Collateral Management E-Book

Michael Simmons

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Serie: Wiley Finance Editions
• Sprache: Englisch

Seitenzahl: 1123

Veröffentlichungsjahr: 2019

Beschreibung

Insight into collateral management and its increasing relevance in modern banking In the wake of recent financial crises, firms of all sizes have adjusted their policies to incorporate more frequent instances of collateral management. Collateral Management: A Guide to Mitigating Counterparty Risk explains the connection between the need for collateral management in order to alleviate counterparty risk and the actions that firms must take to achieve it. Targeted at middle and back office managers seeking a hands-on explanation of the specifics of collateral management, this book offers a thorough treatment of the subject and attends to details such as internal record management, daily procedures used in making and receiving collateral calls, and settlement-related issues that affect the movements of cash and securities collateral. An expert in financial topics ranging from trade lifecycle to operational risk, author Michael Simmons offers readers insight into a field that, so far, is struggling to produce enough expertise to meet its high demand. * Presents hands-on advice and examples from a bestselling, internationally renowned author who introduces his third book on operations and operations-related activities * Explains the relationship between collateral management and preventing institutional defaults, such as the recent Lehman Brothers downfall Since 2008, firms have recognized and embraced the importance of collateral management, but this book will provide practitioners with a deeper understanding and appreciation of its relevance.

Leseprobe

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Collateral Management

A Guide to MitigatingCounterparty Risk

MICHAEL SIMMONS

This edition first published 2018© 2019 John Wiley & Sons, Ltd

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Library of Congress Cataloging-in-Publication Data

Names: Simmons, Michael, author.Title: Collateral management : a guide to mitigating counterparty risk / Michael Simmons.Description: Chichester, West Sussex, United Kingdom : John Wiley & Sons, 2019. |   Series: Wiley finance series | Includes bibliographical references and index. | Identifiers: LCCN 2018043094 (print) | LCCN 2018044295 (ebook) | ISBN    9781119377108 (Adobe PDF) | ISBN 9781119377122 (ePub) | ISBN 9780470973509    (hardcover)Subjects: LCSH: Collateralised debt obligations. | Credit derivatives. | Security (Law)Classification: LCC HG6024.A3 (ebook) | LCC HG6024.A3 S556 2019 (print) | DDC    332.64/5—dc23LC record available at https://lccn.loc.gov/2018043094

A catalogue record for this book is available from the British Library.

ISBN 978-0-470-97350-9 (hardback)ISBN 978-1-119-37710-8 (ePDF)ISBN 978-1-119-37712-2 (ePub)ISBN 978-1-119-37717-7 (obook)

Cover Design: WileyCover Images: © KJ_Photography/Shutterstock; © agsandrew/Shutterstock; © Alex Staroseltsev/Shutterstock; © ESB Professional/Shutterstock

For Allyson, Keir and Freya

CONTENTS

Cover

Foreword

Acknowledgements

About the Author

Introduction

Part 1 Introductory Elements

Chapter 1 Fundamental Collateral Concepts

Chapter 2 The Nature and Characteristics of Collateral Types

2.1 Cash Collateral: Overview

2.2 Bond Collateral: Overview

Note

Part 2 Sale & Repurchase (Repo) Trades and Collateral

Chapter 3 Sale & Repurchase (Repo) Trades and Collateral – Introduction to Repo

3.1 Introduction to Repo

3.2 Participants in the Repo Marketplace

Chapter 4 Sale & Repurchase (Repo) Trades and Collateral – Classic Repo Trades

4.1 Cash-Based Classic Repo Transactions

Chapter 5 Sale & Repurchase (Repo) Trades and Collateral – The Repo Trade Lifecycle

Introduction

5.1 Pre-Trading

5.2 Trade Execution

5.3 Pre-Settlement

5.4 Settlement of Opening Leg

5.5 Throughout Lifetime of Trade

Evening of Thursday 8th June 2017

Morning of Friday 9th June 2017

Evening of Friday 9th June 2017

Morning of Monday 12th June 2017

Evening of Monday 12th June 2017

Morning of Tuesday 13th June 2017

5.6 Settlement of Closing Leg

Chapter 6 Sale & Repurchase (Repo) Trades and Collateral – Stock-Based Classic Repo Trades

