Preparing the Buy-Side to Optimize Collateral 4th Annual Collateral Management Forum - Erik vynckier

ALM for Life Insurers, 18–19 Sepetember 2013AllianceBernstein.com
Erik Vynckier Chief Investment Officer—Insurance (EMEA)
Wien/Vienna 28 May 2015
Preparing the Buy-Side to Optimize Collateral
4th Annual Collateral Management Forum

Agenda
Asset Allocation + Derivatives Overlay = Collateral
Cleaning the Credit Support Annex
Planning Liquidity with Potential Future Exposure
High Performance Computation
Operating Model: the Integrated Front-to-Back Office
1

Long-Term Investors Crave Persistent Illiquidity Premium
2
As of December 2014
Source: AllianceBernstein
Senior Unsecured
Private Placement
Senior
Infrastructure Debt
Junior
Infrastructure Debt
Senior Secured
Unitranche Loans
Transitional
Commercial Real
Estate Loans
15
25
200
100
100
50
300
150
400
200
Range of Indicative Illiquidity Premiums (basis points)

How Do Insurers and Pension Funds Replicate Liabilities?
Investments in Assets and Derivative Overlays Requiring Collateral
3

Collateral Management
Derivatives May Constrain Asset Allocation
Collateral may be tight
Collateral needs to be funded, and suffers haircuts
Opportunity cost for having to hold cash for collateral, constrains investment strategy
Repo markets to generate cash involves extra operations and costs and an agreed legal
framework known as GMRA (global master repurchase agreement)
Volatile and/or illiquid assets are ruled out as collateral
Clearing and settlement through a clearing house requires a “clean” cash CSA
The future of un-cleared derivatives?
Pension funds benefit from a transition phase where they are not forced to clear their
derivative trades
The future of un-collateralized derivatives?
Non-financial corporates below certain trading and exposure thresholds
Heavy capital charges (CVA) borne by counterparty in Basel III impact pricing
4

OTC Derivatives Regulatory Overview
5
6

Regulations Impacting Derivatives
Avalanche of Regulations Effective or in the Making
Dodd-Frank and European Markets Infrastructure Regulation (EMIR)
Financial Counterparties which includes insurers, reinsurers and fund structures
Interest rate derivatives (fixed/floating interest rate swaps, basis swaps, forward rate
agreements, overnight index swaps) captured
New trade, novation, notional increase, maturity extension, (swaptions) physical
exercise
Use of central clearing with initial margin and variation margin
Trade execution facility
Reporting to a trade repository
Check the adoption agenda for clearing
Financial Transaction Tax could apply multiple times to a single trade (counterparties +
laying off risk through inter-broker dealer)
6

Reporting Templates for Solvency II Pillar 3: D1 – D6
D1: line-item reporting of assets held for insurer
D2: derivatives (trades and open positions)
D3: comprehensive insurer report
D4: look-through table (fund-of-funds)
D5: securities financing
D6: collateral
7
Trial-runs ahead of regulatory implementation are a must!

Agenda
8

Valuation of Swaps
Credit Support Annex Impacts Bootstrapping and Discounting
Present Value of an interest rate swap receiving fixed rate F which trades at fixed rate M:
Value = DV01 x (F – M) [you receive F where, if you traded today, you would receive M]
DV01 = Σ day-count fraction (i) x discount factor(i) x notional(i) [i sums all future cash flows]
Collateral dependent discounting triggers a multi-curve & multi-currency handling of a plain vanilla swap
Market standard quotation for USD Libor 3M, EUR Euribor 3M, GBP Libor 6M discount with the
domestic overnight rate, USD US Fed Funds—EUR EONIA—GBP SONIA
Dual-curve bootstrapping of market quotes solves for arbitrage-free forwards of the swap rate –
project one yield curve, discount with another yield-curve.
If CSA is not market standard, discount the projected forwards with a different discount curve, resulting
in a different fair value for the swap!
Credit-risky collateral requires a credit spread to be applied to the discount curve
Foreign currency collateral implies cross-currency bootstrapping, incorporating cross-currency basis
Choice of collateral currency in multi-currency CSA further complicates valuation
the “cheapest-to-deliver” currency on a forward basis in a rough approximation ignoring
optionality
9

Swap Pricer
Sample Trading Screen for a Swap
10
© Thomson Reuters Eikon

CSA-dependent Valuation Matters
Trading and Balance Sheet, Re-couponing, Novation, Collateral…
Trading with broker-specific CSA
Forward pricing or quotation — quoting a cash settlement on maturity is now
standard in the swaptions market: choose your own discounting
But we still need essential agreement on amount of collateral to post or receive
Efficiently comparing CSA-dependent broker quotes requires advanced software
Clean the book of legacy positions with re-couponing or novation to a cash CSA or
to a different broker
Settlement at mark-to-market for re-couponing depends on “dirty” CSA
Transfer price and top-up payments to novate swaps between brokers, require
pricing against at least two or preferably all three CSAs
Third-party trade compression services for detecting novation opportunities over
multiple counterparties while maintaining confidentiality (TriOptima)
Requirement to use Swap trade Execution Facility forthcoming
11

