The document discusses the impact of collateral requirements on the use of over-the-counter (OTC) derivatives by final clients. It notes that derivatives are often the best tool for transferring risk, but that appropriate derivatives may not be available or may be too costly or cumbersome due to collateral requirements, which can negatively impact the real economy. The document examines studies on the positive economic impact of derivatives and provides a case study of a Swiss pension fund's use of derivatives. It also discusses challenges posed by regulatory uncertainty and lack of collateral safety for end users.

1. Giuseppe Ballocchi, CFA
University of Lausanne and Board of Governors, CFA Institute
Collateral Management Forum, Vienna, 29 May 2015
Back to the basics: the impact
of collateral requirements on
the use of OTC derivatives by
final clients

2. 2

3. 3
The purpose of derivatives: risk transfer
• Financial markets: a risk transfer engine (although imperfect and incomplete)
• R. Schiller: The New Financial Order
– We need to create more financial derivatives to hedge fundamental risks
• Derivatives: very often the best tool to transfer (i.e. take on or lay off) risk (but there
are derivative-induced risks as well…)
• In the current uncertain macroeconomic environment, there is more interest for tactical
asset allocation and extreme risk protection.
• If appropriate derivatives are not available for hedging, or too costly or cumbersome,
the real economy suffers.

4. 4
A few findings
• Macroeconomic Assessment Group on Derivatives (Cecchetti et al., BIS, 2013, p. 3):
“…the group found little prior analysis of how derivatives can affect the
economy”.

5. 5
 Deriving the economic impact of derivatives: growth through risk
management (The Milken Institute, 2014, but funded by CME Group). The
study concludes that from 2003 to 2012 in the US derivatives:
– added 150 billion to US GDP
– boosted employment (0.6%) and industrial production (2.1%)
 There are a few studies showing positive microeconomic impact ( e.g.
Bartram, Brown and Conrad (2011) conclude that derivative usage results
in risk reduction and in an increase in firm value for large sample of non-
financial firms from 47 countries.
The impact of derivatives on the economy

6. 6
A short case study: a leading Swiss public pension fund
1. In order to avoid damaging home bias in investing, derivatives to hedge currency
risk are indispensable:
– Swiss pension fund assets amount to about 115% of GDP, i.e. 50% of the total
Swiss stock market cap (which is itself exceptionally high as a fraction of GDP)
2. To control duration: IR swaps
3. To mitigate inflation risk: inflation swaps and commodity swaps
• Note: risk management , including hedging of unwanted risks, cannot be conducted on
the basis of the most probable scenario (or the best forecast), but must consider
worst-case outcomes.
• This very conservative, prudently managed pension fund with absolutely no leverage,
ends up with a gross nominal derivative position that can be larger than its assets.

7. 7
A short case study: the challenges
• Regulatory uncertainty and extraterritorial reach of regulation:
– Avoid Dodd Frank by not having US counterparties (fragmentation in ISDA survey)
– Subject to EMIR, but without the temporary clearing exemption available to
European pension funds
• Lack of certainty about collateral safety (depending on segregation
model/jurisdiction), (with related reputational risk).
• Operational issues (including collateral availability and cost) and costs.

8. 8
Are assets used as collateral well protected ?

9. 9
 Assessing the safety of posted collateral under nearly all circumstances requires
a thorough legal analysis. A future crisis may also lead to unforeseen
circumstances and unprecedented measures (see Vestia case study).
 A simple economic framework: compare the credit risk arising from derivative
operations to the overall portfolio credit risk and avoid correlated credit risk e.g.:
– Reduce direct exposure to the credit of financial institutions in the presence
of operational exposure from collateralization
– Reduce exposure to systemic risk if one is making extensive use of CCP
Collateral safety

10. 10
 Central counterparty clearing does not remove credit risk from the system.
 It just redistributes it. But it also increases transparency.
– It removes the need for the Asset Owner to establish an independent
valuation (necessary for effective credit risk mitigation in the bilateral mode)
 Will central counterparties become unmanageable hot spots of systemic risk?
 Not enough thought has been given to the needs of the final Client (who is not a
clearing broker).
Central counterparty clearing

