Collateral Management

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Collateral management has moved to the top of the agenda for many institutions as a tool to help mitigate credit risk and manage liquidity. This approach has mainly been driven by regulatory changes such as Basel III, Solvency II and G20 requirements pertaining to the central clearing of over the counter (OTC) derivatives. Basel III will require banks to hold more capital against their uncollateralised exposures, which will force more banks to increase their collateral requirements with clients. In turn, financial institutions will have to find the most efficient way for managing their collateral to manage liquidity as uncollateralised trades will become more expensive due to the CVA requirements.

The Hedge Fund Academy will explore the impact proposed regulatory changes will have on collateral management and liquidity requirements for the whole South African Market. Implementing a collateral management process can be challenging and implementing an insufficient collateral management system and process may even result in much greater losses.

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Collateral Management

  1. 1. © 2012 Hedge Fund Academy. All rights reserved. COLLATERAL MANAGEMENT1
  2. 2. © 2012 Hedge Fund Academy. All rights reserved. CLIENTS2
  3. 3. INTRODUCTION • Hedge Fund Academy & Ramplin Capital© 2012 Hedge Fund Academy. All rights reserved. • Training, Advisory and Structuring – Collateral , OTC derivatives & CCP – Hedge Funds & other alternative funds – Regulations (Reg 28, Basel III, UCITS, G20) 3
  4. 4. © 2012 Hedge Fund Academy. All rights reserved.4
  5. 5. G20 REQUIREMENT All standardised OTC derivative trades should All OTC derivatives trades should be reported be centrally cleared to a trade repository© 2012 Hedge Fund Academy. All rights reserved. 2009 commitment to reform the OTC derivatives market in 4 key areas: Standardised OTC derivatives should be traded Higher capital charges should be implemented on exchange or electronic platforms where for non-cleared OTC derivatives appropriate 5
  6. 6. REGULATIONS - TIMETABLE 2011 2012 2013 2014 2015 2016 2017 2018 + Basel 2.5 Market and securitisation rules Basel 3 Revised capital ratios© 2012 Hedge Fund Academy. All rights reserved. Quality of capital Enhanced capital requirements Capital buffers Margin for uncleared swaps G20 Clearing Transparency and execution Higher margin for non-cleared OTC Reporting requirements Dodd Frank Registration Mandatory clearing Transparency and execution Reporting requirements 6
  7. 7. LIQUIDITY LIQUIDITY LIQUIDITY LCR • Short-term measure, compares a banks liquid assets against a one© 2012 Hedge Fund Academy. All rights reserved. month acute liquidity stress • Stress factors: – Ratings downgrade – Deposit runs – Lack of funding roll-overs – Increases in haircuts and collateral calls 7
  8. 8. © 2012 Hedge Fund Academy. All rights reserved. ECONOMIC VS REGULATORY CAPITAL _________________________________________________________________________________________________________________________________________________________________________________________________________________________ _____________________ 8
  9. 9. REGULATORY VS.. ECONOMIC CAPITAL • Regulator stipulates a specified Regulatory minimum level of capital that Capital each firm must hold.© 2012 Hedge Fund Academy. All rights reserved. • Firm determined amount needed to cover excess of worst-case loss Economic over expected loss, function of capital risk • Can be more but not less than the regulatory capital 9
  10. 10. IMPACT OF COLLATERAL ON CAPITAL REQUIREMENTS Predicted credit exposure for a 10 year swap under a variety of collateral conditions 4,000,000 No collateral Predicted Exposure in GBP 3,500,000 Monthly collateral calls Daily collateral calls 3,000,000© 2012 Hedge Fund Academy. All rights reserved. 2,500,000 Summary Average Peak Exposure Exposure No collateral 3,793,585 14,609,547 2,000,000 Monthly collateral calls 221,958 2,352,755 1,500,000 Daily collateral call 134,473 1,404,670 1,000,000 Notes All data in British Pounds Sterling (GBP). 500,000 The transaction modeled is a 10 year par 0 interest rate swap, with a GBP 100 million notional principal. We assume a zero unsecured threshold in the collateral agreement, and allow for a 7 day “cure” period between an event of Time default and the liquidation of collateral. Rate of the red line curve takes this shape due to the amortisation effect and the fusion effect what the market is doing for example. 10
  11. 11. ECONOMIC CAPITAL REDUCTION FOR BANKS 600 550 500 450 400 350 © 2012 Hedge Fund Academy. All rights reserved. 300 250Portfolio Value ($m) 200 150 100 50 0 -50 -100 -150 Economic Capital (no netting & no collateralisation): $ 1,000,000 -200 -250 Economic Capital (with netting, but no collateralisation): $ 190,000 -300 Economic Capital: ( with netting and collateralisation: $ 37,000 -350 Economic Capital measured through the CVA process -400 A ug Dec A pr A ug Dec A pr A ug Dec A pr A ug Dec A pr A ug Dec A pr 2002 2002 2003 2003 2003 2004 2004 2004 2005 2005 2005 2006 2006 2006 2007 Forward Date 11
