BNP Paribas. The Challenge of OTC Derivarives Clearing

OTC derivatives
The challenge of deriving clear benets

An in-depth look at regulatory changes and their impact on institutional investors
A research publication from BNP Paribas
Managing editor
Franck Lambert, Head of marketing, BNP Paribas Securities Services
Contributing editors
Florence Fontan, Head of European affairs, BNP Paribas Securities Services David Beatrix, Business development - market and financing services, BNP Paribas Securities Services Mark Armstrong, Legal European regulatory affairs, BNP Paribas Corporate and Investment Banking Nicolas Mehta, Head of OTC derivatives documentation, policy and development, BNP Paribas Corporate and Investment Banking
Additional contribution
Jeremie Pellet, Head of regulatory affairs, BNP Paribas Corporate and Investment Banking Florent Benhamou, Market risk products, BNP Paribas Securities Services Cyril Ettori, Head of market and counterparty risk analysis, BNP Paribas Securities Services Eric Roussel, Head of product management, trade and market solutions, BNP Paribas Securities Services
Special thanks
Jonathan Duff, Communications manager, BNP Paribas Securities Services Mark Hillman, Head of marketing and communications, BNP Paribas Securities Services
Table of
contents
06 08 10 14 16
Executive summary Part 1: Overview of the regulatory initiatives affecting OTC derivatives
1.1 Dodd-Frank Act and EMIR: similar but different 1.2 Ucits and Solvency II: increasing requirements on the valuation of OTC derivatives
Part 2: The impact of regulations on investment managers operations, financing needs and counterparty risk exposure
2.1 Operational aspects of the introduction of cleared OTC derivatives
Navigating the documentation provisions Connecting to SEFs, affirmation platforms and trade repositories Renewing your approach to OTC derivatives valuation Adapting your collateral management set-up Choosing a clearing broker
18
30
2.2 New funding challenges

The rise of collateral requirements Analysing your options for collateral optimisation and transformation
37
2.3 A new paradigm for counterparty risk

The implications of CCP models Upgrading the approach to counterparty risk measurement
42 44 48 52
Next steps About BNP Paribas Glossary Contacts
Executive
Summary
Over the years, over-the-counter (OTC) derivatives have given institutional and corporate investors a flexible tool for hedging a large range of risks. The swap market has grown very large. Then the 2008 financial crisis occurred and critics accused the OTC derivatives markets of triggering and amplifying the crisis due to the swap markets sheer size. Since the 2008 crisis, regulators have proposed a number of initiatives aimed at making the market safer. Chief among such initiatives are the Dodd-Frank Act in the US and the European Market Infrastructures Regulation (EMIR) in Europe. The two are similar in the way they treat OTC derivatives, particularly as they seek to mitigate systemic risk and boost transparency. However, there are a number of important differences that cannot be overlooked, raising the thorny issue of transatlantic regulatory arbitrage. In parallel, other regulations such as Europes undertakings for collective investment in transferable securities (Ucits) directive and Solvency II frameworks are forcing institutional investors to be more risk-conscious when using OTC derivatives. At the heart of their requirements is the valuation challenge of complex instruments, with a clear objective to promote independent, sophisticated and more frequent pricing. Electronic execution and clearing are surely coming, in conjunction with a requirement to mark derivatives to market on a daily basis. In short, the barrage of regulatory initiatives will change the entire OTC derivatives industry dramatically and institutional investors will need to look closely at the impact of these initiatives on three areas: 1 Operations: first, diverging documentation requirements on both sides of the Atlantic will present legal challenges. Beyond that, frontand back- office teams will have to change the way they handle cleared OTC derivatives (interface/connectivity with execution and affirmation platforms among other things). At the same time, they must upgrade existing internal procedures and systems to meet more stringent requirements for un-cleared OTC derivatives. Middleoffice teams may struggle to adapt their reporting capabilities and valuation techniques for both cleared and un-cleared OTC derivatives, often referred to as portfolio bifurcation. This forces the issue for a hybrid yet state-of-the-art collateral management set-up. As a result of these operational changes, many institutional investors will look to outsourcing as a way to mitigate complexity. Funding: collateral requirements will become more complex and will ultimately rise due to new rules for collateral eligibility at CCPs and the co-existence of cleared and un-cleared OTC derivatives. This already worries investors, particularly in times of tight liquidity. Executing brokers and clearers will increasingly be judged on their skill in working with custodians to make the best use of collateral. Counterparty-risk measurement: centrally cleared OTC derivatives markets are deemed to be safer during times of adverse market conditions. However, investors will have to learn how to do business with a more diverse array of counterparties: dealers, clearers and central counterparties (CCPs), and to consider the best option to safeguard their collateral. Increasingly detailed regulatory provisions will challenge asset managers, especially in Europe, to measure counterparty risk at fund level. 7
Part 1:
Overview of the regulatory initiatives affecting OTC derivatives
Part 1: Overview of the regulatory initiatives affecting OTC derivatives
1.1 Dodd-Frank Act and EMIR: similar but different

From Pittsburgh to Washington and Brussels
A little more than a year after the collapse of Lehman Brothers, the G20 countries met in Pittsburgh in September 2009. They passed a resolution stating: all standardised OTC derivatives contracts should be traded on the exchanges or via electronic trading platforms, where appropriate, and cleared through CCPs by end of 2012 at the latest. Principally, the resolution sought to allay systemic risk in the market for OTC derivatives, and to make transparent (pre- and post-trade) transactions that were widely perceived as opaque. It sparked a lively debate on both sides of the Atlantic about how best to overhaul and regulate the OTC derivatives markets. The US Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) on 15 July 2010, which was signed into law by President Obama on 21 July, 2010. The implementation of the Dodd-Frank Acts derivatives reforms (contained in Title VII), initially due to take effect on 16 July 2011, has been delayed by the US regulators until later in 2012. Title VII of the Dodd-Frank Act creates a new regulatory framework for participants and products in OTC derivatives markets. It requires most derivative products to be traded on execution platforms, cleared through CCPs according to strict rules governing capital, margin, reporting, record keeping and business conduct, or collateralized on a bilateral basis, and reported to Swap Data Repositories. On 15 September 2010, the European Commission published its formal legislative proposal for regulation on OTC derivatives, central counterparties and trade repositories: European Market Infrastructures Regulation (EMIR). Like the Dodd-Frank Act, the proposed European Union (EU) Regulation aims to fulfil the commitments given at the G20 Pittsburgh summit: all standardised OTC derivatives should be cleared through CCPs by the end of 2012 at the latest. Moreover, EMIR contains additional provisions related to the confirmation process, collateral mechanisms, independent valuation and reporting of OTC transactions to trade repositories. The proposed EU Regulation is still in draft form and is subject to amendment during the EU legislative process. Political agreement on the final text is expected sometime in Q4 2011. Both the proposed EU Regulation and the Dodd-Frank Act envisage that there will be extensive regulatory standards that will significantly affect how the two regimes operate. In the EU, the European Securities and Markets Authority (ESMA) will have the important job of developing most of these standards and rules (to be finalised by the end of June 2012, albeit this seems like a moving target). In the US, the job falls mostly to the Securities Exchange Commission (SEC) and the Commodities Futures Trading Commission (CFTC).
Objectives and spirit

The Dodd-Frank Act and EMIR share the same approach when it comes to regulation of the OTC derivatives markets. Both seek above all to 10
mitigate systemic risk and increase transparency. However, there are significant differences between the two, and those differences are growing as EMIR passes through the legislative process in Brussels. The thorny issue of transatlantic regulatory arbitrage is ever present. The Dodd-Frank Act tackles some things that EMIR does not, but some of these will be addressed in a separate review by the EUs markets in financial instruments directive (MiFID). Notably, draft MiFIR (ie, the proposed amendments to MiFID will take the form of a directive and a regulation) will cover pre- and posttrade transparency requirements for OTC derivatives transactions and the non-equity markets, and the mandatory trading of OTC derivatives on organised trading facilities (OTFs) or derivatives trading venues (DTVs). A draft legislative proposal on the latter is expected from the European Commission in late October 2011. Both the draft EU Regulation and the Dodd-Frank Act aim to impose mandatory clearing and reporting obligations on a broadly defined class of OTC derivatives (with notable differences for some classes of derivatives). Both, however, allow regulators like ESMA in the EU and CFTC in the US to decide which derivatives are eligible and when the clearing obligation applies. The draft EU Regulation is potentially less burdensome for certain end-usersfor example, pension funds albeit that this is still a moving targetin terms of the clearing obligation. Under the Dodd-Frank Act, the clearing obligation applies to everyone trading an eligible contract, although non-financial entities may escape them when entering into certain hedging transactions. In the EU, the clearing obligation applies to all financial counterparties. Non-financial counterparties only become subject to the clearing obligation when their positions exceed a specified clearing threshold yet to be defined by ESMA and certain hedges will be excluded. The Dodd-Frank Act imposes margin requirements on dealers and major swap participants entering into un-cleared transactions. At the counterpartys request, the initial margin (Independent Amount) must be segregated with an independent third party custodian. The latest compromise draft of the European Regulation discussed at Member State level requires financial counterparties to prove that they can measure, monitor and mitigate operational and credit risk (non-financial counterparties are exempt except when the clearing threshold is breached). Derivatives contracts entered into once the Regulation is in force must show that collateral has been accurately and appropriately exchanged. There is no mandatory requirement to segregate collateral in accounts, only a requirement to distinguish such collateral if a request is made by one of the parties prior to contract execution. However, the extent of segregation is not clear. Neither is there any distinction made between initial and variation margin. There are also questions as to whether segregation is at CCP level and at clearing-member level. The latest draft Regulation also considers permitting competent EU authorities to exempt intra-group transactions from the collateral requirements (such transactions are defined in the draft). Both the Dodd-Frank Act and the proposed EU Regulation envisage subjecting dealers to rules for registration and business conduct. The US regime also extends registration, conduct of business and margin/capital rules to major swap participants. 11
Both the Dodd-Frank Act and the proposed EU Regulation seek to allow cross-border clearing by permitting the recognition or exemption of non-domestic CCPs. It remains unclear, however, how these provisions will operate in practice. The Dodd-Frank Act requires compliance with all US rules providing trade repository services across borders (including indemnification). The proposed EU Regulation currently requires recognition of nonEU repositories by ESMA, provided certain conditions are met. Among these conditions is an international agreement with the third country and co-operation arrangements. We do not know yet what obligations EMIR and Dodd-Frank Act will impose when the parties to a transaction are on different sides of the Atlantic. The Dodd-Frank Act requires the execution of OTC derivatives contracts subject to the clearing obligation on a swap execution facility (SEF) or on a futures or securities exchange. The SEF or exchange will have to make the derivative available to trade, with post-trade transparency in real time for cleared derivatives and to position limits. In the EU, as noted previously, these issues are being addressed separately as part of the MiFID review. Until the European Commission publishes its legislative proposal later in 2011, it is premature to state to what extent the EU will mirror the relevant Dodd-Frank requirements. The EU proposals currently have no equivalent to the US push out rule restricting the derivatives activities of banks. They also do not have an equivalent to the Volcker rule that restricts banks from carrying out proprietary trading.
DoDD-Frank act anD EuropEan MarkEt InFrastructurEs rEgulatIon: DIFFErEnt spEEDs IIn Europe, EMIR is still under negotiation at the European Parliament. It is expected to be finalised before the end of 2011. EMIR is a European regulation, not a directive. This means it will pass directly into national law without a period of national transposition by each EU member state. Despite this fast-track approach, however, EMIR is not expected to come into force before the end of 2012 at the earliest as the European Commission, with the support of ESMA and other European regulators, needs to adopt almost 30 technical standards. In mid June 2011, the CFTC and SEC took actions that will likely defer most of the Dodd-Frank Act requirements regulating swaps and security-based swaps. Temporary relief will give market participants until the first quarter of 2012 to complythe initial date was to have been July 2011. To date, the SEC and CFTC have issued very few final rules, including how they even define the term swap.
Dodd-Frank Act signed 21 July Rule making by CFTC and SEC
CFTC temporary exempt relief 14 June
Initial deadline for rule making 16 July
Title VII Rulemaking deadline 1st Quarter
Rules effective date 4th Quarter
US (Dodd-Frank)
2010
2011
2012
31st Dec G20 Deadline
European Comission Prorposal
Creation of ESMA
EP vote on EMIR
ESMA publishes technical standards
MiFID review
15 September Europe (EMIR)
1 January
European Parliament ECON vote on EMIR
4th Quarter
May
4th Quarter
EMIR enforcement
24 May
Council agreement on EMIR
31 December
20 June
12
acts anD rEgulatIons: transatlantIc DIFFErEncEs
EU: EMIR Scope