11. 11
 After a few teething problems in its operational set up, CCP clearing (and
other regulation) is going to enhance systemic stability, ensuring that
derivatives are manufactured safely, and serve the intended purpose, for the
benefit of the economy.
– Regulation-induced liquidity reduction (e.g. in fixed income) is not
altogether unintended, but meant to drive home the true cost (and limits)
of liquidity provision.
 BIS Macroeconomic Assessment Group on Derivatives
– The macroeconomic impact of OTC derivatives regulatory reform are
likely to be positive, with a long run GDP impact of between 0.09 to
0.13%.
The optimistic view on regulatory developments

12. 12
 Tight coupling: the components of a process are critically interdependent,
they are linked together with little room for error or time for recalibration or
adjustment.
– Charlie Chaplin’s caricature assembly line in The Mechanical Age
– Causes: Nonstop information flow and unquenchable demand for instant
liquidity. It is accentuated by leverage and some risk management
practices.
 The Regulation Trap: the natural reaction to market breakdown is to add
layers of protection and regulation. But it may lead to unintended
consequences, compounding crisis rather than extinguishing them because
the safeguards add even more complexity which creates more failure.
Source: R. Bookstaber
The pessimistic view: complexity and regulation

13. 13

14. 14

15. 15
A Copernican revolution ?
• Status quo:
– The financial stability debate does not focus sufficiently on the current and potential
needs of derivative end users, and the wider macroeconomic impact of derivative
use.
– The finance industry is too self-referential (J. Kay).
• What should happen ? A Copernican revolution.
– Put final clients first !
– Holistic analysis of cost/benefits of derivatives for the entire economy, balancing the
need for financial stability against the cost imposed by derivative regulation,
including the financial instability that could arise from not using derivative
strategies as hedging tools because of their costs or any access barriers.
– Fiduciary duty: the gold standard, as opposed to suitability, which is inferior by
far.

16. 16
 The perspective: we must take the point of view of the Asset Owner (and
final client).
 This is a holistic perspective that cuts through many layers of agents and
complexity.
 The profound understanding of client needs that ensues is a source of lasting
competitive advantage
– Collateral (and generally OTC derivative implementation) is a challenge,
but also a wonderful opportunity to get closer to the client.
 But it is quite difficult to achieve (e.g. silos).
Putting end users first in derivative space

17. 17
 Asset Owners (and their agents) should adopt a holistic perspective
– Risk analysis e.g. in the asset/liability management framework
– Mitigation/hedging of unwanted risks as per Board-approved risk appetite
– Consideration of implementation aspects of derivative strategies and the
interplay with the entire portfolio
Investment and risk governance for an Asset Owner

18. 18
 Asset Owners (and their agents) should adopt a holistic perspective:
– Risk analysis e.g. in the asset/liability management framework
– Mitigation/hedging of unwanted risks as per Board-approved risk appetite
 From Collateral Optimization 1.0 (where collateral assets and derivative
strategies are given), to Collateral Optimization 2.0, where derivative
strategies (including collateral issues) are examined in the asset allocation
process (and the collateral value of assets is taken into account):
– Derivative strategy implementation is part and parcel of investment
strategy: collateral cannot be relegated to a back office implementation
issue. It should be elevated to the Investment Committee.
Elevating the profile of collateral management

19. 19
 Understand our instrument universe
– Which derivatives make up the lion’s share of our exposure (globally and
on a per counterparty basis) ? Is it FX, IR, inflation swaps, commodity
swaps or other ?
 Understand the level of instrument complexity
– Do we deal mainly in plain vanilla instruments ?
– If not, why ? It is often preferable to have a simpler and liquid (albeit
imperfect) hedge, rather than a customized, complex and illiquid one.
Customize strategies, not building blocks !
 Estimate realistic collateral needs and availability of eligible collateral
General checklist

20. 20
 Derivative implementation is inherently multidisciplinary:
– Credit and liquidity risk
– Advanced derivative valuation and collateral
– Specialized multi-jurisdictional legal issues
– Operational concerns
 It is challenging to assemble all these competences with the needed
synergies
– Even if especially large players in principle have all of this, how can it be
brought to bear for the end user, i.e. the asset owner ?
Many challenges….

