Collateral Management

© 2012 Hedge Fund Academy. All rights reserved.

COLLATERAL MANAGEMENT

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CLIENTS

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INTRODUCTION

• Hedge Fund Academy & Ramplin Capital

• Training, Advisory and Structuring
– Collateral , OTC derivatives & CCP
– Hedge Funds & other alternative funds
– Regulations (Reg 28, Basel III, UCITS, G20)

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G20 REQUIREMENT

All standardised OTC derivative trades should
All OTC derivatives trades should be reported be centrally cleared
to a trade repository

2009 commitment to
reform the OTC derivatives
market in 4 key areas:

Standardised OTC derivatives should be traded
Higher capital charges should be implemented
on exchange or electronic platforms where
for non-cleared OTC derivatives
appropriate

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REGULATIONS - TIMETABLE

2011 2012 2013 2014 2015 2016 2017 2018 +
Basel 2.5 Market and securitisation rules
Basel 3 Revised capital ratios

Quality of capital
Enhanced capital requirements
Capital buffers
Margin for uncleared swaps
G20 Clearing
Transparency and execution
Higher margin for non-cleared OTC
Reporting requirements
Dodd Frank Registration
Mandatory clearing
Transparency and execution
Reporting requirements

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LIQUIDITY LIQUIDITY LIQUIDITY

LCR
• Short-term measure,
compares a banks liquid
assets against a one

month acute liquidity
stress
• Stress factors:
– Ratings downgrade
– Deposit runs
– Lack of funding roll-overs
– Increases in haircuts
and collateral calls

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ECONOMIC VS REGULATORY
CAPITAL
_________________________________________________________________________________________________________________________________________________________________________________________________________________________
_____________________

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REGULATORY VS.. ECONOMIC
CAPITAL

• Regulator stipulates a specified
Regulatory
minimum level of capital that
Capital
each firm must hold.

• Firm determined amount needed
to cover excess of worst-case loss
Economic over expected loss, function of
capital risk
• Can be more but not less than
the regulatory capital
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IMPACT OF COLLATERAL ON CAPITAL
REQUIREMENTS

Predicted credit exposure for a 10 year swap
under a variety of collateral conditions
4,000,000
No collateral
Predicted Exposure in GBP

3,500,000 Monthly collateral calls
Daily collateral calls
3,000,000

2,500,000 Summary Average Peak
Exposure Exposure
No collateral 3,793,585 14,609,547
2,000,000
Monthly collateral calls 221,958 2,352,755
1,500,000 Daily collateral call 134,473 1,404,670

1,000,000 Notes
All data in British Pounds Sterling (GBP).
500,000 The transaction modeled is a 10 year par
0 interest rate swap, with a GBP 100 million
notional principal. We assume a zero unsecured
threshold in the collateral agreement, and allow
for a 7 day “cure” period between an event of
Time
default and the liquidation of collateral.

Rate of the red line curve takes this shape due to the amortisation effect and the fusion effect
what the market is doing for example.

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ECONOMIC CAPITAL REDUCTION FOR BANKS

600
550
500
450
400

350

300
250
Portfolio Value ($m)

200
150

100
50
0
-50
-100

-150
Economic Capital (no netting & no collateralisation): $ 1,000,000
-200
-250
Economic Capital (with netting, but no collateralisation): $ 190,000
-300 Economic Capital: ( with netting and collateralisation: $ 37,000
-350
Economic Capital measured through the CVA process
-400

A ug Dec A pr A ug Dec A pr A ug Dec A pr A ug Dec A pr A ug Dec A pr
2002 2002 2003 2003 2003 2004 2004 2004 2005 2005 2005 2006 2006 2006 2007
Forward Date

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CVA
_________________________________________________________________________________________________________________________________________________________________________________________________________________________
_____________________

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BASEL III – CVA

• Credit value adjustment

• Seeks to mitigate counterparty credit risk in
bilateral trades
• Based on the riskiness of the counterparty
• Will significantly increase capital requirements
for uncleared OTC derivatives

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EXEMPTION FROM CLEARING IN EU