Chapter 7 Sale & Repurchase (Repo) Trades and Collateral – Repo Trade Variations

7.1 Buy/Sell Backs (Overview)

7.2 Tri-Party Repo (Overview)

7.3 Delivery by Value (Overview)

7.4 Repo Central Clearing (Overview)

7.5 GC Pooling (Overview)

7.6 RepoClear (Overview)

Chapter 8 Sale & Repurchase (Repo) Trades and Collateral – The Global Master Repurchase Agreement

Part 3 Securities Lending & Borrowing and Collateral

Chapter 9 Securities Lending & Borrowing and Collateral – Introduction to SL&B

9.1 Introduction to Securities Lending

9.2 Introduction to Securities Borrowing

Chapter 10 Securities Lending & Borrowing and Collateral – Principles of SL&B

10.1 Principles of Securities Lending

10.2 Principles of Securities Borrowing

10.3 Lendable and Borrowable Assets

10.4 Participants in the Securities Lending & Borrowing Marketplace: Introduction

10.5 Securities Lending & Borrowing: Legal Documentation

10.6 Securities Lending & Borrowing and Collateral

10.7 Conclusion

Note

Chapter 11 Securities Lending & Borrowing and Collateral – The SL&B Trade Lifecycle

11.1 Pre- Trading

11.2 Trade Execution

11.3 Pre-Settlement

Trade Date: 28th October

11.4 Settlement of Opening Leg

Opening Value Date: 29th October

11.5 Throughout Lifetime of Trade

Opening Value Date +1: 30th October

Opening Value Date +2: 31st October

Opening Value Date +3: 1st November

Opening Value Date +4: 2nd November

11.6 Recall and Return of Securities

11.7 Settlement of Closing Leg

Closing Value Date: 3rd November

11.8 Settlement of Fees & Rebates

11.9 Additional Factors

Chapter 12 Securities Lending & Borrowing and Collateral – Accessing the SL&B Marketplace

12.1 Routes to Market

12.2 Collateral Management

Chapter 13 Securities Lending & Borrowing and Collateral – The Global Master Securities Lending Agreement

Part 4a OTC Derivatives and Collateral

Chapter 14 OTC Derivatives and Collateral – Transaction Types – Introduction

14.1 Exchange-Traded Derivatives

14.2 OTC Derivatives

14.3 Exchange-Traded Derivatives Versus OTC Derivatives: Summary

14.4 The Future of OTC Derivatives

Chapter 15 OTC Derivatives and Collateral – Transaction Types – Generic Structural Aspects

15.1 OTC Derivative Products

15.2 OTC Derivative Trades – Generic Trade Components and Subsequent Actions

15.3 OTC Derivatives: Trade Processing and Collateral Processing

15.4 OTC Derivatives: Exposure and Collateral Management

Chapter 16 OTC Derivatives and Collateral – Transaction Types – Interest Rate Swaps

16.1 Definition

16.2 Purpose

16.3 Trade Components

16.4 Interest Payment Calculation

16.5 IRS Operations Activity: Overview

16.6 IRS and Collateral Management

Chapter 17 OTC Derivatives and Collateral – Transaction Types – Credit Default Swaps

17.1 Definition

17.2 Purpose

17.3 Trade Components

17.4 Cost of Protection

17.5 Credit Events

17.6 CDS Operations Activity: Overview

17.7 Settlement Following Credit Events

17.8 The Protection Seller’s Risk

17.9 CDS and Collateral Management

17.10 CDS Variations

Chapter 18 OTC Derivatives and Collateral – Transaction Types – Foreign Exchange Swaps

18.1 Definition

18.2 Purpose

18.3 Trade Components

18.4 FXS Operations Activity: Overview

18.5 Foreign Exchange Swaps and Collateral Management

18.6 Foreign Exchange Swap Variations

Chapter 19 OTC Derivatives and Collateral – Transaction Types – Cross-Currency Swaps