21. 21
 Implementation shortfall (A. Perold, 1988): difference between real
performance and paper performance
– Takes into account execution cost and opportunity cost (the cost of not
trading or delaying trading), e.g. in transition management
– Generally recognized as the best measure of implementation cost
 My conceptual proposal to evaluate the implementation of investment
strategies with derivatives:
– Augment the implementation shortfall measure to take into account
collateral flows from collateralization
– Take into account the risks (e.g. operational, counterparty, liquidity,
systemic) due to the derivative strategy
A conceptual framework to assess implementation of derivative strategies

22. 22
- 1081
- 23
+ 316
+ 701
- 103 + 36
- 15
Commission
Price
Impact
Trader Timing
Opportunity
Liquidity
Supplying
Liquidity
Neutral
Liquidity
Demanding
Trading Conditions
- 178
- 60- 327
Source: Wagner (Handbook of
Portfolio Management)
The iceberg of transaction costs (basis points)

23. 23
Impact of changes in regulation on derivatives
 It is quite difficult to foresee the impact
– Higher capital requirements (e.g. from Basel III) may reduce liquidity, but impact
may be smaller than for bond trading, and liquidity may be filled by non-banks
– Dodd/Frank and EMIR bring advantages, as well as costs
 Simple and short-dated derivatives are unlikely to be affected
 Larger bid/ask spread for longer maturity derivatives and a move away from
complex derivatives are likely.
 In the implementation shortfall framework we recommend, derivatives are likely to
remain the best instrument to lay off unwanted risk or to take on tactical exposure.

24. 24
Impact of changes in regulation on derivatives
 It is quite difficult to foresee the impact
– Higher capital requirements (e.g. from Basel III) may reduce liquidity, but impact
may be smaller than for bond trading, and liquidity may be filled by non-banks
– Dodd/Frank and EMIR bring advantages, as well as costs
 Simple and short-dated derivatives are unlikely to be affected
 Larger bid/ask spread for longer maturity derivatives and a move away from
complex derivatives are likely.
 In the implementation shortfall framework we recommend, derivatives are likely to
remain the best instrument to lay off unwanted risk or to take on tactical exposure.

25. 25
 Any measurement is subject to error (which in classical physics means deviation
from the true value):
– Statistical error, which can be essentially eliminated if the measurement can
be repeated an arbitrarily large number of times
– Systematic error, which is caused by inherent limitations of the measurement
method, and can be lessened only by improving the method itself
 A measurement is:
– Accurate, if its deviation from the true value is small
– Precise, if repeated measurements yield very similar observations
 A measurement can be precise without being accurate, if its systematic error is
large.
Valuation: a few key concepts from physics

26. 26
 Finance is more complex than physics: there is no such thing as the true value
of an OTC derivative
– We must recognize that systematic error can be very large (model error,
sudden drying up of liquidity, etc).
 But physics still helps: there is a confidence interval around the true value.
This confidence interval results from valuation uncertainty (statistical and
systematic error in physics terms).
 If the difference between our valuation and that of the counterparty is within
this confidence interval, there is no reason to start a dispute.
Valuation uncertainty

27. 27
 Preparing for crisis is onerous, but quite beneficial.
 Among the (many) issues to address:
– Operational continuity and speed of response
– How challenging will it be to replace terminated derivatives operationally
and liquidity-wise ? It will be quite difficult if we are demanding liquidity in
a crisis scenario.
– Assess correlation of collateral in our hands and exposure. E.g. this
correlation was quite favourable for equity lending with top quality
government bond collateral.
 Good news: the crisis provided us with a number of case studies (but not yet
for CCP failure … )
Preparing for crisis: the failure of a major counterparty

28. 28
Conclusions
 We need a Copernican revolution: the collateral (and derivative)
debate must be focused on end users.
– Regulation must take into account macroeconomic effects and not create
create suboptimal outcomes by making hedging unduly difficult or costly.
The regulation trap should be avoided.
– Collateral management is an excellent opportunity to create lasting
competitive advantage by putting end users first and gaining unique
insight into their needs and objectives.
 Implementation shortfall and the iceberg of transaction costs as
conceptual tools to evaluate the implementation of derivative strategies.
 Derivatives are likely to remain the best instrument to lay off unwanted risk or
to take on tactical exposure.

29. 29
Recommendations
 Keep making a judicious use of derivatives, and at the same time keep monitoring:
 Changes in regulation and the creation of new instruments
 Changes in derivative liquidity and market structure, in the light of existing
positions, and the liquidity requirements of existing strategies
 Toward Collateral Optimization 2.0: collateral and the implementation aspects of
derivative strategies:
– Must be considered as part and parcel of investment strategy and cannot be
relegated to a back office issue.
– Their interplay with asset allocation must be taken into account at the investment
strategy level.
– A wide range of multidisciplinary competences must be brought to bear.