• Pension funds in Europe have been granted
exemption from central clearing

• Dilemma …
– Opting for exemption means opting for higher capital
charges on uncleared OTC and therefore a higher
CVA and therefore higher price putting on the same
position
– Impact on asset managers, pension funds and
corporates

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MITIGATING CVA

• Buy protection like a CDS or Cdi (if available on

a single name counterparty)

• Collateralise the trade with both initial and
variation margin (probably cash)

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ESTIMATED GLOBAL COLLATERAL
REQUIREMENTS FOR CCP TRADES

Source Gross Net Notes

Oliver Wyman $3,1tr $700bn $700bn middle of the range $500
- $800bn

Bank of $156bn - Financial Stability paper Oct

England $594bn 2012

BIS $718bn Range $303bn - $1.167tn
depending on volatility (BIS
working paper March 2012)

OCC $2.56tr Based on OCC’s large dealers

Moody’s $3.6tr “New OTC regulations will boos
demand for eligible collateral”

$3tr - $4trn gross additional collateral

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CURRENT COLLATERAL LEVELS

• ISDA Margin Survey, 2012:
– $3.6tr of collateral already supporting non-cleared
OTC derivative transactions.
– CVA will potentially increase this number.

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IMPACT ON NON-DEALERS

Initial margin requirements for comprehensive central
clearing of OTC derivatives by BIS working paper 373

Collateral requirements for IRS - Volatility of market values
Low Medium High
Dealers $15bn $29bn $43bn
Non-dealers $252bn $470bn $699bn

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NETTING

• Separating trades into cleared and uncleared
trades will lose the benefit of netting across the
portfolio and potentially result in higher collateral
calls per portfolio (client).

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FOREIGN CCP

• Dodd Frank requirements – Jan 2013

• Cost of foreign funding ($ funding)
• FX risk
• No interest on collateral

Offshore vs. local argument…

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DRAFT HEDGE FUND REGULATIONS

• Limit counterparty exposure under an OTC
derivative to 10% of NAV
– banks would now have to post collateral back to
hedge funds in order to maintain the 10% limit

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REG 28

• OTC paper … collateralisation of pension funds
and exposure management
• No rehypothecation of pension fund assets

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COST OF COLLATERAL
_________________________________________________________________________________________________________________________________________________________________________________________________________________________
_____________________

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OPPORTUNITY COST OF
COLLATERAL

• An additional R1 tied up in collateral means one
can’t do anything with it.

• Impact on ROE / performance of the fund

• Cost of collateral:
– The funding cost of collateral vs. the interest received
on the collateral
– Now add all the noughts you can find in a trillion $
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BASIC FEES ASSOCIATED WITH
COLLATERAL MANAGEMENT

People • Skilled collateral staff

• Legal expenses associated with the
Legal negotiation process and the development and

maintenance of necessary documentation

• Operational and technology costs associated
Ops with administering the process, integrated
systems

• Custody fees and financing costs associated
Custody with the pledging, receiving and monitoring of
collateral

Financing • Collateral funding (optimisation)

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CASH VS. SECURITIES
COLLATERAL

• Cash remains the dominant form of collateral
• Government securities is the next most common
• Basel III and other regulations will put pressure
on the use of cash collateral

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CASH IS STILL DOMINANT

Operational Cash fully
Risk of sovereign

simplicity, 80% of fungible, easy to
debt – European CCP clearing
collateral still rehypothecate, no
crisis
cash recharacterisation

Stricter eligibility
Low interest rate
schedules- No segregation of
environment, low
decline in cash collateral,
cost of funding
corporate bonds Basel III
cash
& equities

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CHALLENGES OF CASH
COLLATERAL

Greater focus on
structuring cash
Cash Interest
reinvestment
reinvestment risk Basel III liquidity calculation,
solutions for both
(rate & c/party requirements especially during
the buy and sell
default) failed settlements
side (on and off
balance sheet)

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SECURITIES COLLATERAL

• Regulations and the increased requirements for

liquidity and collateral will force counterparties to
search for alternative forms of collateral.

