Central Clearing - Implications for Collateral Management

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Central Clearing - Implications for Collateral Management

  1. 1. Central Clearing: Implications for Collateral Management Kenny Nicoll 4th September 2013
  2. 2. Teach-in Central Clearing: Implications for Collateral Management 4th September 2013 EMIR Update 2
  3. 3. Teach-in Central Clearing: Implications for Collateral Management 4th September 2013 3 EMIR regulations are an attempt by the G20 to reduce systemic risk in the banking system They aim to bring greater visibility of derivative positions and encourage standardisation In September 2009, the G20 committed to introducing the following changes to OTC derivative markets: 1. All OTC derivatives should be traded on electronic platforms 2. All derivative contracts should be reported to Trade Repositories 3. Where possible, derivatives should be cleared through Central Counterparties (CCP) 4. Non-centrally cleared derivatives should be subject to higher capital requirements EMIR is part of a globally co-ordinated effort to reduce risk in derivative markets: Europe US Electronic Execution MIFID Dodd-Frank Act Clearing EMIR Dodd-Frank Act Derivatives Reporting EMIR Dodd-Frank Act Capital Requirements for CPP Exposures Basel / CRD Basel Bilateral Margin for Non-Cleared Swaps Basel / IOSCO Basel / IOSCO Source: Morgan Stanley
  4. 4. Teach-in Central Clearing: Implications for Collateral Management 4th September 2013 EMIR: Key Dates Without an exemption in place, the impact of clearing could be as soon as Dec 2013 (front-loading date) 4 Source: European Securities and Markets Authority (ESMA) Q1 2013 Q2 2013 Q3 2013 Q4 2013 Q1 2014 Q2 2014 Q3 2014 Q4 2014 CCP application closes Earliest that the front- loading period could start (6m pre Go-Live) Clearing obligation starts for IRS Front-loading date: Swaps entered into after this point must be cleared following the go live date.
  5. 5. Teach-in Central Clearing: Implications for Collateral Management 4th September 2013 Liquidity Policy: an Overview 5
  6. 6. Teach-in Central Clearing: Implications for Collateral Management 4th September 2013 6 The key challenge for pension schemes is to establish a liquidity policy which allows for enough collateral in the world of Central Clearing while maintaining portfolio efficiency Liquidity Policy Backloading Exemption Collateral Management Product Mix / Portfolio Effects Monitoring and Rebalancing
  7. 7. Teach-in Central Clearing: Implications for Collateral Management 4th September 2013 Backloading 7
  8. 8. Teach-in Central Clearing: Implications for Collateral Management 4th September 2013 8 Backloading: Voluntarily deciding to novate legacy IRS into Clearing Backloading involves a tradeoff between credit risks and Clearing costs • Risk transfer to Clearing House (e.g. LCH) reduces credit exposure vs swap counterparties • Moving swaps into Clearing will carry cost implications with it (i.e. initial margin) -200 -100 - 100 200 300 400 500 600 700 800 A B C D Counterparty IRS (pv01) Inflation swap (ie01) TRS (pv01) Repo (pv01) -400 -200 - 200 400 600 800 1,000 1,200 1,400 1,600 A B C D LCH Counterparty IRS (pv01) Inflation swap (ie01) TRS (pv01) Repo (pv01) Sample Portfolio: Impact of Backloading IRS on RiskSample Portfolio: Risk per Counterparty
  9. 9. Teach-in Central Clearing: Implications for Collateral Management 4th September 2013 9 Variation Margin can be a source of cash, particularly where a scheme has a large number of counterparties or significant in-the-money swaps • Backloading in the money swaps can release cash (before initial margin impact in gilts) • Alternative: remain bilateral and re-coupon IRS to release cash, although this incurs frictional costs -60 -40 -20 0 20 40 60 80 100 120 140 A B C D Counterparty IRS Inflation TRS Repo -60 -40 -20 - 20 40 60 80 100 120 140 A B C D LCH Counterparty IRS Inflation TRS Repo Sample Portfolio: Mark to Market Impact of Backloading IRSSample Portfolio: Mark to Market (£m) per Counterparty
  10. 10. Teach-in Central Clearing: Implications for Collateral Management 4th September 2013 Exemption 10