30. 30
Back to the basics: the impact of collateral
requirements on the use of OTC derivatives by final
clients.
The value added by derivatives in portfolio
management and to economic activity
Optimistic (and pessimistic) scenarios for the future
of OTC derivatives
Open challenges
Pragmatic guidelines for derivative usage

31. 31
Are derivatives dangerous ?

32. 32
The purpose of derivatives: risk transfer
• Financial markets: an imperfect and incomplete risk transfer engine
– Regulation should not add to imperfection (e.g. unjustified barriers to entry, national
segmentation, etc.)
• R. Schiller: The New Financial Order
– Creation of financial derivatives to hedge fundamental risks
• Derivatives: very often the best tool to transfer (i.e. take on or lay off) risk (but there
are derivative-induced risks as well…)
• In the current uncertain macroeconomic environment, there is more interest for tactical
asset allocation and extreme risk protection.
• If appropriate derivatives are not available for hedging, or too costly or cumbersome,
the real economy suffers.

33. 33
 Standard theory assumes that derivative market makers can lend and borrow at
the risk-free rate
 In reality funding and collateralization impact derivative pricing
 A valuation framework to make such impacts into account has become available
(Johannes and Sundaresan, Bianchetti, Piterbarg, Fuji and Takahashi)
Collateral agreements and derivative pricing

34. Interest Rate Swap
Properties:
- Maturity
- Pay frequencies for both legs
- Day count conventions for both legs
- Floating leg index: Libor 3m, 6m, EONIA…
- Fixed leg coupon rate <= traded value
A B
fixed
floating

35. 35
Interest Rate Swap

36. 36
Rate projection

37. 37
Rate projection: Single curve approach
6m 12m quoted implied
03/10/2000 5.0400 5.1569 5.1515 5.1441 0.7372
EURIBOR FRA 6x12
|delta| (bp)date

38. Rate projection: Single curve approach
- The single curve approach does not work since the 2007 crisis!
0,0000
20,0000
40,0000
60,0000
80,0000
100,0000
120,0000
140,0000
160,0000
180,0000
200,0000
10.3.2000
2.15.2002
6.30.2003
11.11.2004
3.26.2006
8.8.2007
12.20.2008
5.4.2010
9.16.2011
EUR FRA 6x12 market vs. single curve implied

39. 39
 Cash collateral in the same currency of the trade reduces to discounting at the
collateral rates.
 Cash collateral in a different currency introduces an additional cross currency basis.
 Cash collateral in a choice of currencies introduces a non-linear cross currency
basis adjustment
 Taking into account actual rules in collateral agreement and effective collateral
management practice requires additional correction terms, some of which need to
be accounted for at collateral account netting sets.
 This is why it is recommended to post collateral in the instrument currency, without
optionality in the CSA agreement (as in the Standard CSA), to obtain the most
favourable transaction price.
Impact of collateral currency on valuation (Trovato)

40. 40
Model risk in illiquid markets
 Illiquidity and jumps/gaps increase model risk
 Evaluation risk (i.e what I called systematic risk earlier on): how does the market
price attainable in the market differ from the mark-to-model evaluation price ?
− Uncertainty in model inputs (e.g. implied volatility curves)
− Model risk
− Liquidity (and market access) risk
− The more complex the derivative, and the further away it is from liquid options with
transparent prices, the larger the evaluation risk

41. 41
Liquidity: market and funding liquidity (Borio)
 Liquidity: more easily recognized than defined
 Working definition: a market is liquid if transactions can take place rapidly and with
little impact on price (affects the implementation shortfall of a trade)
 Liquidity is generally not observable (it can be measured only through proxies)
 Generally ignored in standard financial models (which assume frictionless markets)
 Market liquidity has several dimensions:
 Tightness (e.g. bid/ask spread)
 Depth (maximum size of transaction that is absorbed without affecting price)
 Immediacy: speed at which orders can be executed
 Resiliency: ease with which prices return to normal after temporary order
imbalances
 Funding liquidity: ability to “cash in” value (either via sale or access to external funding)
 Critical for the orderly execution of trades (hence for market liquidity)