19.1 Definition

19.2 Purpose

19.3 Trade Components

19.4 CCS Operations Activity: Overview

19.5 Cross-Currency Swaps and Collateral Management

19.6 Cross-Currency Swap Variations

Chapter 20 OTC Derivatives and Collateral – Legal Protection – Introduction

Note

Chapter 21 OTC Derivatives and Collateral – Legal Protection – Master Agreement and Schedule

21.1 Introduction

21.2 Content of the ISDA Master Agreement

21.3 Content of the Schedule to the Master Agreement

21.4 Negotiating and Signing the Document Framework

21.5 Trading Following Signing of Document Framework

21.6 Trade Confirmation

21.7 Summary

Chapter 22 OTC Derivatives and Collateral – Legal Protection – Credit Support Annex

22.1 Introduction

22.2 Signing of CSA and Trade Execution

22.3 New versus Old CSAs

22.4 OTC Derivative Exposures

22.5 CSA Legal Structures

22.6 Responsibilities Under the CSA: Overview

22.7 Day-to-Day Use of the CSA

22.8 CSA Components

22.9 Ownership of Collateral

22.10 Example Negotiated CSAs: Overview

22.11 Party Liquidation: Impact on Collateral

22.12 Conclusion

Chapter 23 OTC Derivatives and Collateral – Static Data

23.1 Introduction

23.2 Static Data and New OTC Derivative Trades

23.3 Static Data and Collateral Management

23.4 How Software Systems Hold Collateral-Related Static Data

23.5 Sources of Static Data

23.6 Setting Up of and Maintenance of Static Data

23.7 Conclusion

Note

Chapter 24 The OTC Derivative Collateral Lifecycle

24.1 The OTC Derivative Collateral Lifecycle – Introduction

Chapter 25 OTC Derivatives and Collateral – The Collateral Lifecycle – Pre-Trading – Legal Documentation

Chapter 26 OTC Derivatives and Collateral – The Collateral Lifecycle – Pre-Trading – Static Data

Chapter 27 OTC Derivatives and Collateral – The Collateral Lifecycle – Trading – Trade Execution

27.1 Trade Execution: Introduction

27.2 Trade Execution Methods

27.3 Trade Execution, Trade Processing and Collateral Processing

27.4 Trade Execution and Future Cashflow Discounting

27.5 Conclusion

Chapter 28 OTC Derivatives and Collateral – The Collateral Lifecycle – Post-Trading – Trade Capture

28.1 Trade Capture: Introduction

28.2 Trade Capture within Separate Trading and Operations Systems

28.3 Trade Capture within a Single Trading and Operations System

28.4 Trade Reference Numbers

28.5 Trade Capture Error Identification

28.6 Trade Capture and Collateral Management

28.7 Conclusion

Note

Chapter 29 OTC Derivatives and Collateral – The Collateral Lifecycle – Post-Trading – Trade Confirmation/Affirmation

29.1 Trade Confirmation/Affirmation: Introduction

29.2 Trade Confirmation versus Trade Affirmation

29.3 Electronic Trade Confirmation/Affirmation

29.4 Conclusion

Chapter 30 OTC Derivatives and Collateral – The Collateral Lifecycle – Post-Trading – Trade/Portfolio Netting

30.1 Introduction

30.2 Benefits of Trade/Portfolio Netting (Portfolio Compression)

30.3 The Trade/Portfolio Netting (Portfolio Compression) Process

30.4 Internal Treatment of Netted (Compressed) Trades

30.5 The Future of Trade/Portfolio Netting (Portfolio Compression)

30.6 Conclusion

Chapter 31 OTC Derivatives and Collateral – The Collateral Lifecycle – Throughout Lifetime of Trade – Portfolio Reconciliation

31.1 Introduction

31.2 Purpose of Portfolio Reconciliation

31.3 Reasons for Portfolio Discrepancies

31.4 Advantages and Disadvantages of Portfolio Reconciliation

31.5 The Portfolio Reconciliation Process

31.6 Conclusion

Note

Chapter 32 OTC Derivatives and Collateral – The Collateral Lifecycle – Throughout Lifetime of Trade – Marking-to-Market