  11. 11. Teach-in Central Clearing: Implications for Collateral Management 4th September 2013 EMIR implementation timeline: When does the Exemption window really start? 11 Source: European Securities and Markets Authority (ESMA) Q1 2013 Q2 2013 Q3 2013 Q4 2013 Q1 2014 Q2 2014 Q3 2014 Q4 2014 15 Sep 2013 Portfolio Reconciliation Dispute Resolution Portfolio Compression EMIR protocol CCP application closes 15 Mar 2013 RTS now in force CCP application window opens 15 Mar 2014 National Competent Authority (NCA) decision to authorise CCPs Q4 2013 First CCPs authorised: Clearing Member obligations Front loading period starts (6m pre Go-Live) Jan 2014 (estimated) Trade reporting obligation to trade repositories Summer 2014 Clearing obligation starts (subject to CCP authorisation)
  12. 12. Teach-in Central Clearing: Implications for Collateral Management 4th September 2013 12 Exemption Timeline: Importance of the exemption window is relative to the amount of hedging planned for that period Legacy ClearedExempt Start of Pension Scheme Exemption Front-Loading Window prior to Go Live Date End of Pension Scheme Exemption August 2015 (if not extended) Size of Hedge: 50% 10% 40% Timing: • Most likely date for mandatory Clearing is Summer 2014 • Likelihood is that pension scheme exemption will be extended beyond August 2015 • Backloading decision is important where legacy swaps make up a high proportion of the overall hedge • Exemption window serves to extend legacy status for hedges enacted in exemption period
  13. 13. Teach-in Central Clearing: Implications for Collateral Management 4th September 2013 Collateral Management 13
  14. 14. Teach-in Central Clearing: Implications for Collateral Management 4th September 2013 What is changing? In a Cleared world, collateral requirements involve both non-Cleared & Cleared portfolios Collateral amount is changing as initial margin now required 14 Cleared % Non-Cleared % Portfolio Initial Margin Variation Margin Initial Margin Variation Margin Total Collateral Requirements Required Collateral
  15. 15. Teach-in Central Clearing: Implications for Collateral Management 4th September 2013 In a Cleared world, more collateral will be required due to initial margin requirements Also, variation margin on cleared swaps must be met in cash. Hence the ability to source cash is important. 15 Other Assets (LDI & non-LDI) Collateral Non-Cleared % Cleared % Investment Portfolio LDI Portfolio VM VM IM Collateral Requirement Other Assets (LDI & non-LDI) Collateral Investment Portfolio
  16. 16. Teach-in Central Clearing: Implications for Collateral Management 4th September 2013 16 Gilts Gilts Top Up fund Cash for VM Initial Margin (LCH) Other assets Other assets MTM gains Before After Clearing Key Points: • Mark to Market (MTM) gains: These will sit in a cash account unless swept into other assets • Other assets: Using other assets to replenish the Cash VM and Top Up Fund will pull the portfolio out of balance. Periodic review needed • Initial Margin: Sourced from other assets and posted in gilts • Cash for VM: Initial margin is often used as proxy. Used to cover MTM moves • Top Up Fund: this is required to replenish the Cash VM fund. When exhausted it must be replaced by transforming other assets. The mix of collateral required will also change as a result of Central Clearing The diagram below shows the impact of initial margin on an overall investment portfolio
  17. 17. Teach-in Central Clearing: Implications for Collateral Management 4th September 2013 Product Mix and Portfolio Effects 17
  18. 18. Teach-in Central Clearing: Implications for Collateral Management 4th September 2013 Product Mix: Under Central Clearing, there are several choices available to an LDI portfolio manager when sourcing risk. The different options have different initial margin (and hence collateral) treatment on a standalone basis. 18 Best Initial Margin Treatment Worst Initial Margin Treatment Gilts Legacy swaps Bilateral swaps (under EUR 8bn) Gilt repo Cleared ‘real portfolios’ (see following two slides) Cleared interest rate swaps, Cleared inflation swaps Bilateral swaps (over EUR 8bn in 2019), TRS etc