  12. 12. © 2012 Hedge Fund Academy. All rights reserved. CVA _________________________________________________________________________________________________________________________________________________________________________________________________________________________ _____________________ 12
  13. 13. BASEL III – CVA • Credit value adjustment© 2012 Hedge Fund Academy. All rights reserved. • Seeks to mitigate counterparty credit risk in bilateral trades • Based on the riskiness of the counterparty • Will significantly increase capital requirements for uncleared OTC derivatives 13
  14. 14. EXEMPTION FROM CLEARING IN EU • Pension funds in Europe have been granted exemption from central clearing© 2012 Hedge Fund Academy. All rights reserved. • Dilemma … – Opting for exemption means opting for higher capital charges on uncleared OTC and therefore a higher CVA and therefore higher price putting on the same position – Impact on asset managers, pension funds and corporates 14
  15. 15. MITIGATING CVA • Buy protection like a CDS or Cdi (if available on© 2012 Hedge Fund Academy. All rights reserved. a single name counterparty) • Collateralise the trade with both initial and variation margin (probably cash) 15
  16. 16. ESTIMATED GLOBAL COLLATERAL REQUIREMENTS FOR CCP TRADES Source Gross Net Notes Oliver Wyman $3,1tr $700bn $700bn middle of the range $500 - $800bn Bank of $156bn - Financial Stability paper Oct© 2012 Hedge Fund Academy. All rights reserved. England $594bn 2012 BIS $718bn Range $303bn - $1.167tn depending on volatility (BIS working paper March 2012) OCC $2.56tr Based on OCC’s large dealers Moody’s $3.6tr “New OTC regulations will boos demand for eligible collateral” $3tr - $4trn gross additional collateral 16
  17. 17. CURRENT COLLATERAL LEVELS© 2012 Hedge Fund Academy. All rights reserved. • ISDA Margin Survey, 2012: – $3.6tr of collateral already supporting non-cleared OTC derivative transactions. – CVA will potentially increase this number. 17
  18. 18. IMPACT ON NON-DEALERS Initial margin requirements for comprehensive central clearing of OTC derivatives by BIS working paper 373© 2012 Hedge Fund Academy. All rights reserved. Collateral requirements for IRS - Volatility of market values Low Medium High Dealers $15bn $29bn $43bn Non-dealers $252bn $470bn $699bn 18
  19. 19. NETTING© 2012 Hedge Fund Academy. All rights reserved. • Separating trades into cleared and uncleared trades will lose the benefit of netting across the portfolio and potentially result in higher collateral calls per portfolio (client). 19
  20. 20. FOREIGN CCP • Dodd Frank requirements – Jan 2013© 2012 Hedge Fund Academy. All rights reserved. • Cost of foreign funding ($ funding) • FX risk • No interest on collateral Offshore vs. local argument… 20
  21. 21. DRAFT HEDGE FUND REGULATIONS© 2012 Hedge Fund Academy. All rights reserved. • Limit counterparty exposure under an OTC derivative to 10% of NAV – banks would now have to post collateral back to hedge funds in order to maintain the 10% limit 21
  22. 22. REG 28© 2012 Hedge Fund Academy. All rights reserved. • OTC paper … collateralisation of pension funds and exposure management • No rehypothecation of pension fund assets 22
  23. 23. © 2012 Hedge Fund Academy. All rights reserved. COST OF COLLATERAL _________________________________________________________________________________________________________________________________________________________________________________________________________________________ _____________________ 23
  24. 24. OPPORTUNITY COST OF COLLATERAL • An additional R1 tied up in collateral means one can’t do anything with it.© 2012 Hedge Fund Academy. All rights reserved. • Impact on ROE / performance of the fund • Cost of collateral: – The funding cost of collateral vs. the interest received on the collateral – Now add all the noughts you can find in a trillion $ 24
  25. 25. BASIC FEES ASSOCIATED WITH COLLATERAL MANAGEMENT People • Skilled collateral staff • Legal expenses associated with the Legal negotiation process and the development and© 2012 Hedge Fund Academy. All rights reserved. maintenance of necessary documentation • Operational and technology costs associated Ops with administering the process, integrated systems • Custody fees and financing costs associated Custody with the pledging, receiving and monitoring of collateral Financing • Collateral funding (optimisation) 25
  26. 26. CASH VS. SECURITIES COLLATERAL© 2012 Hedge Fund Academy. All rights reserved. • Cash remains the dominant form of collateral • Government securities is the next most common • Basel III and other regulations will put pressure on the use of cash collateral 26
  27. 27. CASH IS STILL DOMINANT Operational Cash fully Risk of sovereign© 2012 Hedge Fund Academy. All rights reserved. simplicity, 80% of fungible, easy to debt – European CCP clearing collateral still rehypothecate, no crisis cash recharacterisation Stricter eligibility Low interest rate schedules- No segregation of environment, low decline in cash collateral, cost of funding corporate bonds Basel III cash & equities 27
  28. 28. CHALLENGES OF CASH COLLATERAL© 2012 Hedge Fund Academy. All rights reserved. Greater focus on structuring cash Cash Interest reinvestment reinvestment risk Basel III liquidity calculation, solutions for both (rate & c/party requirements especially during the buy and sell default) failed settlements side (on and off balance sheet) 28