32.1 Introduction

32.2 Generic Marking-to-Market Principles

32.3 The Origin of Prices

32.4 Uses of Marking-to-Market

32.5 Trends in Marking-to-Market Frequency

Chapter 33 OTC Derivatives and Collateral – The Collateral Lifecycle – Throughout Lifetime of Trade – Exposure Calculation

33.1 Introduction

33.2 Credit Support Annex

33.3 Determining Exposure Amounts and Direction

33.4 Cash Collateral versus Bond Collateral

33.5 Exposures on Individual Trades versus Portfolios

33.6 Conclusion

Chapter 34 OTC Derivatives and Collateral – The Collateral Lifecycle – Throughout Lifetime of Trade – Receiving Margin Calls

34.1 Introduction

34.2 Incoming Margin Call: Both Cash and Securities Collateral

34.3 Incoming Margin Call: Cash Collateral

34.4 Incoming Margin Call: Securities Collateral

Determining Haircut Percentage: Example Calculations

34.5 Conclusion

Chapter 35 OTC Derivatives and Collateral – The Collateral Lifecycle – Throughout Lifetime of Trade – Issuing Margin Calls

35.1 Introduction

35.2 Issuing a Margin Call Notification

35.3 Collateral Proposed by Counterparty

35.4 Verifying the Counterparty’s Proposed Collateral

35.5 Transaction Capture

35.6 Actioning Receipt of Incoming Collateral

35.7 Monitoring Receipt of Collateral

35.8 Updating Books & Records

35.9 Performing Reconciliation

35.10 Updating Records of Cumulative Collateral

35.11 Conclusion

Note

Chapter 36 OTC Derivatives and Collateral – The Collateral Lifecycle – Throughout Lifetime of Trade – Holding Collateral

36.1 Introduction

36.2 Legal Structures Impacting the Holding of Collateral

36.3 Reuse and Rehypothecation of Collateral: Benefits and Risks

36.4 Holding Bond Collateral with Reuse and Rehypothecation Rights

36.5 Holding Bond Collateral without Rehypothecation Rights

36.6 Holding Collateral and Operational Control

36.7 Bond Collateral

36.8 Cash Collateral

36.9 Conclusion

Note

Chapter 37 OTC Derivatives and Collateral – The Collateral Lifecycle – Throughout Lifetime of Trade – Post-Trade Execution Events – Introduction

Chapter 38 OTC Derivatives and Collateral – The Collateral Lifecycle – Throughout Lifetime of Trade – Post-Trade Execution Events – Novation

38.1 Introduction

38.2 Reasons for Novation

38.3 Impact of Novation on Books & Records

38.4 Impact of Novation on Collateral Management

38.5 Conclusion

Chapter 39 OTC Derivatives and Collateral – The Collateral Lifecycle – Throughout Lifetime of Trade – Post-Trade Execution Events – Unwind

39.1 Introduction

39.2 Reasons for Unwinding

39.3 Impact of Unwinding on Books & Records

39.4 Impact of Unwinding on Collateral Management

39.5 Conclusion

Chapter 40 OTC Derivatives and Collateral – The Collateral Lifecycle – Throughout Lifetime of Trade – Post-Trade Execution Events – Offset

40.1 Introduction

40.2 Reasons for Offsetting

40.3 Impact of Offsetting on Books & Records

40.4 Impact of Offsetting on Collateral Management

40.5 Conclusion

Chapter 41 OTC Derivatives and Collateral – The Collateral Lifecycle – Throughout Lifetime of Trade – Post-Trade Execution Events – Credit Events

41.1 Introduction

41.2 Impact of Credit Events on Books & Records

41.3 Impact of Credit Events on Collateral Management

41.4 Conclusion

Chapter 42 OTC Derivatives and Collateral – The Collateral Lifecycle – Throughout Lifetime of Trade – Collateral Substitution

42.1 Introduction

42.2 Reasons for Collateral Substitution

42.3 The Process of Collateral Substitution

42.4 Risks in Settlement of Collateral Substitution

42.5 Urgency of Collateral Substitution

42.6 Impact of Collateral Substitution on the Collateral Taker

42.7 Unwanted Exposures in Collateral Substitution

42.8 Updating Books & Records

42.9 Conclusion

Chapter 43 OTC Derivatives and Collateral – The Collateral Lifecycle – Throughout Lifetime of Trade – Income & Corporate Action Events