  19. 19. Teach-in Central Clearing: Implications for Collateral Management 4th September 2013 19 Bloomberg now has an initial margin calculation tool (using an approximate LCH methodology). • The graph, left, shows the initial margin requirement for IRS at various tenors (5-50 years) [red line] • LCH has yet to release the calculation methodology for inflation swaps - 10.0 20.0 30.0 40.0 50.0 60.0 70.0 5 10 15 20 30 40 50 BpsxRisk Tenor (yrs) Initial Margin multiples (of pv01) by tenor for single trade only IRS per Bberg Product Mix: Estimating initial margin requirements is not a trivial task Trades with different tenors will be treated differently. This is also true at portfolio level Key points: The pv01 multiples vary with tenor, so applying a simple multiple is at best an approximation It is necessary to know the mix of rates / inflation in the liabilities and the duration for the scheme
  20. 20. Teach-in Central Clearing: Implications for Collateral Management 4th September 2013 20 -200,000 -100,000 - 100,000 200,000 300,000 400,000 500,000 600,000 700,000 800,000 0-10 yrs 11-20 yrs 21-30 yrs 31-40 yrs 41+ yrs Riskinpv01andie01 Tenor buckets pv01 ie01 Sample portfolio of 94 ZC Interest Rate Swaps (IRS) and 76 ZC Inflation Swaps (total liability hedge c. £4bn): PV01 and IE01 across tenor buckets Portfolio Effects: Effect of combining rates and inflation in a ‘real’ portfolio
  21. 21. Teach-in Central Clearing: Implications for Collateral Management 4th September 2013 21 Scenarios 1. Rates (IRS) only (2.0m total pv01 net*) 2. Inflation only (1.3m total ie01 net*) 3. Real portfolio (1.3m pv01 and 1.3m ie01 net*) 4. Both rates (2.0m pv01 net*) and inflation (1.3m ie01 net*) * Curve risk is a factor .0 mio 10.0 mio 20.0 mio 30.0 mio 40.0 mio 50.0 mio 60.0 mio 70.0 mio 80.0 mio IRS only Inflation only Real All IRS and ILS IMrequirement 1 IM requirement under 4 different scenarios: 2 3 4 Portfolio Effects: IM requirement constitutes a sea change in portfolio construction Best execution will become a portfolio decision rather than being solely based on best price Observations (initial margin required) •Inflation is a driving factor (#2). •Real portfolio (#3) is risk reducing •The whole portfolio (#4) is below inflation only (#2) – due to the real portfolio effect Impact on Product Mix (cleared and non cleared) Real effect: Better to source both inflation and rates through swaps, rather than inflation swaps combined with (non cleared) gilt repo
  22. 22. Teach-in Central Clearing: Implications for Collateral Management 4th September 2013 Monitoring and Rebalancing 22
  23. 23. Teach-in Central Clearing: Implications for Collateral Management 4th September 2013 23 Given the implications of Central Clearing, it is vital for schemes to develop a clear system for monitoring portfolio efficiency and ensuring enough collateral is available when needed Inputs into Decision-Making Process: • Backloading and exemption choices • Capability: are the various legal documents (e.g. GMRA) in place to allow flexibility? • Product Mix (use of cleared and non-cleared sources of risk) • Portfolio Effects Outputs: • Monitoring framework & liquidity triggers • Collateral waterfall (order in which assets transformed into collateral) • Re-investment order for MTM gains • Portfolio review: periodic rebalancing of assets back to “ideal portfolio” Trustee Investment Manager Advisor Set Monitoring and Rebalancing Policy
  24. 24. Teach-in Central Clearing: Implications for Collateral Management 4th September 2013 Conclusion 24
  25. 25. Teach-in Central Clearing: Implications for Collateral Management 4th September 2013 25 Several options exist for pension schemes in a Centrally-Cleared world concerning what to clear and when. These have credit risk, collateral and portfolio implications. Putting a solid framework in place is an important step in retaining control of the transition process Liquidity Policy Backloading Exemption Collateral Management Product Mix / Portfolio Effects Monitoring and Rebalancing