Broad range of OTC derivatives but limited to derivatives on specific underlyings (MiFID Annex I, Section C) Out of scope/exempt: Spot foreign exchange (FX) transactions, commercial forward FX transactions, some kinds of physically settled commodity transactions
US: Dodd-Frank
Applies to a broad range of OTC derivatives including any agreement, contract or transaction that is, or in the future becomes, commonly known to trade as a swap Out of scope/exempt: Spot FX transactions, some types of physically settled commodity transactions and certain physically settled forward transactions in securities Possibility for the Treasury secretary to exclude FX swaps and forwards from the clearing obligation (but not the reporting obligation)
Clearing obligation
Mandatory clearing of eligible derivative contracts for trades entered into between financial counterparties and third country entities (including those which would be exempted if EU entities) Two ways to determine clearing eligibility: (a) Bottomup: CCP request and (b) Top-down: ESMA in consultation with the ESRB (incentivise EU CCPs to clear; use of non-EU CCPs) Criteria: (1) systemic risk reduction (2) liquidity of contracts (3) availability of pricing information (4) ability of the CCP to handle contract volumes (5) level of client protection provided by the CCP EMSA to define details in secondary legislation by 30 June 2012
Clearing obligation applies to anyone who enters into a derivative subject to the clearing obligation; applies to trades between US and non-US counterparties In general, the rules do not apply to derivatives trades that do not have a direct impact/connection with US commerce (eg Foreign CCP, Foreign counterparty probably excluded) Mandatory clearing of swaps determined by the CFTC (for swaps) and SEC (for security based swaps) as eligible provided a central clearing house exists Criteria: differ from the EU; for example, the US regulators are required to take into account the effect on competition, including clearing costs CFTC can also restrict trading in non-cleared contracts and stay the application of the clearing obligation Stricter oversight of swap dealers and major swap participants, including registration with the CFTC, BCR, position limits and stricter capital and margin requirements Customised trades may trade OTC, but must be reported to a trade repository and likely to be subject to higher capital and margin charges Transactions between financial and non-financial counterparties not exempt from the margin requirements, but regulators have indicated that these provisions should not apply to end-users Secondary rule-making will define capital and margin requirements
Non-cleared trades
Bilateral trading of non-cleared trades possible, provided general risk management measures are in place (eg mitigation of operational and credit risk, including requirements for electronic confirmation, portfolio reconciliation, daily mark to market of outstanding contracts, segregated exchange of collateral or appropriate holding of capital) Capital requirements directive (CRD) IV likely to impose higher capital charges for non-cleared trades and 1-3% risk weighting for CCP exposures
Reporting
Financial counterparties and non-financial counterparties that exceed an information threshold are subject to the reporting obligation of OTC derivatives contracts to Trade Repositories, no later than the working day following the execution, clearing, or modification of the contract Possibility for a counterparty to report OTC derivatives contracts on behalf of another counterparty When a trade repository is registered by ESMA for reporting a particular type of OTC derivative, all those derivatives previously entered into shall be reported to that repository within 120 days
Each swap, either cleared or uncleared, shall be reported to a registered Swap Data Repository as soon as technologically practicable after time of trade execution (appropriate delay will apply for block trades) Responsibility of reporting uncleared swaps to SDR will depend on a hierarchy of counterparty types Uncleared derivatives existing at enactment generally must be reported to a registered trade repository or the relevant regulator, under rules that must be adopted by October 2011, within 30 days of the final rules or other time period specified in the rules CFTC/SEC to draft secondary regulations pursuant to statutorily prescribed deadlines General effective date is 360 days after date of enactment (21 July 2010), but rulemaking is likely to extend beyond this period
Timeline
Draft Regulation in the co-decision procedure and under review by the European Parliament and Member States For the Regulation to come into effect, both Parliament and member states need to jointly negotiate and agree a single text (expected for end 2011) ESMA to draft technical standards by 30 June 2012
Most rules will provide opportunity for public comments for Technical standards need to be adopted by the Commission 30 days (some rules 45-60 days) to be legally effective Regulation has direct effect (unlike a directive) and requires no implementing legislation would enter into force 20 days after official publication (anticipated end of 2012 but could be earlier if politically expedient) CCPs that have an existing national authorisation would have two years to obtain authorisation Other provisions do not take effect until implementing regulatory standards are adopted (eg information and clearing thresholds for non-financial counterparties) EMIR generally unclear on the non-application of the new requirements to existing trades (grandfathering provision)
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1.2 Ucits and Solvency II: increasing requirements on OTC derivatives valuation
Beyond EMIR and Dodd-Frank, the industry has witnessed mounting regulatory pressure for more independent, sophisticated and frequent valuation. Which investors are most affected? Which jurisdictions have the most detailed provisions?
Asset management
Since January 2009 (Ucits III 4th amendment), European asset managers are required to use independent valuation sources for all positions. The financial crisis of 2008 prompted some countries to move ahead on their own without waiting for the European Regulation to evolve. In France, the Autorit des Marchs Financiers (AMF) published its own instructions as early as 9th December 2008. Asset managers must now have internal pricing capabilities for valuing the term financial instruments (comprising OTC derivatives) they hold in their portfolios. The Ucits IV directive, entered into force on 1 July 2011, allows managers to invest in OTC derivatives, provided that the OTC derivatives are subject to reliable and verifiable valuation on a daily basis (Article 50 of the Ucits IV directive). Ucits IV also requires them to be able to monitor at any time the risk of the positions and their contribution to the overall risk profile of the portfolio (Article 51). In July 2010 the Committee of European Securities Regulators (CESR) published its own guidelines. These cover risk management and the calculation of global exposure and counterparty risk for Ucits (CESR/10-788). They will change current market practices dramatically. The OTC derivatives exposure must now be computed on the basis of a commitment approach much more sophisticated than computing mark-to-market exposure. Moreover, even when a commitment approach does not apply, the guidelines generally call for more advanced models of counterparty risk. The use of OTC derivatives has spread widely since Ucits III included them among eligible securities. The trend has even led the European commission to create the term sophisticated Ucits to designate these funds with innovative investment strategies. As a result, the above requirements for independent, sophisticated and more frequent pricing of OTC derivatives are having an impact on very large areas of the investment community. Since its third version, Ucits has become Europes flagship investment vehicle, spreading globally as a brand. So the question of how to value OTC derivatives interests more than just European asset managers. Asset managers in Asia or hedge funds trying to use Ucits vehicles to attract institutional investors are directly concerned.
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Insurance
Insurance companies operating in Europe face slightly different issues regarding OTC derivatives. The Solvency II legislation places risk management at the heart of their operations. It imposes an approach based on cash flow, requiring consistent valuation of assets and liabilities and computation of stresstested values to obtain the Solvency Capital Requirement (SCR) and Minimum Capital requirement (MCR). Insurance companies traditionally tend to focus rather on the modelling of their liabilities rather than their assets. The former are complex and very specific, while the latter can be evaluated at relatively low cost by external parties. The new regulations will change this dramatically. Insurance portfolios typically contain OTC derivatives such as interest rate or credit default swaps and inflation-linked instruments and to hedge the guaranteed minimum returns in variable annuity products. The new consistency requirement between assets and liabilities will compel insurance companies to develop complex data warehouses and look-through reporting. They will need to improve their data cleansing processes in conjunction with asset valuation processes. That is why we believe insurance companies will further rely on their asset management departments to value their fund assets. For valuations of their direct holdings in OTC, however, they will tend to rely more on external providers.
solvEncy II In a nutshEll The European directive Solvency II must be applied from the 1 January 2014, by all insurance companies based in Europe. It has the first objective to place risk management at the heart of all insurance companies, imposing a cash-flow based approach, and harmonising insurance sector practices. The second objective is to protect policyholders through robust and comprehensive risk management practice. The directive is composed of three pillars: Pillar I, quantitative requirement on capital computation, has the most important impact in terms of OTC valuation and reporting capabilities. It aims to make the market consistent in terms of valuation of assets and liabilities and the computation of their stressed values to obtain the Solvency Capital Requirement (SCR) and Minimum Capital requirement (MCR) Pillar II, supervisor review, aims at better organisation of- and more operational and governance controls over- investment management Pillar III, disclosures: a comprehensive reporting approach to the regulator, the company board and the investors Solvency II requirements also impact asset managers, in particular because Pillar I imposes on insurance companies look-through reporting capabilities to analyse their underlying portfolio of funds. This results in increasing pressure on asset managers to bring further transparency to their allocation.
Regulatory provision for OTC derivatives valuation is not new but it is now reaching a critical point. This is particularly true in Europe, which is adding layers of provisions and requirements at both the European and national levels. While EU legislation seems to be taking the lead, the impact is already worldwide, especially for asset managers. Indeed, whether the need arises from having to respect Ucits requirements or to help their insurance clients comply with Solvency II, the pressure is on asset managers to fully understand the details and intricacies of the new legislation.
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Part 2:
The impact on investment managers operations, financing needs and risk exposure
17
Part 2: The impact on investment managers operations, financing needs and risk policies
2.1 Operational aspects of the introduction of cleared OTC derivatives