  29. 29. SECURITIES COLLATERAL • Regulations and the increased requirements for© 2012 Hedge Fund Academy. All rights reserved. liquidity and collateral will force counterparties to search for alternative forms of collateral. • Increase in the use of securities collateral 29
  30. 30. BENEFITS OF SECURITIES AS COLLATERAL Reduction in FX Reduction of risk (where© 2012 Hedge Fund Academy. All rights reserved. funding cost required) No reinvestment Possibility to risk include received collateral in a stock loan programme (caution legal risk) 30
  31. 31. CHALLENGES OF SECURITIES AS COLLATERAL Credit risk of Price volatility of Ability to price issuer security© 2012 Hedge Fund Academy. All rights reserved. Concentration Relatedness Liquidity risk Dealing with corporate Perfection of Rehypothecation actions, security interest redemptions etc. 31
  32. 32. QUALITIES OF “GOOD” COLLATERAL ASSETS Pricing and Transparency Correlation© 2012 Hedge Fund Academy. All rights reserved. Legal risk Volatility of collateral Liquidity – ability to sell Credit quality the collateral of the issuer 32
  33. 33. QUALITIES OF “GOOD” COLLATERAL ASSETS Eligibility list© 2012 Hedge Fund Academy. All rights reserved. Triparty collateral Haircuts agreements Collateral Asset Re- Concentration hypothecation Custody and potential of settlement asset efficiency 33
  34. 34. © 2012 Hedge Fund Academy. All rights reserved. CONSEQUENCES _________________________________________________________________________________________________________________________________________________________________________________________________________________________ _____________________ 34
  35. 35. SHIFTING FOCUS© 2012 Hedge Fund Academy. All rights reserved. • The management of risk, liquidity and capital must be at the heart of banks’ strategies in the future. 35
  36. 36. COLLATERAL OPTIMISATION • As counterparties look to assess the capital needs and true profitability of individual product lines, firms are trying to:© 2012 Hedge Fund Academy. All rights reserved. – minimise capital requirements through activities such as cross netting and central clearing – while at the same time seeking to ensure best use of ”cheaper” internal assets • They are also seeking ways to accurately allocate and measure the true cost of each underlying business. 36
  37. 37. OPTIMISATION • Greater importance to market participants. • Optimisation refers to the ability to post and re-use© 2012 Hedge Fund Academy. All rights reserved. collateral according to delivery preferences such as: – Cost of funding and delivery – Liquidity and market capitalisation – Embedded haircuts in the CSA – Availability of assets to the delivering party – Cost of reinvestment and yield – Ability to re-use 37
  38. 38. OPTIMISATION • As collateralisation becomes more commoditised through process improvement and automation. • Increasing trend to introduce business rules around© 2012 Hedge Fund Academy. All rights reserved. maximising the efficiency and minimising the cost of collateral. • Basel III will force optimisation • 71% of the large dealers optimise daily • Over 60% of market participants only optimise when the movement of collateral is materially sufficient to warrant investigation and operational effort. 38
  39. 39. G20 REQUIREMENT All OTC derivative trades should be All standardised OTC derivative trades reported to a trade repository should be centrally cleared (WITHOUT COLLATERAL IT IS (MORE COLLATERAL) MEANINGLESS)© 2012 Hedge Fund Academy. All rights reserved. 2009 commitments to reform the OTC derivatives market in 4 key areas: Higher capital charges should be Standardised OTC derivatives should be implemented for non-cleared OTC traded on exchange or electronic platforms derivatives (HIGHER CVA OR MORE where appropriate COLLATERAL) 39
  40. 40. MARKET IMPACT • Impact of CVA on non- cleared trades Corporates Derivatives for hedging e.g. • Impact of collateral currency and interest rate requirements due to risk. Manage volatility of Basel III / higher capital earnings. If hedging© 2012 Hedge Fund Academy. All rights reserved. on non-cleared trades / becomes more expensive, impact on banks will corporates opt out? • Building infrastructure to Insurance companies Hedging long dated collateralise or become liabilities client of CCP member Hedge funds / Asset Execution of strategies • Loss of portfolio managers margining • Impact on portfolio Pension funds Long dated swaps to performance manage the risk in a pension scheme Dealers Increased capital requirements 40
  41. 41. CHALLENGES • Regulators are moving at different speed : US (Dodd Frank) vs. Europe (EMIR & ESMA) vs. South Africa© 2012 Hedge Fund Academy. All rights reserved. • Adoption of Basel III in US slow vs. the rest • Basel vs. non-Basel regulated entities – opportunity for arbitrage? • Rise in demand for “safe or good quality collateral” • SA legal framework for the use of securities as collateral 41
  42. 42. CONTACT DETAILS Marilyn Ramplin© 2012 Hedge Fund Academy. All rights reserved. Hedge Fund Academy / Ramplin Capital 01 783 9390 marilyn@hedgefundacademy.co.za www.ramplincapital.com www.hedgefundacademy.co.za 42

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