  26. 26. Teach-in Central Clearing: Implications for Collateral Management 4th September 2013 13-15 Mallow Street London EC1Y 8RD Telephone : +44 (0) 20 7250 3331 www.redington.co.uk Contacts Robert Gardner Founder & Co-CEO Direct Line: 0207 250 3416 robert.gardner@redington.co.uk 26 Kenny Nicoll Director Direct Line: 0203 326 7111 kenny.nicoll@redington.co.uk Tom McCartan Vice President Direct Line: 0203 326 7139 tom.mccartan@redington.co.uk Greg Fedorenko Associate Direct Line: 0203 326 7122 greg.fedorenko@redington.co.uk Disclaimer For professional investors only. Not suitable for private customers. The information herein was obtained from various sources. We do not guarantee every aspect of its accuracy. The information is for your private information and is for discussion purposes only. A variety of market factors and assumptions may affect this analysis, and this analysis does not reflect all possible loss scenarios. There is no certainty that the parameters and assumptions used in this analysis can be duplicated with actual trades. Any historical exchange rates, interest rates or other reference rates or prices which appear above are not necessarily indicative of future exchange rates, interest rates, or other reference rates or prices. Neither the information, recommendations or opinions expressed herein constitutes an offer to buy or sell any securities, futures, options, or investment products on your behalf. Unless otherwise stated, any pricing information in this message is indicative only, is subject to change and is not an offer to transact. Where relevant, the price quoted is exclusive of tax and delivery costs. Any reference to the terms of executed transactions should be treated as preliminary and subject to further due diligence . Please note, the accurate calculation of the liability profile used as the basis for implementing any capital markets transactions is the sole responsibility of the Trustees' actuarial advisors. Redington Ltd will estimate the liabilities if required but will not be held responsible for any loss or damage howsoever sustained as a result of inaccuracies in that estimation. Additionally, the client recognizes that Redington Ltd does not owe any party a duty of care in this respect. Redington Ltd are investment consultants regulated by the Financial Conduct Authority. We do not advise on all implications of the transactions described herein. This information is for discussion purposes and prior to undertaking any trade, you should also discuss with your professional tax, accounting and / or other relevant advisers how such particular trade(s) affect you. All analysis (whether in respect of tax, accounting, law or of any other nature), should be treated as illustrative only and not relied upon as accurate. ©Redington Limited 2013. All rights reserved. No reproduction, copy, transmission or translation in whole or in part of this presentation may be made without permission. Application for permission should be made to Redington Limited at the address below. Redington Limited (6660006) is registered in England and Wales. Registered office: 13-15 Mallow Street London EC1Y 8RD email: emir@redington.co.uk
  27. 27. Teach-in Central Clearing: Implications for Collateral Management 4th September 2013 Appendix: Summary of EMIR Protocol 27
  28. 28. Teach-in Central Clearing: Implications for Collateral Management 4th September 2013 28 Regulatory Technical Standards come into effect on 15 September 2013 They concern risk management of non-cleared OTC derivatives ISDA: EMIR Portfolio reconciliation, dispute resolution and disclosure protocol (the “EMIR Protocol”) Amends ISDA (and non-ISDA) to comply with EMIR requirements (19th July 2013) Breach of Protocol does not give a right to terminate or constitute an event of default Portfolio reconciliation: All non cleared OTC derivatives outstanding as at 15 Sept 2013 to be reconciled Reconciliation of key terms including valuation Frequency determined by number outstanding: 500+ daily; 51+ weekly; 1-50 quarterly Dispute resolution: Applies to all non cleared OTC derivatives. FCs and NFCs: procedures in place to identify, record and monitor disputes. Disputes not resolved in 5 business days to be dealt with by specific process FCs required to report to regulator any disputes in excess of 15 days or €15m Portfolio compression: (not part of EMIR Protocol) unilateral requirement Applies to all non cleared OTC derivatives. FCs (and NFCs) with more than 500 OTC non cleared with a counterparty Procedure to regularly (at least twice per year) conduct a portfolio compression exercise.

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