Navigating the documentation provisions
Differing approaches in the EU and the US have fostered the adoption of different clearing of OTC derivatives. What is the impact on documentation and how should investors approach it? Europe
The EU approach is in essence a principal model. Today, the bilateral agreement adopted between two counterparties dealing OTC derivatives is typically the master agreement published by the International Swaps and Derivatives Association (ISDA). It is composed of several components: Master agreement: defines the general terms and conditions that will guide the relationship (obligations, events of default, governing law) Schedule: adapts the Master Agreement to specific needs of the parties and sets out any particular terms the parties agree will apply to transactions between them Conformation: sets out the term of a specific transaction Credit support annex/deed: relates to the financial collateral that will be exchanged between the parties (eligibility, frequency, haircuts, thresholds.)* The new reforms will add to these documentation requirements. Clients will now have to sign one or more clearing agreements that bring into effect an additional agreement such as an ISDA master agreement with a collateral annex for cleared transactions. Transactions will continue at present to be entered into directly between the client and the clearing member (or executing broker, under a give-up relationship). Once the clearing broker has entered into or accepted the transaction with the client, an equivalent transaction must also be registered in the client account of the clearing member at the clearing house. Of course, all this comes on top of the master agreement with the executing broker. This is backed up with security interest in favour of the client over the receivable on that clients account with the clearing house. This is designed to mitigate clients credit risk to the clearing member under the cleared ISDA agreement and cleared credit support annex (CSA). It does not, however, extend to any exposure under the existing non-clearing ISDA and CSA, or indeed to any other relationship between the client and the clearing member. Cleared transactions also require the following documents to be put in place:
*Note that this is not put in place for all counterparties.
Master give-up and back-loading agreement between the executing broker and clearing member
18
Designation notice given by the clearing member to the executing broker relating to the specific client in question Compensation agreement which addresses what would happen between the executing broker and the client, should the clearing member not accept the transaction in question within the stated time frame. Clearing fees and other auxiliary matters (as relevant) are set out in a side letter.
United States
the clients margin and other obligations to the clearing house, faces the CCP. The documentation would be a customer account agreement (developed from the form used for existing listed derivative transactions) with an addendum addressing specific issues in relation to cleared OTC derivatives. These might include termination and close-out mechanisms, and any porting arrangements.
The US model, on the other hand, is an extension of the futures model: a futures commission merchant (FCM), acting as agent and guarantor of
appendices). Clearing fees and interest rates on cash margin are set out in a separate side letter. In addition, there is an Execution Agreement (similar to a give-up documentation suite) which can be either bilateral (client and executing broker) or, subject to CMC rulemaking in this regard, trilateral (client and executing broker and FCM). The tables below set out the proposed documentation and documentary approaches for clearing OTC derivatives with CCPs in US and Europe, respectively:
Since these are likely to be standard for all CCPs, one agreement should suffice (though there may also need to be CCP-specific
us approach to lEgal FraMEwork Contract label Purpose Execution or or Clearing?

FCM (Customer Account Agreement) FIA Addendum Business Terms Side Letter (or Schedule 2) FIA Give-Up Agreement Clearing Clearing Clearing Execution/ Clearing
Signing parties Client

X X X X
Executing Broker
X
Clearer
X X X (X)
CCP
(Focus on LCH.Clearnet SwapClear IRS, ICE Clear Credit and CME IRS)
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EuropEan approach to lEgal FraMEwork Contract label Purpose Execution or or Clearing?

ISDA (including CSA) CCPs Clearing agreement, including a cleared CSA & cleared ISDA Clearing deed of assignment Clearing compensation agreement Give up agreement Designation Notice Execution Clearing
Signing parties Client

X X X X
Executing Broker
X X X X
Clearer
CCP
Clearing Execution Execution/ Clearing Execution/ Clearing
X X X
(Focus on LCH.Clearnet Ltd SwapClear IRS)
It seems fair to say that the clearing industry could benefit from further standardisation of documentation.
Connecting to SEFs, affirmation platforms and trade repositories

Adopting central clearing for eligible OTC trades will be a burden for all institutional investors. While most participants expect to make their operations more efficient in the coming years, looming regulatory deadlines will exert significant pressure sooner or later. Which operating model will be needed? How similar will OTC clearing processes look to the familiar futures commission merchant (FCM) model or the general clearing member (GCM) model?
It will take time before OTC trades can be as completely automated as listed derivatives are. We anticipate the process for automating OTC clearing will move forward in fits and starts in the early days. With listed derivatives, in contrast, machines can currently execute and control trades, run risk calculations, accept, reject or reconcile trades without the need for human hands. The diagram below illustrates the existing set-up for Chicago Mercantile Exchange (IRS & CDS contracts) and the target for SwapClear (IRS contracts.) Note that institutional investors will be required to interact with swap execution facilities and affirmation platforms. 20
1 Step 1: Execution and choice of CCP
The block trade is executed on a SEF (Swap Execution Facility) by both parties (the Executing Broker and the Client), including the choice of the CCP The block trade is transferred to an Afrmation Platform
2 Step 2: Afrmation, allocation and choice of futures
Executing broker
Swap Execution Facility Execution choice of CCP Afrmation Platform

1
Client
Front Ofce
Front Ofce
commission merchant (FCM)

The Executing Broker (EB) alleges the block trade (and selects an FCM if not self-cleared) The Client afrms the block trade, allocates the trade to Unique Client ID (e.g.funds) and selects one or several FCM(s) The trade is submitted for clearing to the CCP
3 Step 3: Clearing Consent
Middle Ofce
Afrmation Allocation choice of FCM

3
Trade Support
A Clearing Consent Request is sent by the CCP to the clearing members (Client FCM and EB FCM) The clearing members give their Clearing Consents Give-up
4 Step 4: Intraday Clearing
Risk Give up
Clearing consent
Risk Give up
The CCP runs its risk lters After risk lters are passed, the novation and conrmation of the trade occur simultaneously and a clearing notication is sent to Client FCM, EB FCM and the Afrmation Platform Transaction is allocated in FCM Position Accounts (PA) held by the CCP (for Clients: 1 PA per Unique Client ID= legal entity)
5 Step 5: Post-trade processing
EB (selfcleared) or FCM (EB)
4 Novation Clearing 5
CCP
Post-trade processing Trade Repository
FCM (Client)
Notes: On SwapClear, allocation will potentially be possible post clearing (TBC) On CME, Clearing Consent can be automated through a Risk Filter engine parameterised by the clearing member
Netting Reporting: the trade is integrated by the CCP into the appropriate Trade Repository Reconcilliation Margining and payments
Execution platforms
While the exact definition and mandatory obligations of SEFs are still being worked out, the Dodd-Frank Act mandates that all clearable swaps be executed on SEFs. MiFID 2 will likely include a similar provision for Europe. We expect it to set out an obligation to deal on organized trading facilities (OTFs). Existing platforms like Bloomberg, Tradeweb, and Market Axess are all seeking have the SEF label. They need it to comply with US regulations and to attract liquidity on their systems.
Affirmation and confirmation platforms

Most sell-side firms are already connected to electronic affirmation platforms (mainly ICE Link for CDS and Markitwire on IRS), which are used to match the economic terms of a transaction immediately after execution. They are used extensively for swaps, although use can vary widely between contracts, and ease the electronic confirmation given the existing STP functionalities between the affirmation and confirmation platforms. Yet the use of electronic affirmation is still optional, and small/ medium sized asset managers do not commonly affirm their trades electronically. The vast majority perform only a small number of OTC trades per month, and if they compare the relatively small operational risk with the significant investment cost, they have little incentive to connect to the electronic platforms. 21
Tomorrow, in a world where eligible OTC contracts will have to be executed on organised trading facilities and cleared through a CCP, electronic trade matching and automation in general will not be an option anymore. Asset managers will have to communicate electronically with their counterparts whether it is by connecting to execution platforms when they exist or to affirmation platforms. Execution platforms are still developing and as we have seen the exact regulatory framework is not yet finalised. It is hence early days to know the exact remit of both execution platforms and affirmation platforms. We can however expect affirmation platforms to expand further in the field of non-cleared trades. In any case, following the encouragement by both regulators and ISDA, the industry is moving towards more Straight Through Processing (STP) and electronic affirmation. For bilateral trades (non-cleared OTC) the EMIR proposal explicitly states that where available trade confirmation should be made via electronic means. Institutional investors will have to adapt despite the complexity of setting-up and maintaining connections to those platforms.
Connection to Swap Data Repositories/Trade Repositories

