Managing cash as collateral
A middle office approach to collateral management
Daniel Burgos Zarazo September 2009

1. The role of energy firms as cash managers
1.1 Some background on underlyings
Commodity and credit derivative events grow
Interest rate derivatives' grow too but equity and forex decline

1. The role of energy firms as cash managers
1.2 Use of credit support docummentation
Credit risk/operational risk of trading similar for non-energy OTC
Percentage of reported energy trades covered by CSA kinked

1. The role of energy firms as cash managers
1.3 Extent of exposure collateralization
Exposure collateralization is stronger than trade volume
Transactions that are collateralized are more heavily so
Cash has moved from energy to other derivatives

1. The role of energy firms as cash managers
1.3 Extent of exposure collateralization
Cash is circa 83% of collateral!
Increase in use of government securities and cash,
decline of other such as corporate bonds and equity

2. Cash flow netting as efficient collateral management
2.1 Background
"The growth of privately negotiated derivatives markets has led to large,
variable credit exposures".
"These credit exposures are substantially reduced through the netting of
these obligations under master agreements and the collateralisation of the
remaining exposures".
"Netting and collateralisation are keys to maintaining the stability of the
international markets and preventing cascading insolvencies in jurisdictions
around the world resulting from the failure of a major participant around the
world".
"Netting and collateralisation can only achieve these ends, however, if the
parties can be certain that the terms of their netting and support agreements
will be upheld in the relevant jurisdictions."
Source: The ISDA 2002 model netting act

2. Cash flow netting as efficient collateral management
2.2 How it works
"The loss a party will experience from the default of a counterparty is
equivalent to the cost of replacing the transaction, less any
recovery".
"The replacement cost for a derivatives transaction represents the
present value, at the time of default, of the expected future net cash
flows" those cash flows fluctuate over time with significant volatility.
The use of bilatelal netting allows firms to calculate counterparty
exposure with respect to derivatives master agreements on a net
basis with reduced risks and costs in comparison with multiple
settlement gross transactions.
Source: The ISDA 2002 model netting act

2. Cash flow netting as efficient collateral management
2.3 Practical points: Cherry picking
"The term "cherry picking" refers to a power that some insolvency
officials have under the insolvency laws of certain jurisdictions to
reject certain contracts burdensome to the insolvent party while
affirming contracts beneficial to the insolvent party."
Netting overcomes this problem "by making it clear that the master
agreement and all transactions entered under it constitute a single
agreement between the parties which must therefore be affirmed or
rejected as a whole by the insolvency official".
Source: The ISDA 2002 model netting act

2. Cash flow netting as efficient collateral management
2.4 Practical points: Systemic risk
"Market participants face a considerable exposure to risks
stemming from the failure of a major market participant causing
cascading insolvencies."
"Netting considerably lessens this consequential effect by reducing
counterparty exposure at each node in the network (...) and by
encouraging best practices".
A reduction in systemic risk means a possibility to leverage further!
Source: The ISDA 2002 model netting act

2. Cash flow netting as efficient collateral management
2.5 Practical points: Multibranch close-out netting
Multibranch netting provisions reduce the amount of cash flowing by
requiring money to move "to or from one of the counterparties, regardless
of the branch through which any or all of the transactions are booked".
2.6 Practical points: Impact of cash flow netting on collaterallization
"Collateral arrangements are entered into mainly as a method of credit
enhancement to cut the credit risk remaining under derivatives master
agreements once the effects of close-out netting are taken into account."
"Collateralisation reduces the capital adequacy risk weighting of
exposures under derivatives transactions to the risk weighting of collateral
itself."
Source: The ISDA 2002 model netting act

2. Cash flow netting as efficient collateral management
2.7 Enforceability of netting and collateral arrangements
It's important to "not only have a netting agreement in place, but also
obtain a legal opinion stating that that netting agreement will be upheld in
all relevant jurisdictions."
Also time and resources needed to ensure or execute enforceable
agreements must be noted both for counterparties and the firm itself.
Source: The ISDA 2002 model netting act

2. Cash flow netting as efficient collateral management
2.8 Implementation
"Since 1989 laws expressively protecting the enforceability of netting
for privately negotiated derivatives transactions in local insolvency
proceedings have been enacted in many jurisdictions."
Check with your legal consel or trade association!
Depending on implementation:
Netting legislation may be sketchy "very technical and hardly
accessible to non-specialist lawyers.
or "generally confirm the effectiveness of close-out netting and the
various intermediate steps".
Sources: The ISDA 2002 Model Netting act
March 2006 memo of implementation

3. Time and market valuation and execution constraints of
collateralized energy transactions
3.1 General automation considerations

3. Time and market valuation and execution constraints of
collateralized energy transactions
3.1 General automation considerations

3. Time and market valuation and execution constraints of
collateralized energy transactions
3.1 General automation considerations

3. Time and market valuation and execution constraints of
collateralized energy transactions
3.1 General automation considerations

3. Time and market valuation and execution constraints of
collateralized energy transactions
3.2 Errors in trade capture
Around 10% of commodity derivatives' trade records had to be amended in 2009 (12% for
credit) of which 54% were attributable to the front office (49% in credit).

3. Time and market valuation and execution constraints of
collateralized energy transactions
3.3 Automation in electronic confirmations

3. Time and market valuation and execution constraints of
collateralized energy transactions
3.4 Automation in electronic confirmations

3. Time and market valuation and execution constraints of
collateralized energy transactions
3.4 Other time factors in electronic confirmations

3. Time and market valuation and execution constraints of
collateralized energy transactions
3.5 Achievements in confirmation processing times

3. Time and market valuation and execution constraints of
collateralized energy transactions
3.6 Criteria used to prioritize outstanding confirmations

3. Time and market valuation and execution constraints of
collateralized energy transactions
3.7 Trade affirmation benchmarking

3. Time and market valuation and execution constraints of
collateralized energy transactions
3.7 Trade affirmation benchmarking

3. Time and market valuation and execution constraints of
collateralized energy transactions
3.8 Settlements

3. Time and market valuation and execution constraints of
collateralized energy transactions
3.8 Settlements

3. Time and market valuation and execution constraints of
collateralized energy transactions
3.9 Nostro breaks
Breaks are typically reconciled within 3 to 5 days

4. Offshore business centres and cash management

4. Offshore business centres and cash management
What support services do you require from the OBC?
Underlying: some OBC's are more familiar with certain industries which
should translate to cost advantages if support requirements are important
Technical capabilities like IT infrastructure/affinity with communication
nodes
Counterparts: are they accepting or at synergy with your OBC choice?
Legal/diplomatic relations with non-OBC markets

Managing cash as collateral
A middle office approach to collateral management
Thank you for your interest!
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