Pricers and Tri-party Valuation
Tools and Investment Operations
Pricing toolkits and market data
Derivatives toolkits FiNCAD F3, Quantifi, SciComp, SuperDerivatives, NumeriX,
Murex … with multi-curve discounting
Market data vendors Bloomberg, Thomson Reuters Eikon, SuperDerivatives…
Inter-broker dealers seeing significant derivatives flow may be the most reliable
market data sources: ICAP, Tullett Prebon, Cantor Fitzgerald …
Tri-party valuation with escalation for discrepancies – Unless you agree in valuation,
you cannot agree on collateral to post or receive
Insurer or asset manager
Counterparty (investment bank)
Custodian
Independent valuation services (SuperDerivatives, Bloomberg, mark-it)
12

Agenda
13

Simulating Rate Scenarios
Swap Rates across all Tenors at Future Time Steps
14

Mark-to-Market of Each Swap at Every Step for a Scenario
15

Mark-to-Market of Entire Swap Portfolio for Each Scenario
16

Portfolio Exposure Across Scenarios indicates Potential Liquidity Sink
17
Potential Future Exposure (PFE)
the maximum expected
counterparty exposure or collateral
requirement within a specified high
level of confidence
Expected Positive Exposure (EPE)
the Expected or average Exposure up
to a given future date t.
Credit Valuation Adjustment (CVA)
the adjustment to the price of a
derivative to take into account
counterparty credit risk = Expected
Positive Exposure x Probability of
Default x Loss Given Default

Agenda
18

High-Performance Computing – What Are the options?
19
Multi-core for embarrassingly parallel tasks
NVIDIA Tesla, Kepler, Maxwell …
Programming models OpenCL, OpenACC, OpenMP, CUDA
Data bandwidth considerations, hosting and moving of the data
Libraries (NAG, NVIDIA, MathWorks) and domain specific languages (SciComp)
Dataflow Simulation on Field-Programmable Gate Arrays
Standardised and portable OpenCL
MaxCompiler high-level programming language for dataflow computing
Clouds
On-demand bursting fills punctual requirements
Outsourced, low capital cost
Hosting the data in the cloud?

NVIDIA GPU Computing: Graphical Processing Units
20

VERY MANY Computational Cores on a Chip
21

Data-Flow Computation on FPGA
Pipeline Programming Generates Fresh Simulations @ 300 MHz
22

Agenda
23

New Operating Model for Investment Management
24
Front-office needs to understand collateral and liquidity consequences of its investment
decisions
Back-office not just an operation task but crucial input into asset allocation, asset-liability
management, hedging best practices, reporting and compliance
Collateral and liquidity management a critical input into overall balance sheet and capital
management of bank, insurer, pension fund
Product Pricing and Product Development in Banking, Insurance and Pensions require
accurate liquidity pricing and sound collateral practices
Position monitoring and liquidity analytics need to upgrade so as to accurately report &
plan collateral & liquidity

Read Up and Connect with Colleagues
25
Clear Path Analysis study: “Collateral Management for Institutional Investors”
https://www.clearpathanalysis.com/product/104-cmli-2014/
International Securities Services: “Collateral Management”
http://www.iss-mag.com/collateral-management/iss-magazine-discusses-
collateral-management-wi

Disclaimer
This information is issued by AllianceBernstein Limited, 50 Berkeley Street, London W1J 8HA,
a company registered in England under company number 2551144. AllianceBernstein Limited
is authorised and regulated in the UK by the Financial Conduct Authority (FCA – Reference
Number 147956). This information is directed at Professional Clients only. It is provided for
informational purposes only and is not intended to be an offer or solicitation, or the basis for any
contract to purchase or sell any security, product or other instrument, or for AllianceBernstein to
enter into or arrange any type of transaction as a consequence of any information contained
herein. The views and opinions expressed in this document are based on AllianceBernstein's
internal forecasts and should not be relied upon as an indication of future market performance.
Past performance is no guarantee of future returns. This information is not intended for public
use.
© 2013 AllianceBernstein
26

A WORD ABOUT RISK
Market Risk: The market values of the investments may rise and fall from day to day, so investments may
lose value.
Interest Rate Risk: Bonds may lose value if interest rates rise or fall—long-duration bonds tend to rise and fall
more than short-duration bonds.
Credit Risk: A bond’s credit rating reflects the issuer’s ability to make timely payments of interest or capital—
the lower the rating, the higher the risk of default. If the issuer’s financial strength deteriorates, the issuer’s
rating may be lowered and the bond’s value may decline.
Allocation Risk: Allocating to different types of assets may have a large impact on returns if one of these
asset classes significantly underperforms the others.
Foreign Risk: Investing in overseas assets may be more volatile because of political, regulatory, market and
economic uncertainties associated with them. These risks are magnified in assets of emerging or developing
markets.
Currency Risk: currency fluctuations may have a large impact on returns and the value of an investment may
be negatively affected when translated into the currency in which the initial investment was made.
Capitalization Size Risk (Small/Mid): Holdings in smaller companies are often more volatile than holdings in
larger ones.
© 2013 AllianceBernstein
27

Preparing the Buy-Side to Optimize Collateral 4th Annual Collateral Management Forum - Erik vynckier

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Preparing the Buy-Side to Optimize Collateral 4th Annual Collateral Management Forum - Erik vynckier