Swap Data Repositories (in the US)/Trade Repositories (in the EU) have been pushed by regulators on both sides of the Atlantic. New rules being drafted will govern the content of such databases, along with how fast and how frequently participants report their positions to regulators. We predict that industry pressure to delay the reforms will push these requirements into 2012 for the US and 2013 for the EU. Nevertheless buy-side entities will have to wait until these rules are finalized to see their positions reported to the various repositories. In the US, the Dodd-Frank Act states that cleared swaps other than large notional swaps (ie block trades) must be reported as soon as technologically practicable after the time of trade execution. While the definition of the entity responsible for reporting cleared swaps is still under debate, the responsibility for the reporting of non-cleared swaps to the Swap Data Repositories falls on the counterparty which has the highest rank in a hierarchy of counterparty types*. This should solve part of the reporting issues for financial and non-financial entities. If this rule stands, a buy-side partys positions will be reported to the trade repository (TR) by its dealer for bilateral trades. On cleared trades, we anticipate that the reporting of cleared trades will be performed by the clearers on behalf of their final clients. In Europe, all OTC derivatives transactions will also have to be reported to a trade repository no later than the business day following execution, clearing or modification. A counterparty may delegate this reporting to its clearing broker, the CCP or an external agent. We expect a number of institutional investors to make use of these options. At the moment, industry initiatives for trade repositories stand at different stages depending on the asset class:
*Section 729 of Dodd-Frank Act sets a hierarchy of counterparty types for reporting obligation purposes, in which SDs [Swap Dealers] outrank MSPs [Major Swap Participants], who outrank non-SD/ MSP counterparties, which would solve part of the reporting issues for financial and non-financial entities (as per the Dodd-Frank definition).
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Fixed income products and especially credit derivatives have historically been the asset classes moving fastest towards electronification. The trend gained momentum in the past decade as operational risk grew in tandem with the booming market. Today almost all credit derivative trades are confirmed electronically in the DTCC from both the sell and buy sides. DTCC even built a Global Repository for OTC Credit Derivatives within its Trade Information Warehouse. This was achieved by adding copper records to the existing gold records (legally binding transactions confirmed electronically). The copper records are single-sided, non-legally binding transactions, and comprise more bespoke contract submissions that are not eligible for electronic confirmation. On interest rates, TriOptimas Interest Rate Trade Reporting Repository (IRTRR) has been active since early 2010. Major sell-side dealers submit their positions to the repository. After March, 2011, however, the ISDA launched a new request for proposal (RFP) for an Interest Rate Repository that would match the CFTCs new list of operating standards. DTCC was selected in early May 2011. What will TriOptima IRTRR become when DTCC starts operating? Good question, since participants will not relish maintaining links with two repositories for the same asset class. For equity derivatives, DTCCs Equity Derivatives Reporting Repository was launched in August 2010. For commodity derivatives, in June 2011 DTCC (in a jointventure with EFETnet) won the bid (issued by the ISDA) to establish a Commodity Derivatives Trade Repository For foreign exchange derivatives, a request for proposal (RFP) issued jointly by ISDA and AFME will aim at setting up a Forex Derivatives Repository. Iberclear and Clearstream also announced in December 2010 the creation of REGIS-TR with Iberia and Telefonica as pilot clients. While DTCC is in a good position to setup a global trade repository across all asset classes, there is a strong possibility that each regulator will request the creation of trade repositories for its respective geographical zone. Yet it remains unclear how EMIR and DFA will respond. The monitoring of systemic risk is one of the top regulatory priorities, but there is no guarantee that regulators will choose to monitor it in the same way. As a result it could be difficult for a given trade repository to comply with both frameworks. The frequency of reporting is also set to increase. Under the CFTCs proposed rules, all swaps must be reported in real time to the Swap Data Repository except block trades, which are subject to a 15-minute delay in reporting. Can internal organisations, procedures, and systems respond adequately given this constraint? We do not yet know. More disquieting still is the question of how much such speedy actions will cost. Level 1 measures for EMIR are not yet approved so the frequency requirement is still up in the air. The draft proposal, however, already requires both cleared and non-cleared trades to be reported. It adds that ESMA will be responsible for recommending in detail how to avoid double reportingthis is to be part of its 23
proposition for level 2 measures. This is a similar objective to the one pursued by CFTC with its hierarchy of counterparty types. Lastly, how to report daily valuations to those trade repositories raises new questions. Currently only static data are reported by participants. Over time, we expect regulators to require additional information so as to better measure the exposure between participants.
Connection to SEFs, adoption of affirmation and confirmation platforms, management of reporting to trade repositories the sell side may be familiar with CCP clearing and its procedures, but institutional investors are not. They have much less experience in CCP-related operational processes. They are about to face a new reality. Entering the complex clearing world will require institutional investors to turn towards expert operational partners, be it their clearer or their middle-office service provider.
Renewing your approach to OTC derivatives valuation

Converging regulations are pushing institutional investors to value their assets, in particular OTC derivatives, in an independent, more sophisticated and more frequent manner. Are asset managers and corporates prepared to meet this challenge and what issues should they be considering?
Most institutional investors have developed internal valuation resources for simple OTC derivatives. IRS, CDS or plain vanilla options still represent the vast majority of the traded exposure and the characteristics of these instruments are relatively standard. The valuation model is straightforward to implement and market data is easy to get from data providers like Bloomberg, Markit, Reuters and others. These internal solutions, however, often do not follow the processing of trades all the way through. Nor are they adapted to the latest regulations. Moreover, insufficient market data regarding, say liquidity, can complicate the valuation of even simple products. This happened frequently during the 2008 crisis.
CCPs prices will help but not enough

In the era of reform now dawning, CCPs will provide valuations of cleared OTC Derivatives on a next day basis. This will not remove the need for independent, third-party valuation, however, even for cleared OTCs. Indeed, possible discrepancies between different CCP algorithms may require price reconciliation. These price discrepancies will probably recur frequently and require quick resolution. Lets take the example of pricing for Interest Rate Swaps. Here the timing of the reference data snapshot may vary from one CCP to another, so discrepancies will arise. In this case, internal valuation could solve the problem by harmonising all prices on a single curve. Discrepancies can also arise naturally from a hedging strategy comprising cleared and non-cleared products. In this case 24
different methodologies and market data for cleared and noncleared trades could render the entire strategy less efficient. Non-cleared OTC derivatives and structured products will compel buy-side institutions to develop a robust valuation process, suited to the complexity and the transparency requirements for the instruments in question. Asset managers will have to take into account several alternative pricing sources, including counterparties, in-house valuations and independent third parties, so as to ensure the robust pricing approach required by regulators.
Vendors can help as long as they are transparent

Institutions should beware the temptation to hold down in-house pricing costs by relying exclusively on external vendor prices to challenge their counterparties. Here they must avoid the blackbox effect. This means that vendors should report their own price computations transparently and disclose the market data used for the valuation, together with the mathematical sensitivities associated with the price. The vendor should also allow for the counterparty to challenge the price whenever necessary, with the former enlisting experts to explain the gap between two prices.
In-house is possible but not straightforward

Those who decide to perform valuations in-house must pay particular attention to the technical challenges posed by complex OTC derivatives. Independent valuation requires specific expertise in data management and generates related costs. Scarce or nonobservable data such as correlations, volatility surfaces or exotic currency prices can be complicated to obtain. Sometimes, the sell side itself may be the only source. It is closer to the market where the price formation occurs. At the same time, over-reliance on sell-side data can compromise the independence of buy-side OTC prices. Additional data sources are required, which is why buy-side companies ask for an external valuation service. In-house OTC valuation resources must also be fast. Ucits IV, EMIR and other upcoming regulations will require daily computation. Production, controls and reporting must all operate efficiently for an in-house system to work with the required frequency. The efficiency of OTC valuation relies on team expertise but also on the performance of a system capable of embracing powerful booking and trade management capacities together with the latest generation of pricing engines. Front-to-back STP platforms such as Murex, Simcorp or Calypso provide those functionalities and can synchronise with risk and collateral management modules. But the substantial investments required to implement such systems can encourage partnering with an expert provider, who will help to meet the regulatory requirement efficiently.
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Institutional investors to embrace more sophisticated pricing methodologies

The more precise the pricing of the contract is, the more optimised the call for collateral will be. As a result, we expect increasing demand for second generation improvements in the pricing process. Such sophisticated pricing methodologies are already widely used by sell-side firms and it is now a matter of time before institutional investors adopt them. One of the main ways to achieve the expected level of accuracy is to factor counterparty risk properly. Counterparty risk has to be taken into account to evaluate the collateral-driven margin calls. In practice, this means the Credit Value Adjustment (CVA) has to be computed at the portfolio level and the incremental CVA must be reflected in the pricing of each transaction. The CVA computation relies on an advanced probabilistic approach and finely calibrated credit market data. The CVA also has to be computed on a pre-trade basis, which is quite a challenge for almost all buy-side companies. Moreover the credit crunch in 2008 highlighted the need for valuation methodologies to account for the nature of collateral (if any) that applies to OTC transactions dealt under a Credit Support Annex (or equivalent collateral agreement). Thus discounting methodologies that take into account overnight interest rate swaps (OIS) spreads are increasingly popular and are progressively replacing the LIBORbased methodologies. Central counterparties themselves are moving to OIS discounting methodologies in their swap-clearing activities.
Regulation and evolving market practices will require a profound rethink of the valuation processes and systems for pricing OTC derivatives. Pricing from CCPs will help but will not suffice. Sourcing alternative prices and adopting the sell-side pricing methodologies is the way forward. Yet, given the complex nature of the instruments, those who buy and sell OTC derivatives are probably better off delegating those increasingly complicated tasks to external partners.
Adapting your collateral management set-up

From a collateral management perspective, the introduction of central clearing will give rise to portfolio bifurcation. Once cleared, OTC trades will refer to clearing agreements, while bilateral OTC trades will continue to refer to ISDA Credit Support Annexes (or local jurisdiction collateral agreements). What will be the impact on collateral management operations and which areas should be looked at?
Although the volume of bilateral trades will decrease in favour of cleared trades, portfolio bifurcation will nonetheless imply a duplication of the processes. The existing bilateral process will remain in place, but a second path will be needed to route the cleared trades to the adequate clearing agreement. 26
This will have a substantial impact on the way back offices work. They will now need clearers reports to perform tasks they used to handle independently, such as processing upfront fees, swap coupon payments, position reconciliations, clearing-fee payments and credit event processing on CDSs. Yet they will also continue to process non-cleared trades as they do under the current OTC model. The clearers reports will also be used by the accounting and collateral departments. They will serve to register each positions mark-to-market and collateral value (the independent valuation of OTC trades has been discussed in a previous section). Although inspired by the bilateral processes, the clearing path will have specific requirements for collateral processing:
Counter valuation ex-post margin call payment

For bilateral transactions, the independent valuation of trades is performed prior to the feed of the collateral systems. It is the basis for the exposure calculation to agree or dispute the margin calls. For cleared transactions, disputing the clearers margin calls will take a slightly different form, even though this independent valuation can still make sense from a control point of view. The client will first pay/ receive the margin calls calculated by the clearer, and afterwards have the option to contact the clearer in case of disagreement. Disagreements should in theory remain rare, given the expected level of automation in the cleared OTC world, and the calculation of mark-to-markets by the CCPs. This should therefore provide a valuation consensus to all participants.
Adaptation of systems to new constraints

The modelling of a clearing agreement can differ substantially from the usual bilateral collateral agreement. In bilateral agreements, the eligibility criteria usually apply indifferently to independent amounts and variation margin. But in the cleared OTC environment initial and variation margins may be treated differently.
Organising information flows

For bilateral transactions, many communications between counterparties concerning, say, margin calls or positions are made through emails. For cleared transactions, however, the workflow will rely on the clearers automated reporting capability. Volumes of collateral exchanges are likely to be higher if the regulator sets standards on thresholds and minimum transfer amounts at a near-zero level for the majority of participants.
Its not just the cleared trades

