Solution Manual for Principles of Corporate Finance 14th Edition by Richard B...
BCBS 261 - Collateral and Margin Management for Uncleared Derivatives
1. Collateral and Margin Management
for Uncleared OTC Derivatives
- BCBS 261
Nikat Malik
May 2014
All Rights Reserved
2. BCBS 261 - Overview
BCBS 261 - Collateral & Margin Management
Focus Areas:
• All standardised OTC derivatives should be traded on exchanges or electronic platforms
• All standardised OTC derivatives should be cleared through central counterparties (CCPs)
• OTC derivatives contracts should be reported to trade repositories
• Non-centrally cleared derivatives contracts should be subject to higher capital requirements
• Margin requirements on non-centrally cleared derivatives
Key Objectives:
• Reduction of systemic risk
• Promotion of central clearing
Key Principles:
• Appropriate margining practices for all derivatives transactions not cleared by CCPs
• All financial firms and systemically important non-financial entities must exchange initial & variation margin
• Methodology for calculating initial & variation margin should be consistent across entities; reflect the PFE (initial
margin) & CE (variation margin); and exposures are fully covered at a high degree of confidence
• Ensure that collateral for initial and variation margin can be liquidated in a reasonable amount of time in the
event of default; and be able to hold their value in a time of financial stress after accounting for haircut.
• Initial margin should be exchanged by both parties on a gross basis (without netting); and ensure that (i) the
margin is immediately available to the collecting party in the event of default
• Transactions between a firm and its affiliates should be subject to appropriate regulation
• Regulatory regimes should interact to result in consistent margin requirements across jurisdictions
• Margin requirements should be phased over a period of time to ensure that costs associated with the new
framework can be managed
3. Margin on Uncleared OTC Derivatives
BCBS 261 - Collateral & Margin Management
Summary of Proposals:
Initial Margin is required for Financial Firms and Systemically Important Non-Financial Firms,
if the notional outstanding >8b euro and total gross initial margin exposure is >50m
IM to be paid gross without netting between parties
IM to be held so as to make it readily accessible to a non-defaulting party
FX spot and forwards are exempt
FX portion of a Currency Swap is exempt
Variation Margin to be exchanged with a zero threshold
Minimum transfer capped at €500,000
Threshold capped at €50m, on a Group basis
Establishment of eligible collateral rules must involve regulators, including any haircuts applied
Conditional re-hypothecation allowed in certain cases eg. Hedging
Limit on haircuts imposed by regulator (e.g. 20%) in order to maintain sufficient liquidity
Eligible Collateral comprises of cash, high quality government bonds, central bank securities,
high quality corporate bonds, high quality covered bonds, equities in major stock indexes, gold
4. Margin on Uncleared OTC Derivatives
BCBS 261 - Collateral & Margin Management
Summary of Proposals:
Initial margin to be either a schedule based approach or
a statistical approach using 99% confidence with a 10 day holding period
• Each asset class considered separately for initial margin
• Each historic scenarios period to include a period of 'financial stress'
• Historic period capped at 5 years
• Scenarios in financial stress period to be equally weighted
• Model to be approved by regulators
• Total initial margin across major asset classes will be sum of initial margin per asset class
• Lack of correlation across asset classes means IM must be specific per asset class
Phasing
• 1st Dec 2015 VM on new trades must meet these rules, VM on old trades not changed
• 1st Dec 2015 IM approach applies to new trades, IM on old trades unaffected
• 1st Dec 2015 to 30th Nov 2016: Any firm with a portfolio over €3trn to exchange IM
(measured during June - Aug 2015)
• 1st Dec 2016 to 30th Nov 2017: Inclusion threshold down to €2.25trn
• 1st Dec 2017 to 30th Nov 2018: Inclusion threshold down to €1.5trn
• 1st Dec 2018 to 30th Nov 2019: Inclusion threshold down to €750bn
• 1st Dec 2019 onwards, inclusion threshold down to €8bn
5. Margin on Uncleared OTC Derivatives
BCBS 261 - Collateral & Margin Management
Summary of Proposals:
Schedule for Initial Margin when using the Schedule Based Approach
Schedule for Haircuts
Asset Class Initial Margin Requirement (% of Notional Exposure)
Credit: 0–2 year duration 2
Credit: 2–5 year duration 5
Credit 5+ year duration 10
Commodity 15
Equity 15
Foreign exchange 6
Interest rate: 0–2 year duration 1