• Increase in the use of securities collateral

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BENEFITS OF SECURITIES AS COLLATERAL

Reduction in FX
Reduction of risk (where

funding cost required)

No reinvestment Possibility to
risk include received
collateral in a
stock loan
programme
(caution legal
risk)

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CHALLENGES OF SECURITIES AS
COLLATERAL

Credit risk of Price volatility of
Ability to price
issuer security

Concentration
Relatedness Liquidity
risk

Dealing with
corporate Perfection of
Rehypothecation
actions, security interest
redemptions etc.

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QUALITIES OF “GOOD” COLLATERAL
ASSETS

Pricing and
Transparency
Correlation

Legal risk

Volatility of
collateral
Liquidity –
ability to sell
Credit quality the collateral
of the issuer

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QUALITIES OF “GOOD” COLLATERAL
ASSETS

Eligibility list

Triparty
collateral
Haircuts agreements

Collateral
Asset
Re- Concentration
hypothecation
Custody and potential of
settlement asset
efficiency

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CONSEQUENCES
_________________________________________________________________________________________________________________________________________________________________________________________________________________________
_____________________

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SHIFTING FOCUS

• The management of risk, liquidity and capital must be at
the heart of banks’ strategies in the future.

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COLLATERAL OPTIMISATION

• As counterparties look to assess the capital needs and
true profitability of individual product lines, firms are trying
to:

– minimise capital requirements through activities such
as cross netting and central clearing

– while at the same time seeking to ensure best use of
”cheaper” internal assets

• They are also seeking ways to accurately allocate and
measure the true cost of each underlying business.
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OPTIMISATION

• Greater importance to market participants.

• Optimisation refers to the ability to post and re-use

collateral according to delivery preferences such as:
– Cost of funding and delivery
– Liquidity and market capitalisation
– Embedded haircuts in the CSA
– Availability of assets to the delivering party
– Cost of reinvestment and yield
– Ability to re-use

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OPTIMISATION

• As collateralisation becomes more commoditised through
process improvement and automation.

• Increasing trend to introduce business rules around

maximising the efficiency and minimising the cost of collateral.

• Basel III will force optimisation

• 71% of the large dealers optimise daily

• Over 60% of market participants only optimise when the
movement of collateral is materially sufficient to warrant
investigation and operational effort.

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G20 REQUIREMENT

All OTC derivative trades should be
All standardised OTC derivative trades
reported to a trade repository
should be centrally cleared
(WITHOUT COLLATERAL IT IS
(MORE COLLATERAL)
MEANINGLESS)

2009 commitments to
reform the OTC
derivatives market in 4
key areas:

Higher capital charges should be
Standardised OTC derivatives should be
implemented for non-cleared OTC
traded on exchange or electronic platforms
derivatives (HIGHER CVA OR MORE
where appropriate
COLLATERAL)

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MARKET IMPACT

• Impact of CVA on non-
cleared trades
Corporates Derivatives for hedging e.g.
• Impact of collateral
currency and interest rate
requirements due to
risk. Manage volatility of
Basel III / higher capital
earnings. If hedging

on non-cleared trades /
becomes more expensive,
impact on banks
will corporates opt out?
• Building infrastructure to
Insurance companies Hedging long dated collateralise or become
liabilities client of CCP member
Hedge funds / Asset Execution of strategies • Loss of portfolio
managers margining
• Impact on portfolio
Pension funds Long dated swaps to performance
manage the risk in a
pension scheme
Dealers Increased capital
requirements

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CHALLENGES

• Regulators are moving at different speed : US (Dodd
Frank) vs. Europe (EMIR & ESMA) vs. South Africa

• Adoption of Basel III in US slow vs. the rest
• Basel vs. non-Basel regulated entities – opportunity for
arbitrage?
• Rise in demand for “safe or good quality collateral”
• SA legal framework for the use of securities as collateral

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CONTACT DETAILS

Marilyn Ramplin

Hedge Fund Academy / Ramplin Capital
01 783 9390
marilyn@hedgefundacademy.co.za
www.ramplincapital.com
www.hedgefundacademy.co.za

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