Notwithstanding the adaptation of the collateral processes to central clearing requirements, the industry has already staked out areas of bilateral collateral management that will affect everybody involved in OTC derivatives activities. Among them are the growing number 27
of collateral agreements, the increased frequency of calls, and the need to resolve disputes in a timely manner. Efficient collateral management procedures have become a major concern for everyone, financial or non-financial, involved in OTC derivatives activities. A collateral roadmap and best practices have been issued in 2010. The ISDA, market participants and industry associations have jointly confirmed their commitment to enhance bilateral risk management in a letter sent to the Federal Reserve and supervisors of the ODSG (OTC Derivatives Supervisors Group) on 31 March 2011. The main points are: Implementation of the Dispute Resolution Convention and Market Polling Procedure, and improvement of dispute reporting Proactive portfolio reconciliation, which is considered as good market practice for dispute prevention (58% of the 2011 ISDA margin survey respondents indicated that they regularly perform portfolio reconciliations) Electronification through the use of standard messages in order to increase straight-through-processing Portfolio compression Some of these commitments are oriented more towards dealers holding huge derivatives portfolios. Nonetheless, institutional investors usually follow broader trends, especially when they hold substantial OTC positions. They increasingly learn from the sell-side and benefit from its best practices. Already today, the growth in the number of counterparties is making collateral management fiendishly complex. This is particularly true for asset managers with a significant number of funds under management. The number of transactions and the frequency of margin calls are increasing drastically. Moreover, they are spread among a much broader array of collateral eligibilities. The performance of the collateral management system often lies at the heart of the problem. Its task is great. It must model collateral conditions efficiently for each collateral agreement, it must import data from many sources in a timely and efficient manner, it must monitor the effective settlements of collateral transfers. Moreover, collateral management of OTC derivatives demands specific staff expertise and carries its own unique costs. The day is soon coming when further significant investment in personnel and systems will be needed. The stringent processes of central clearing, dispute resolutions on bilateral positions, OTC portfolio reconciliations, electronic messaging, and the need to monitor market evolution will demand it.
The complexity of the different cleared and non-cleared OTC processes and the growth in processing volumes will strain existing back-office and collateral-management systems. Serious system and procedure upgrading will be required. For these reasons, outsourcing the collateral operations to a specialist provider who benefits from economies of scale will appeal to institutional investors. As a general observation, the custodian who keeps the assets safe is also best-placed to keep collateral safe and to provide collateral agent services.
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Choosing a clearing broker

While institutional investors are not expected to connect directly to CCPs, they will need to find a way to interact with a clearer who is connected to the CCPs on their behalf. What selection criteria should investors use?
As mentioned earlier, the clearing broker will help institutional investors adapt to the new workflow for cleared OTC derivatives. The broker will also serve as the go-between with CCPs. Eligibility criteria for CCP membership will be strict but the selection process for appointing a clearer is still critical. Here are some key factors to consider: Expertise in legal aspects and market practices: the ability to help with legal documentation should be a given; more important, a clearers legal expert must anticipate future legal questions, not only todays. Operational expertise: the clearer must provide operational support to build connections and adapt processes to central clearing and SEFs. It must also make the necessary upgrade on existing platforms such as ICE Link, DTCC, Markitwire, CLS Excellent credit rating: whereas the credit rating for execution will become less important, it remains predominant in choosing a dealer who is also acting as clearer. Reporting: reporting to local authorities the complete range of trades (cleared, non-cleared) with the appropriate level of information, the right format and frequency is a cumbersome task. And yet it ranks as one of the top concerns of buy-side firms. Quality of relationship: investment firms see the quality of their relationship and partnership with their clearer as a key element of success. Cost: while not the main driver in the decision to appoint a clearer, the question of cost, in particular cost structure, is central. The cost structure needs to be crystal clear and ultimately easy to understand, whether based on a flat fee per trade or the number of deals.
The institutional investor should choose a clearing broker that can tick all of these boxes. In practice, only a few players will be able fulfil all these criteria. Furthermore, the clearer should be part of an organisation that can provide key additional services, such as collateral financing and protection, as we explore in sections 2.2 and 2.3.
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2.2 New funding challenges

The advent of cleared OTCs with competing CCPs and the splitting of portfolios between cleared and non-cleared contracts will increase the complexity of collateral management procedures. It also implies the following funding challenges:
Higher collateral costs due to the generalisation of initial margin requirements and systematic same-day collateralisation (T+0 instead of T+1 for the OTC contract still un-cleared) Lost benefits of exposure netting at portfolio level. Eligible trades executed with a counterparty will be transferred to a clearer, under a clearing contract. Non-eligible trades will remain bilateral, under a collateral agreement. Fragmentation of the collateral requirements across multiple clearers and bilateral counterparties
As a result, the continued use of OTC contracts will generate higher funding requirements for corporations, pension funds and asset managers. All this while liquidity remains scarce. How much bigger will collateral funding requirements be? Beyond collateral optimisation procedures, what options should institutional investors consider?
The rise of collateral requirements

According to the 2011 ISDA margin survey, the number and estimated value of collateral agreements has increased significantly over the past years, with respective cumulative annual growth rates (CAGR) of 26% and 28% since 1999. The figures below show 149,518 collateral agreements reported by respondents in 2010 (of which 90 percent are ISDA agreements), while the estimated amount of collateral in circulation in the OTC derivatives market at the end of 2010 was approximately USD 2.9 trillion. The decreases in the number of agreements and collateral in circulation are mainly due to counterparty consolidation and reduction in counterparty exposures. However it seems reasonable to expect that if volumes of OTC transactions remain at the current levels, the introduction of CCPs will lead to an increase of collateral to be delivered.
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IsDa MargIn survEy 2011 growth oF collatEral agrEEMEnts rEportED by rEsponDEnts as oF yEar EnD, 1999-2010
200,000
Key: reported agreements
150,000
Collateral agreements reported by respondents
100,000
50,000
0 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
IsDa MargIn survEy 2011: growth In valuE oF total rEportED anD EstIMatED collatEral, 2000-2010 (usD bIllIons)
4,000 3,500 3,000 2,500 2,000 1,500 1,000 500 0 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Key Reported Estimated
Value of total and estimated collateral (USD billions)
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The need for sourcing collateral therefore represents a primary concern surrounding the Regulation and the mandatory clearing of OTC derivatives. There are three main reasons: First, institutions that will be in the scope of the regulation will be required to post initial margin on cleared trades. Second, on cleared OTC trades, CCPs will limit the collateral eligible for initial margin and even restrict variation margins to very liquid collateral, that is cash only. Third, collateralizing non-cleared trades, will be mandatory in Europe and most likely in the US (see table below with the CFTC proposed rule on Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants as of 28th April 2011).
Transaction parties
Swap Dealer to Swap Dealer
Swap Dealer to Major Swap Participant
Swap Dealer/Major Swap Participant to financial entity Mandatory collateral
Swap Dealer/Major Swap Participant to Non financial entity Mandatory collateral
Mandatory collateral Margin requirement 99% 10 days Initial Margin or Alternative method Variation Margin Zero threshold 100 000 USD MTA
99% 10 days Initial Margin Initial Margin, Variation Margin and or Alternative method threshold at discretion Variation Margin Zero threshold except for certain types of financial entities (under comment sollicitation)
Collateral conditions to become much more stringent

For bilateral trades, the broker may accept a one-way collateral agreement if it can get the negotiated spread of the OTC contract to compensate for its additional risk. For cleared OTC derivatives, in theory, the model no longer allows counterparties to negotiate better conditions: all counterparties are treated equally by the CCP rule book. Rules regarding acceptable collateral are strict: mainly cash and highly rated bonds. It is unlikely this policy will change and in practice it means an equity fund may be forced to pay the clearer in cash. In practice, especially outside the US, clearers will have the option to adopt a more flexible approach. This is very likely when it comes to large investors or at least significant clients, whose business is strategic enough for the clearer to decide not to adopt the CCPs restrictive criteria. In such cases, clearers would post the full collateral called by the CCP on behalf of its client but not request the corresponding amount from the latter. The adoption of such arrangement is likely to remain limited to a handful of key names and only few investors will be in a position to benefit from it. For the majority of investors, especially asset owners or pension funds with liability-driven investment (LDI) strategies, the move to cleared OTC trades will make a big difference. Initial margin requirements for their OTC positions are likely to be substantial given their long maturities and their outright exposure. The following table uses LCH SwapClear and ICE Clear Credit (formerly known as Ice Trust) as examples. Notice that initial margin can reach almost 10% of the notional amount for an interest-rate swap with a 30-year 32
maturity. Moreover they tend to be fully invested with large pools of securities and little cash and the eligibility restrictions on variation margin will mean raising cash through collateral transformation. This heightens the impact on performance and returns.
ExaMplEs oF InItIal MargIn rEquIrEMEnts by ccps on Irss anD cDss (sInglE traDEs) Notional Pay/Rec
Maturity 2Y 5Y 10Y 15Y 20Y 25Y 30Y
10 000 000 EUR Pay Fix/Receive Float

Initial Margin (EUR) - 38,782 % of notional -0.4% -1.1% -2.7% -5.1% -6.8% -8.3% -9.8%
Notional
10 000 000 EUR
Worst case over 5Y/Holding Period 7 days
ITRAXX.EUROPE.13V1-5Y
Direction Buy Sell Direction Buy Sell Initial Margin (EUR) - 136,452 - 215,004 Initial Margin (EUR) - 462,700 - 695,070 % of notional -1.4% -2.2% % of notional -4.6% -7.0%
- 106,617 - 265,091 - 507,335 - 676,963 - 827,997 - 977,475
ITRAXX.EUROPE.CROSSOVER.13 V2-5Y
Central counterparties whet their appetite