Interest rate: 2–5 year duration 2
Interest rate: 5+ year duration 4
Other 15
Asset Class Haircut (% of Market Value)
Cash in same currency 0
High-quality government and central bank securities:
residual maturity less than one year
residual maturity between one and five years
residual maturity greater than five years
0.5
2
4
High-quality corporatecovered bonds:
residual maturity less than one year
residual maturity between one and five years
residual maturity greater than five years
1
4
8
Equities included in major stock indices 15
Gold 15
Additional (additive) haircut on asset in which the currency of the
derivatives obligation differs from that of the collateral asset
8
6. Collateral Management
BCBS 261 - Collateral & Margin Management
Implications of BCBS 261 on Collateral Management
• reduce available collateral
• increase margins in periods of stress
• stress tests identify impacts of market stresses on collateral supply and demand
• haircuts impact liquidity significantly and cause markets to dry up
• requires "eligible collateral" to be highly liquid and able to hold its value in a time of financial stress
Key Issues in Collateral Management
• Potential shortage of high quality collateral leading to potential “collateral crunch” situations
• Many collateral agreements include the possibility for the receiving party to re-use collateral
• Basel III liquidity coverage ratio (LCR) requiring banks to hold enough liquid assets to get through a 30-day period of severe
funding stress will further reduce the availability of safe assets
• Impact of sovereign downgrades and supply of high quality primary collateral
• Re-use or re-hypothecation of collateral is diminishing
• Inefficiencies in the management of collateral requiring centralised management of collateral across assets and entities to
facilitate group-wide decisions and its most efficient use
• Fragmentation of collateral pools across businesses and geographies
• Inefficiencies in the processing of collateral across markets and activities
• Inadequate standardisation
Required
• Collateral optimization to allow collateral to flow more easily, improve the netting of portfolios in order to reduce margin
calls, independent acceptable valuation, and swapping non-eligible collateral for eligible collateral
• CCP practices for cross-margining (i.e. the sharing of pledged collateral across different cleared assets), expanding the range
of eligible collateral e.g. accepting some high-quality corporate bonds as collateral for OTC swaps or blue chip equities with
appropriate haircuts and concentration limits, and interoperability between CCPs which may allow market participants to
concentrate their portfolio at a CCP of their choice
7. Cost of OTC Derivatives Clearing
BCBS 261 - Collateral & Margin Management
Impact of New Proposal comprises:
New margin requirements
New capital charges
Compliance costs mainly additional reporting requirements e.g. EMIR, etc.
Cost Differential for Clearing OTC Derivative Transactions (per million euro notional)
The cost of collateral is estimated as the difference between funding cost of collateral and
return earned on posted collateral.
Average collateral composition estimated at 79% cash and 15% government securities with
6% other securities as of 2013, and a cost of collateral at 0.5% assumed for estimation,
hence additional costs from new requirements average 0.55 bps.
Cost Component Cleared Uncleared
Initial Margin 0.10 bps 0.50 bps
Capital Charges 0.03 bps 1.20 bps
Compliance Costs 0.006 bps 0.006 bps
8. Cost of OTC Derivatives Clearing
BCBS 261 - Collateral & Margin Management
Additional Collateral Costs compared using Standardised Approach and Model Based Approach.
The Standardised Approach does not account for risk on a portfolio basis.
Additional Costs for CVA Charge
Uncleared OTC derivatives are subject to additional capital charge to protect against variations in the
credit value adjustment charge. CVA measures asset valuation changes related to counterparty credit
risk. CVA charge is based on current and potential future exposures from OTC derivative transactions.
Required
Robust operational infrastructure and efficient post trade processing,
with a focus on capital efficient products and market offerings to profitably navigate in the new environment.
Data Basis: ISDA, BIS, BCBS-IOSCO, Deloitte, Member Firms Survey
Av. Cost per Method (estimate per million euro notional)
Standardised Approach 2.10 bps
Model Based Approach 0.85 bps
Instrument Type Market Share (estimate per million euro notional)
Interest Rate 77 % 1.00 bps
FX 11 % 2.15 bps
Credit Derivative 4 % 1.80 bps
Equity 1 % 2.40 bps
Other 7 % 1.50 bps