daily If the parties are unable to agree upon the valuations of certain trades, the dispute resolution mechanism which is outlined in the Credit Support Annex will be activated The key concept of the Undisputed Amount Oils the wheels of the CSA , provides ongoing feedback and level of comfort Robust processes to internally escalate disputes or non response

FOREX ASSOCIATION OF INDIA

27

Movement of collateral

T+1 T+1 T+1 T+2

Parties agree par values of the specific assets which they are going to deliver or return. These should not be altered
UNDERSTANDING COLLATERAL FOR OTC DERIVATIVES

once agreed Standard Settlement Instructions (SSIs) are usually established however this can be a cause for operational delay and risk for new agreements or those that remain inactive under a Threshold for a long time Trades included in MTM Exposure as of CoB T may be maturing on T+1 or T+2 Discuss? Avoid side arrangements to settle underlying trades out of proceeds of Collateral posted

FOREX ASSOCIATION OF INDIA

28

Movement of collateral (contd)

T+1 T+1 T+1 T+2

Collateral Operations confirm that the instructed delivery of assets has settled successfully
UNDERSTANDING COLLATERAL FOR OTC DERIVATIVES

Asia time zone - if the delivery was for example in USD you may not become aware of failure to deliver until T+3 Robust processes to internally escalate fails (Collateral Transfers and Underlying Trade settlements) Collateral holdings are updated in Collateral Systems and will be integrated in the calculations for a new statement

FOREX ASSOCIATION OF INDIA

29