Quite naturally, central counterparties (CCPs) like what they see on the regulatory horizon. The reforms will open up profitable opportunities in global markets. Some of the worlds leading CCPs have been quick to size the opportunity. In the US, ICE Clear Credit has already expanded its substantial business clearing credit default swaps to the interdealer market. In Europe, ICE Clear Europe, Eurex and Clearnet SA have also cleared CDS trades. ICE Clear Europe, with dealers firmly behind it, has processed almost 95% of Europes inter-dealer volume. CME is looking to handle interest rate swap (IRS) clearing, and SwapClear, part of LCH.Clearnet Ltd, is eyeing the US market. These recent CCP initiatives should not lead us to forget that as far back as 1999, OTC dealers went into partnership with LCH Clearnet to create SwapClear, the inter-dealer clearing service for interest rates swaps. The impact however was comparatively modest. Todays new CCPs solutions look to satisfy the entire range of buy-side needs, namely clearing trades between clients and dealers and not just between dealers. Competition between CCPs will lead to collateral fragmentation, thus increasing further collateral funding costs for institutional investors. This raises the issue concerning the ideal number of central counterparties. The presence of more than one CCP per market (or even per OTC product) may reduce systemic risk. However, experience in cash equities markets highlights difficulties arising from multiple CCPs. Developing a harmonious approach to risk management has been anything but straightforward in those markets. While we do not expect such concerns to rile the OTC derivatives markets the way they have in the world of equities, competition is coming, and competition of this sort tends to be disruptive, at least in the short term. 33
Tension is expected around the question of collateral sourcing. In a situation of scarce liquidity, stricter eligibility rules and increased amounts of collateral locked in with CCPs, not all institutions will be treated equally. As often in competitive markets, the laws of natural selection will apply: large counterparties will be able to take advantage of their size to grow bigger, and smaller institutions will find it harder to obtain the flexibility they need.
Analysing your options for collateral optimisation and transformation

None of this makes choosing an OTC derivatives clearer any easier. Indeed, contrary to the listed derivatives world where participants can appoint a third-party clearer independently from the execution brokers, all CCPs that currently offer to clear OTC products require the clearing layer to be performed by an entity who is also a trading participant (see chart next page). Historically, CCPs have developed strong relationships with trading participants that were self-clearing their eligible positions to mitigate counterparty exposure. LCH clearnets Swapclear proved its capacity to handle the Lehman bankruptcy, thanks to the partnership with its trading members who liquidated the defaulting members positions. A major event of default generally triggers intense market stress, making the liquidation procedure even harder for the clearer (in the case of client default), or the surviving members (in the case of clearer default). Last but not least, the strong risk management framework needed to manage third-party clearing, added to the technical nature of OTC products, makes it natural for OTC dealers to enter into OTC clearing services. For these reasons, a model where the clearing, risk management and liquidation functions are integrated within the same entity or group is likely to be the most efficient and ultimately less risky for institutional investors. Unless the industry comes up with an alternative, this requirement leaves institutional investors with three main options, as illustrated in the chart below. Either they decide that each of their dealers will also handle clearing (option 1), thus entirely giving up potential netting effects, or they mandate one or a few of their dealers to act as their clearing agent with their other dealers. The approach is likely to vary depending on the size of business institutional clients need to handle. Institutional clients with larger volumes of cleared OTCs, who typically work with between five to ten dealers, will want to consolidate the clearing but not with one single clearer, so as to get a compromise between netting effects and counterparty risk diversification (option 2). Investors with smaller volumes and also tighter collateral funding capabilities will seriously consider the option to consolidate with one single clearer (option 3) who can demonstrate excellent rating while allowing them to maximise netting benefits and thus help reduce the cost of collateral significantly.
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A model in which the CCP calculates margins required to OTC clearers at each final client level is likely to emerge. There is one other possibility: regulations may authorise an OTC clearer to net positions against the CCPs across all its clients. This last model, inspired from the listed derivatives world, may not be the one preferred by the regulators as it would not guarantee the portability principles and the segregation of margins of a clearers client in case another client of that clearer defaults. However positive the netting effect, and putting aside the benefits of proper management of back-loading, institutional investors will look for additional sources to reduce their funding requirements. OTC clearers who can also act as custodians will be able to bring that additional level of sourcing, using transformation solutions. Because they have access to the clients full range of assets, custodians can measure a clients liquidity and credit profile at any moment. There is no need to pre-fund a collateral account, adding needed flexibility to the process. We expect institutional investors to turn towards OTC clearers who can also act as custodians to maximise the benefits of collateral transformation. It helps that many custodians already have financing, securities lending or repo capability. Last but not least, an adequate allocation of assets to the various collateral requirements can help optimise the funding aspect, so that the collateral posted to counterparties and clearers is the cheapest to deliver at any point in time. Practically, the collateral optimisation process will require institutional investors to: Centralise all collateral requirements across various activities in one place Centralise all eligibility criteria in one system, to avoid situations where the first counterparty requesting collateral is the first served, but allocate efficiently the available collateral, depending on the restrictions imposed by each counterparty Optimise the collateral allocation or transformation, depending on cheapest-to-deliver criteria, revenue opportunities and re-hypothecation possibilities in the respect of concentration/correlation limits
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The organisation of many institutions where operations and systems are often separated from listed derivatives, OTC derivatives, repo, securities lending, and the segregation between front- and back-office teams and systems will act as obstacles to the required seamlessness of the process. Working with a collateral agent is set to become the most viable option institutional investors will want to explore.
backloaDIng Market participants anticipate that the provision for mandatory backloading of trades dealt before the entry in application of the Regulation will be removed. Yet clients may backload voluntarily some of the trades in order to optimise the collateral aspect. Indeed, the first cleared trade will depend on an enforcement date of the regulations, regardless of the clients general hedging strategy. This first cleared trade, on a stand-alone basis, may imply significant collateral requirements. To avoid this, the client could decide to backload part of its portfolio to achieve a delta-neutral position and the netting effect. A sound strategy for backloading of trades, through the use of algorithms that would choose the best backloading scenario, could prove to be beneficial to the level of margin required by the clearer.
The volumes of collateral required will increase and at the same time a growing portion will be tied up in CCPs, thus making resource even scarcer. In this context, investors will have to optimise three main options: 1 Choose a set-up with far fewer clearers than executing brokers so as to maximise the netting effect 2 Seek clearers who can work with custodians and help transform collateral 3 Work with a collateral agent to achieve maximum collateral optimisation Astute backloading management will also help reduce collateral needs in the short term.
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2.3 A new paradigm for counterparty risk

The implications of the CCP models
Market reforms will raise new risks. Institutional investors will encounter risk from executing brokers in their role as counterparty. There will also be heightened risk from CCPs and, to a lesser extent, clearers. What segregation model should investors favour and what is the best compromise between protection and operational efficiency?
The Lehman Brothers bankruptcy made the entire buy-side community more sensitive to the need to protect collateral. Socalled independent amounts often turned out to be commingled with other assets or re-used by their prime broker. Clients who did not safeguard collateral with a third-party custodian realised how vulnerable those assets were. According to the 2011 ISDA margin survey, large dealers rehypothecated 73,6% of collateral. New US and EU legislation will endeavour to provide safeguards. CCPs will henceforth make facilities available for each member to hold its client positions and assets (including collateral) completely segregated from its house or proprietary positions. This will protect clients collateral from exposure to losses from the clearing members proprietary account. The debate focuses now on how much protection indirect participants to the CCP will receive. There are four segregation models currently on the table, from which clients may choose, as follows:
Baseline model omnibus account

Clients Clearing member CCP
Clearing member initial margins
Clearing member segregated account
Client 1 initial margins Clearing member clients omnibus account Client 2 initial margins Clearing member clients omnibus account
This model is currently used by CCPs with an active futures derivative business. It allows a larger mutualisation of defaults and is therefore less costly in terms of margin calls. This is the current Futures Commission Merchant model in the US: if a client is unable to pay on a margin call, the FCM (ie the clearing member) is supposed to cover the clients positions. If the FCM is unable to pay, the CCP can use the other customers collateral for the necessary funds. 37
There is one key drawback to omnibus accounts. They may expose any customer to the risk of default by the clearing member or by another of its customers if the FCM is unable to pay.
Legally segregated, operationally commingled (LSOC) model

Clients Clearing Member CCP
Client 1 initial margins Clearing member clients omnibus account Client 2 initial margins
Clearing member clients collateral
Same omnibus account, but CM clients collateral is legally attributable to each customers contracts.
The legally segregated but commingled model was suggested by CFTC in its December 2010 consultations. This model seeks to capture the advantage of individual segregation without disrupting operational processes. Clients assets are held in the same omnibus account, but collateral is legally attributable to each customers contracts. That collateral is on loan to a customer, and is treated as belonging to the customer at the CCP level, but as a debt at the clearing member level. If the clearing member becomes insolvent when a customer defaults, the CCP would transfer open positions to another clearing member. It should have sufficient information to identify the collateral which is attributable to each non-defaulting customer. This model offers high protection for clients but increases costs for the CCPs users, particularly large dealers.
Moving customers to the back of the waterfall (the waterfall model)

Client 1 initial margins Clearing member clients omnibus account Client 2 initial margins
Same omnibus account, but clearing member clients collateral is legally attributable to each customers contracts.
And the CCP could only use the clearing member clients assets if all other clearing member default funds and its own capital have been used
This model was proposed as option 3 by CFTC in December 2010. As in option 2, clients assets are held in the same omnibus account, but their collateral is legally attributable to each customers contracts. 38
However, non-defaulting clients collateral is only at risk in very large defaults, when other clearing member default funds are needed.
Full physical segregation (the individual segregation Model)

Client 1 initial margins
Client 2 initial margins
This last model ensures total legal segregation of a clients collateral property. Assets are held separately from those of other clients, both at the CM and at the CCP. As a consequence, collateral attributable to any non-defaulting customer is not available as a CCP default resource. This model offers the highest degree of protection for clients but the lowest mutualisation of risks at the CCP level. As a result, the CCP will be compensated by higher margin calls. Individual segregation at the customer account level will also increase operational complexity for CCPs.
Which model is best for you?