42. 42
Optical illusion related to asset illiquidity
 Asset illiquidity frequently leads to serious risk underestimation
 Illiquidity (and price smoothing from revaluations based on quotes without transactions
or mark-to-model) result in lower apparent volatility. Examples: lower volatility of real estate versus
equity, returns of some hedge funds, subprime.
 Stale (or smoothed) prices of an illiquid asset result in apparent lower correlation with
liquid assets
 Is advertised alpha in part a liquidity risk premium ?
− What is left of alpha if we account conservatively for liquidity risk ?
 Unrealistically smooth return patterns are especially suspicious

43. 43
Liquidity and option prices
 Option price:
1. Replication cost through dynamic hedging
2. Plus a premium in implied vol (and smile) to historical vol if there is
market asymmetry (option market makers are typically short vol)
“Implied volatility can be thought of as a yield paid to investors for providing
insurance to the market” (Reiss)
 Higher funding costs, and reduced availability of risk capital widen the arbitrage
channel: small misspricings are no longer arbitraged away
 Illiquidity increases model risk (especially when models do not take liquidity into
account)
– Jumps (not taken into account by Black Scholes) may become more material

44. 44
Impact of changes in regulation on derivatives
 It is quite difficult to foresee the impact
– Higher capital requirements (e.g. from Basel III) may reduce liquidity, but impact
may be smaller than for bond trading, and liquidity may be filled by non-banks
– Dodd/Frank and EMIR bring advantages, as well as costs
 Simple and short-dated derivatives are unlikely to be affected
 Larger bid/ask spread for longer maturity derivatives and a move away from
complex derivatives are likely.
 In the implementation shortfall framework we recommend, derivatives are likely to
remain the best instrument to lay off unwanted risk or to take on tactical exposure.

45. 45
Impact of changes in regulation on derivatives
 It is quite difficult to foresee the impact
– Higher capital requirements (e.g. from Basel III) may reduce liquidity, but impact
may be smaller than for bond trading, and liquidity may be filled by non-banks
– Dodd/Frank and EMIR bring advantages, as well as costs
 Simple and short-dated derivatives are unlikely to be affected
 Larger bid/ask spread for longer maturity derivatives and a move away from
complex derivatives are likely.
 In the implementation shortfall framework we recommend, derivatives are likely to
remain the best instrument to lay off unwanted risk or to take on tactical exposure.

46. 46
Conclusions
 We need a Copernican revolution: the collateral (and derivative)
debate must be focused on end users.
– Regulation must take into account macroeconomic effects and not create
create suboptimal outcomes by making hedging unduly difficult or costly.
The regulation trap should be avoided.
– Collateral management is an excellent opportunity to create lasting
competitive advantage by putting end users first and gaining unique
insight into their needs and objectives.
 Implementation shortfall and the iceberg of transaction costs as
conceptual tools to evaluate the implementation of derivative strategies.
– It is crucial to evalaute long term collateral needs for the chosen
derivative strategy

47. 47
Recommendations
 Keep making a judicious use of derivatives, and at the same time keep monitoring:
 Changes in regulation and the creation of new instruments
 Changes in derivative liquidity and market structure, in the light of existing
positions, and the liquidity requirements of existing strategies
 Collateral and the implementation aspects of derivative strategies:
– Must be considered as part and parcel of investment strategy and cannot be
relegated to a back office issue. S
– Their interplay with valuation must be taken into account at the investment strategy
level.
– A wide range of multidisciplinary competences must be brought to bear.

48. 48
 Regime of opaque systemic risk with high policy and political uncertainty.
 The current discussion about fixing finance is tired (R. Urwin).
– Charlie Chaplin’s caricature assembly line in The Mechanical Age
– Causes: Nonstop information flow and unquenchable demand for instant
liquidity. It is accentuated by leverage and some risk management
practices.
 The Regulation Trap: the natural reaction to market breakdown is to add
layers of protection and regulation. But it may lead to unintended
consequences, compounding crisis rather than extinguishing them because
the safeguards add even more complexity which creates more failure.
Source: R. Bookstaber
The current macro

49. 49
A few findings
• ISDA survey (February 2014) of derivative end-users
– Administrative burdens are even more of a concern than hedging costs.
– Geographic market fragmentation, induced by regulation, has a negative impact on
end users ability to manage risk and increases cost.
– OTC derivatives are very important for the firm’s risk management strategy. Their
use in the second quarter of 2014 will be constant.
• BIS Macroeconomic Assessment Group on Derivatives
– The macroeconomic impact of OTC derivatives regulatory reform are likely to be
positive, with a long run GDP impact of between 0.09 to 0.13%.