These four different models come with different costs. The models range from a simple pass-through to complete transformation. Only individual managers or corporate policy can determine the right balance between cost and protection. The Baseline Model is cheaper in terms of collateral requirement from the clearers perspective. It is also offers the least protection and portability for non-defaulting clients. A significant portion of the collateral posted by the clients is kept by the clearers and is not reflected at the CCP level. Moreover the CCP has recourse to all collateral posted by the clearer in the omnibus account in case of clearer default. The LSOC and Waterfall Models offer much more protection than the Baseline Model. They are similar operationally in that all collateral between the clearer and the CCP flows into a single omnibus structure. However, they demand different levels of effort by the CCP to guarantee client segregation and portability when defaults occur. In the case of clearer default, all the collateral attributable to each final client must be identified and transferred to another clearer. In the case of double default (client default triggering a clearers default), the collateral attributable to each nondefaulting client at the CCP must be identified, segregated from the defaulting clients and transferred to another clearer. 39
The LSOC model guarantees that the non-defaulting clients collateral is not used by the CCP as a resource to cover its losses. However, the Waterfall Model differs substantially by permitting the surviving clients collateral to be used to cover losses once the CCP has exhausted its other resources. This last feature makes it harder to monitor counterparty risk In terms of exposure measurement to counterparty risk, since the CCP could draw on a clients collateral in extreme cases. Thus the LSOC model seems to strike the right balance between operational simplicity and client margin protection. The buy-side will assess the risk of its OTC bilateral counterparties the way it always has. And not all OTC trades will be eligible for central clearing. An OTC clearer may be entitled to additional margin from its final client. That will depend on the clearers credit risk assessment of its clients. The client may also be called upon to provide the clearer with a buffer to cover CCP intraday margin call requirements. Clients should take steps to safeguard this buffer should a clearer default. A tri-party arrangement, where a custodian acts as a collateral agent between client and clearer, may be one solution. The final buy-side client would be wise to consider the agents robustness and technological capability in making his choice. Last but not least, CCP clearing may go a long way toward protecting OTC derivatives markets from systemic risk. This hardly means, however, that systemic risk should merely be passed along to central counterparties. Central counterparties must be properly regulated. Their eligibility must depend on their proven ability to manage risk for products that are sufficiently standardised and liquid.
Regulation should help promote the balance between mutualisation of risk and asset protection. It should also take account of the OTC markets distinct characteristics, notably that it is less liquid than the market for listed derivatives. The point is to offer clients and their clearing members the flexibility to choose the model that suits them best. While corporates and institutional investors must look at the choice of model from their own perspective, LSOC seems to strike the right balance between operational simplicity and client margin protection.
Upgrading the approach to counterparty risk measurement

Regulations are increasingly pushing for monitoring counterparty risk in real time. In parallel, the co-existence of cleared and non-cleared OTC derivatives is increasing the number of counterparties to deal with. What approach should institutional investors adopt?
The need to monitor counterparty risk exposure is not new but regulators have considerably increased the requirements around the topics, while expanding the scope of institutions concerned. As we saw in Part 1, be it with Solvency II for insurance companies, or AIFM and Ucits IV for asset managers, all 40
institutional investors, not only banks, have now to take risk management very seriously. Practically, this means computing and monitoring counterparty risk exposure in real time. For instance, regulatory provisions related to asset management have reached such a level that firms actually need to look for more sophisticated methods and then apply them more broadly and more frequently. Indeed, as outlined in a consultation paper issued by the Committee of European Securities Regulators, even the methodology most asset managers have to use for computing daily risk exposure at fund level, often called commitment methodology, may not be up to the task of measuring complex strategies. With the limitations of the commitment methodology exposed, attention is turning towards the more sophisticated approaches used on the sell side. Indeed, banks and broker-dealers use another type of approach that measures forward-looking exposure. The potential future exposure (PFE) method, which includes both netting and diversification effects, is consistent with the market risk approach. This method also factors in collateral balances and the risk profile of each asset and makes a strong case for buyside managers to consider using sell-side industry practices. Tomorrow, as investors deal not only with bilateral counterparties or prime brokers but also with clearers, collateral agents, executing brokers and CCPs, the number of counterparties to monitor will be higher. Actively managing counterparty credit risk limits will help optimise collateral levels. So will accurately measuring the counterparty risk itself. It should be noted, however, that this will require better reporting, not to mention validated production procedures. The structural challenge to managing counterparty risk lies in evaluating the credit quality of counterparties independently. This is especially true for small- and medium- sized institutions. Large institutions can use their own expert credit analysts, whereas smaller institutions will tend to rely more on information from the rating agencies.
Be it for regulatory purposes or collateral optimisation, active counterparty risk measurement is becoming more complex but more desirable than ever. Like the decision for the optimal segregation model vis vis clearers, the strategy regarding counterparty risk measurement has become a critical business issue for corporate and institutional investors. As for many of the issues discussed in this paper, the question is whether they will see the task fit for an in-house team or if its better delegated to an external partner.
41
Next
steps
Faced with such wide-ranging changes in the structure of the OTC derivatives market, institutional investors now need to focus on a large number of issues. These fall within three areas: operational, funding and counterparty risk, as shown in the table below.
Impacts
Operational
Documentation
Actions
igning new set of documentation for cleared OTCs with S clearing broker igning a collateral agreement S Connecting to SEFs uild a technical connection to new or existing execution B platforms, or enter into relationship with a dealing desk that has links with the execution platforms, to search for best execution egister as a market participant, completing the legal R documentation required by both the platforms and the regulators Connecting to affirmation/ confirmation platforms uild a connection to existing affirmation platforms B eview the operational model and process R onsider using an external service provider to manage C the entire scope of connection and process the trades on behalf of institutional investors Connecting to trade repositories Back-office adaptation onnect to trade repositories depending on the regulation C efine a policy on the interfacing with clearers D efine the internal distribution of data to relevant D departments dapt back office, accounting and collateral infrastructure A and organisation onnect to trade repositories depending on the regulation C OTC derivatives valuation ounter-check CCP prices, using robust valuation process C and independent sources or complex instruments, delegate to 3rd party middle- F office providers se Credit Value Adjustment pricing process at portfolio U level, prior to trade execution Collateral management set-up eview the clearers reporting/ask for customisation R dapt collateral management infrastructure and A organization mplement a portfolio reconciliation process I dapt the dispute procedures to the Dispute Resolution A Convention and Market Polling Procedure ncrease STP level with counterparties and custodians I or big portfolios, define a portfolio compression strategy F Clearer selection valuate credit rating E heck quality of relationship C heck operational expertise C egotiate fees and cost structure N egotiate risk policy (intraday margining and credit N limits)
Funding
Clearer selection, collateral optimisation and transformation
hoose a set-up with fewer clearers than executing C brokers so as to maximise the netting effect Seek clearers who can work with custodians and help transform collateral Work with a collateral agent to achieve maximum collateral optimisation
Counterparty risk
Collateral protection Counterparty risk measurement
Define the best collateral segregation structures with clearers and third-party custodians Adapt counterparty risk processes to the portfolio bifurcation, with differentiated treatment of cleared OTC derivatives
43
About
BNP Paribas
45
About BNP Paribas
The bank for a changing world

BNP Paribas is a leader in global banking and financial services and one of the worlds strongest banks. Present across Europe through all its business lines, the Group has four domestic retail banking markets in France, Italy, Belgium and Luxembourg. It has one of the largest international networks with operations in more than 80 countries and 205,300 employees, including 162,500 in Europe, 15,200 in North America and 12,500 in Asia (30 June 2011). BNP Paribas holds key positions in its three core businesses: Retail banking Corporate & Investment Banking Investment Solutions
BNP Paribas Corporate & Investment Banking (CIB) provides tailormade financing, advisory and capital markets services to its clients. It is a globally recognised leader in many areas of expertise including, among others, structured financing and derivatives across a variety of asset classes. BNP Paribas is a European powerhouse in capital markets with a strong franchise elsewhere around the world. BNP Paribas also has a solid corporate advisory franchise in Europe and Asia. In total, CIB employs 19,800 men and women including 7,000 client-facing staff, present in over 50 countries and serving 14,000 clients (9,800 corporates and 4,200 financial institutions).
BNP Paribas Securities Services provides integrated solutions for all operators involved in the investment cycle: sell-side, buy-side and issuers. Having one of the industrys most comprehensive array of services and an on-the-ground presence spanning all continents means we can meet and anticipate our clients needs wherever and whatever their specific activity. Our network is one of the most extensive in the industry, covering over 100 markets, with our own offices in 32 countries. We service over 6,000 funds globally, with USD 6,975 billion of assets under custody and USD 1,244 billion under administration (30 June 2011).
46
A leader in the derivatives industry

With a dedicated and experienced team of 100 collateral management and OTC derivatives reconciliation specialists, together with best-of-breed technology, BNP Paribas manages one of the worlds largest collateral flows and number of counterparties. As member of the International Swaps and Derivatives Association board and as participant in CCPs for OTC derivatives clearing, BNP Paribas actively contributes to shaping the industry and is consistently recognised as an award-winning derivatives house: Equity Derivatives House of the Year (Risk Magazine 2009, Euromoney 2010) Structured Products House of the Year (Risk Magazine 2011) BNP Paribas offers its clients a large dedicated team: 80 collateral management specialists 20 OTC derivatives reconciliation specialists 8 years experience in collateral management on OTC derivatives We are uniquely positioned to actively participate in market developments and bring you a deep understanding of processes and complexities.
A complete solution for derivatives needs:

Non-cleared OTCs Cleared OTCs
BNP Paribas Securities Services Other brokerdealers BNP Paribas CIB Other brokerdealers Other clearers Other brokerdealers BNP Paribas CIB Other clearers BNP Paribas CIB Other brokerdealers Other clearers Other clearers BNP Paribas CIB
Listed derivatives
Trading
Order management Execution
Clearing Reporting
BNP Paribas CIB BNP Paribas CIB
BNP Paribas Securities Services BNP Paribas Securities Services
Joint reporting on cleared trades for clients of BNP Paribas CIB and Securities Services
Post-trade
Trade support
BNP Paribas Securities Services BNP Paribas Securities Services BNP Paribas Securities Services BNP Paribas Securities Services BNP Paribas Securities Services
BNP Paribas Securities Services
Independent valuation Collateral services Asset protection Custody
47
Glossary
Backloading
The action of clearing already existing bilateral OTC derivatives positions.
Collateral management
Typically, two parties enter into an OTC transaction under an Agreement (ISDA framework mainly) that specifies the contractual relationship between the two parties. As part of this Agreement, a specific document (Credit Support Annex/Deed under the ISDA framework) stipulates that some collateral will be exchanged between them to mitigate counterparty risk. Collateral, in the form of cash or securities, is mainly exchanged on the basis of the variation in the value of the exposure between the parties (value of all OTC contracts under the Agreement). This is often referred to as Variation Margin. In addition, Independent Amounts can be requested by one of the parties.
Commitment approach
The method used to calculate the exposure of a portfolio by adding the value of direct positions to the value of the underlying positions for all derivative transactions associated to the portfolio. For example, the exposure associated to a CDS for 1 million of stock translates into an exposure of the same amount - instead of only the one associated with the collateral posted to take the position.
Excess margin
This represents an additional amount coming on top of the margin call as established by the CCP or by usual valuation method.
Financial entity
This type of entity, defined in the CFTC proposed rule as of 28 April 2010, is a counterparty that is not a swap dealer or a major swap participant. A financial entity is: (1) a commodity pool as defined in Section 1a(5) of the Act, (2) a private fund as defined in Section 202(a) of the Investment Advisors Act of 1940, (3) an employeebenefit plan as defined in paragraphs (3) and (32) of section 3 of the Employee Retirement Income and Security Act of 1974, (4) a person predominantly engaged in activities that are in the business of banking, or in activities that are financial in nature as defined in Section 4(k) of the Bank Holding Company Act of 1956, (5) a person who would be a financial entity described in paragraph (1) or (2) if his activities were organised under the laws of the United States or any State thereof; (6) the government of any foreign country or a political subdivision, agency, or instrumentality thereof; or (7) any other person the Commission may designate. 49
Glossary
Grandfathering/grandfather clause
A legal term used to describe a situation in which an old rule continues to apply to some existing situations, while a new rule will apply to all future situations. It is often used as a verb: to grandfather means to grant such an exemption. Frequently, the exemption is limited; it may extend for a set period of time, or it may be lost under certain circumstances.
Independent Amount
The collateral that is delivered by end-users to dealers to protect them from credit exposure. It can be any amount that the parties agree, but it is typically expressed as a fixed currency amount, a percentage of the notional principal amount, or a computation of value-at-risk. Independent Amounts can be defined at the level of the portfolio of transactions between two parties, or can be defined uniquely for each individual transaction. It can also be zero. (See initial margin.) An Independent Amount is additional collateral over and above variation margin, which provides additional protection for the party receiving it, and usually depends on the credit quality of the party paying it. Independent Amounts are a common practice in the Alternative Investment environment between clients who often post IA to dealers/prime brokers. Some clauses in the contract refer to the frequency of the margin calls (maximum frequency is daily), thresholds, minimum transfer amounts, collateral eligibility, notification times, and what happens when two parties cannot agree.
Initial margin or inital margin requirement

The collateral that is deposited by the clearer at the CPP when an OTC derivatives transaction is agreed between two parties and then cleared by a CCP. What is called independent amount in the case of non-cleared OTC transactions becomes an initial margin requirement in the case of cleared transactions.
Major swap participant (MSP)

A non-swap dealer entity (1) holding a substantial position in any of the major categories of swap or security-based swaps (excluding positions held for hedging or mitigating commercial risk), or (2) having positions creating substantial counterparty exposure that could have serious adverse effects on the financial stability of the United States banking system or financial markets, or (3) using high leverage relative to the amount of capital such entity holds and not subject to capital requirements established by an appropriate federal banking agency; also, holding a substantial position in any of the major categories of swap or security-based swaps 50
Margin call
An investor receives a margin call from a broker or clearer (cleared OTC) if one or more of the securities it has bought (with borrowed money) decreased in value past a certain point. The investor is then forced either to deposit more money in the account or to sell off some of its assets.
Non financial entity

A counterparty that is not a swap dealer, a major swap participant, or a financial entity.
Portfolio compression
A process that reduces the overall size (notional value) and the number of line items in credit portfolios, without changing the risk parameters of the portfolio. The method includes a selection of multiple trades having equivalent terms and a determination of the net notional and net coupon. Replacement trades are created, the combined net notional and combined net coupon of which respectively equal the net notional and the net coupon of the multiple trades being replaced. A position-matching method is implemented for portfolio compression. An implied spread is calculated for each position of a portfolio. Positions with an implied spread outside desired bounds are corrected. A buyer and a seller are selected, the buyer having the position with the highest implied spread value of all net long positions and the seller of all net short protection positions. The created trade has a notional value equal to the smaller of the net default exposure and a spread mirroring the implied spread but with a smaller position.
Swap dealer (SD)

Entities commonly understood to be dealers or market-makers of swaps or security-based swaps, or regularly enter into swaps with counterparties as an ordinary course of business, or that make a market of swaps or security-based swaps.
Transformation solutions
Solutions that allow the substitution of assets not eligible as collateral, via financing or collateral upgrade, to assets that are eligible as collateral.
Variation margin
Variation margin is paid by clearing members on a daily or intraday basis in order to reduce the exposure created by carrying highly risky positions. By demanding variation margin from its members, clearing organisations are able to maintain a suitable level of risk and cushions against significant devaluations.
Sources: www.investopedia.com, www.ftadviser.com, www.wikipedia.org
51
Contacts
BNP Paribas Securities Services

Helene Virello, Head of collateral management services and OTC independent valuation services Helene.virello@bnpparibas.com +33 1 57 43 85 24
BNP Paribas Corporate and Investment Banking

Gavin Dixon, Global head, market initiatives and OTC clearing Gavin.dixon@bnpparibas.com +44 20 7595 8417
53
Printed on recycled paper by EditO verso - Designed by the graphics department, corporate communications, BNP Paribas Securities Services - September 2011
The services described in this document are offered through a joint venture between BNP Paribas Securities Services (Securities Services), a wholly owned subsidiary of BNP Paribas S.A., and the Global Equities and Commodity Derivatives and Fixed Income business lines of BNP Paribas S.A. (BNPP). BNP Paribas Securities Services is incorporated in France as a Partnership Limited by Shares and is authorised by the Autorit de Contrle Prudentiel (the ACP) and supervised by the Autorit des Marchs Financiers (the AMF). BNP Paribas S.A. is incorporated in France with limited liability and is authorised and supervised by the ACP for the conduct of its investment business in France. It is also subject to authorisation and regulation in other jurisdictions as described further below. This document is CONFIDENTIAL AND FOR DISCUSSION PURPOSES ONLY and has been prepared for professional investors by BNPP and Securities Services. This document contains general information only and recipients should note that in providing this document, BNPP and Securities Services are not providing any financial, legal, tax, regulatory or other type of advice. This document does not constitute an offer or a solicitation to engage in any trading strategy or to purchase or sell any financial instruments (Financial Instruments). Given its general nature, the information included in this document does not contain all of the elements that may be relevant for a recipient to make an informed decision in relation to any strategies or Financial Instruments or services discussed herein. For the avoidance of doubt, the provision of any information in this document by BNPP and Securities Services does not represent the formation of an agreement between BNPP, Securities Services and any recipients. Any strategies or Financial Instruments discussed in this document could involve the use of derivatives, which are complex in nature and may give rise to substantial risks, including the risk of total loss of any investment. BNPP and Securities Services make no representation as to whether any of the strategies or Financial Instruments discussed herein may be suitable for recipients financial needs or individual circumstances. Recipients must make their own assessment of the risks inherent in, and the suitability of, any such strategies and/or Financial Instruments, using such professional advisors as they may require. BNPP and Securities Services accept no liability for any direct or consequential losses arising from any action taken in connection with the information contained in this document. This document is a marketing communication and does not constitute independent research or financial or other advice. Information contained in this document may have been obtained from third party sources believed to be reliable. BNPP and Securities Services make no representation, express or implied, that any such third party information is accurate or complete. Any opinions and/or estimates contained herein constitute the judgment of BNPP and/or Securities Services and are subject to change without notice. BNPP, Securities Services and their respective subsidiaries and affiliates accept no liability for any such opinions or estimates or any errors or omissions contained within this document. This document is prepared for eligible counterparties and professional clients only, is not intended for retails clients and should not be circulated to any such retail clients (as such terms are defined in the Markets in Financial Instruments Directive 2004/39/EC). It may not be reproduced (in whole or in part), delivered or otherwise communicated to any other person without the prior written consent of BNPP and Securities Services. BNP Paribas London Branch (registered office: 10 Harewood Avenue, London NW1 6AA; tel: [44 20] 7595 2000; fax: [44 20] 7595 2555) is authorised and supervised by the ACP and is authorised and subject to limited regulation by the Financial Services Authority. Details of the extent of our authorisation and regulation by the Financial Services Authority are available from us on request. BNP Paribas London Branch is registered in England and Wales under no. FC13447. www.bnpparibas.com BNP Paribas & BNP Paribas Securities Services (2011). All rights reserved.

BNP Paribas. The Challenge of OTC Derivarives Clearing

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BNP Paribas. The Challenge of OTC Derivarives Clearing

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OTC derivatives

The challenge of deriving clear benets

A research publication from BNP Paribas

Franck Lambert, Head of marketing, BNP Paribas Securities Services

2.2 New funding challenges

2.3 A new paradigm for counterparty risk

Next steps About BNP Paribas Glossary Contacts

Part 1: Overview of the regulatory initiatives affecting OTC derivatives

1.1 Dodd-Frank Act and EMIR: similar but different

Objectives and spirit

Part 1: Overview of the regulatory initiatives affecting OTC derivatives

Dodd-Frank Act signed 21 July Rule making by CFTC and SEC

CFTC temporary exempt relief 14 June

Initial deadline for rule making 16 July

Title VII Rulemaking deadline 1st Quarter

Rules effective date 4th Quarter

31st Dec G20 Deadline

European Comission Prorposal

ESMA publishes technical standards

15 September Europe (EMIR)

acts anD rEgulatIons: transatlantIc DIFFErEncEs

EU: EMIR Scope

Part 1: Overview of the regulatory initiatives affecting OTC derivatives

2.1 Operational aspects of the introduction of cleared OTC derivatives

us approach to lEgal FraMEwork Contract label Purpose Execution or or Clearing?

Signing parties Client

EuropEan approach to lEgal FraMEwork Contract label Purpose Execution or or Clearing?

Signing parties Client

Clearing Execution Execution/ Clearing Execution/ Clearing

(Focus on LCH.Clearnet Ltd SwapClear IRS)

Connecting to SEFs, affirmation platforms and trade repositories

1 Step 1: Execution and choice of CCP

Swap Execution Facility Execution choice of CCP Afrmation Platform

commission merchant (FCM)

Afrmation Allocation choice of FCM

EB (selfcleared) or FCM (EB)

Post-trade processing Trade Repository

Affirmation and confirmation platforms

Connection to Swap Data Repositories/Trade Repositories

Renewing your approach to OTC derivatives valuation

CCPs prices will help but not enough

Vendors can help as long as they are transparent

In-house is possible but not straightforward

Institutional investors to embrace more sophisticated pricing methodologies

Adapting your collateral management set-up

Counter valuation ex-post margin call payment

Adaptation of systems to new constraints

Organising information flows

Its not just the cleared trades

Choosing a clearing broker

2.2 New funding challenges

The rise of collateral requirements

Key: reported agreements

Key Reported Estimated

Value of total and estimated collateral (USD billions)

Swap Dealer to Swap Dealer

Swap Dealer to Major Swap Participant

Swap Dealer/Major Swap Participant to financial entity Mandatory collateral

Swap Dealer/Major Swap Participant to Non financial entity Mandatory collateral

Collateral conditions to become much more stringent

10 000 000 EUR Pay Fix/Receive Float

10 000 000 EUR