43.1 Introduction

43.2 Bond Collateral and Coupon Payments

43.3 Bond Collateral and Corporate Actions

43.4 Conclusion

Chapter 44 OTC Derivatives and Collateral – The Collateral Lifecycle – Trade Termination – Trade Termination

Part 4b OTC Derivatives and Collateral – Legal Documentation

Chapter 45 OTC Derivatives and Collateral – Legal Documentation

Part 4c OTC Derivatives and Collateral – Regulatory Change and the Future of Collateral

Chapter 46 OTC Derivatives and Collateral – Regulatory Change and the Future of Collateral – Introduction

46.1 Introduction

46.2 The Need for Regulatory Change

46.3 Regulatory Changes: Introduction

46.4 Exchanges and Electronic Trading Platforms: Overview

46.5 Central Clearing: Overview

46.6 Trade Repositories: Introduction

46.7 Centrally Cleared and Non-Centrally Cleared Trades

Chapter 47 OTC Derivatives and Collateral – Regulatory Change and the Future of Collateral – Centrally Cleared Trades

47.1 Introduction

47.2 Fundamental Central Counterparty Concepts

47.3 Central Counterparty Operation and Services

47.4 Central Clearing: Advantages & Disadvantages

47.5 Central Counterparty Membership and Non-Membership

47.6 Clearing Member Margin Requirements

47.7 Initial Margin and Variation Margin: Impact on Sell-Side and Buy-Side Firms

47.8 Clearing Member Requirements: Overview

47.9 Clearing Members and their Clients: Account Structures

47.10 The Clearing Obligation

47.11 Treatment of Legacy Trades

47.12 Central Counterparties and Interoperability

47.13 Product, Party and Trade-Related Static Data

47.14 Operational Implications of Central Clearing: Overview

47.15 Legal Documentation: Overview

47.16 Status of Individual Central Counterparties

47.17 Central Clearing and the OTC Derivative Collateral Lifecycle

47.18 Collateral Transformation

Chapter 48 OTC Derivatives and Collateral – Regulatory Change and the Future of Collateral – Non-Centrally Cleared Trades

48.1 Introduction

48.2 Reasons for the Existence of Non-Centrally Cleared Trades

48.3 Market Participants Executing Non-Centrally Cleared Trades

48.4 Non-Centrally Cleared Trades: Margin Regulations

48.5 Non-Centrally Cleared Trades: Legal Documentation

48.6 Non-Centrally Cleared Trades: Further Risk Mitigation Regulations

48.7 Non-Centrally Cleared Trades: Trade Reporting Regulations

Note

Glossary of Terms

Useful Websites

Further Reading

Index

End User License Agreement

List of Tables

Chapter 2

Table 2.1

Table 2.2

Table 2.3

Table 2.4

Table 2.5

Table 2.6

Chapter 4

Table 4.1

Table 4.2

Table 4.3

Table 4.4

Table 4.5

Table 4.6

Table 4.7

Table 4.8

Table 4.9

Table 4.10

Table 4.11

Table 4.12

Table 4.13

Table 4.14

Table 4.15

Table 4.16

Table 4.17

Table 4.18

Table 4.19

Table 4.20

Table 4.21

Table 4.22

Table 4.23

Chapter 5

Table 5.1

Table 5.2

Table 5.3

Table 5.4

Table 5.5

Table 5.6

Table 5.7

Table 5.8

Table 5.9

Table 5.10

Table 5.11

Table 5.12

Table 5.13

Table 5.14

Table 5.15

Table 5.16

Table 5.17

Table 5.18

Table 5.19

Table 5.20

Table 5.21

Table 5.22

Chapter 7

Table 7.1

Table 7.2

Chapter 10

Table 10.1

Table 10.2

Table 10.3

Table 10.4

Table 10.5

Chapter 11

Table 11.1

Table 11.2

Table 11.3

Table 11.4

Table 11.5

Table 11.6

Table 11.7

Table 11.8

Table 11.9

Table 11.10

Table 11.11

Table 11.12

Table 11.13

Table 11.14

Table 11.15

Table 11.16

Table 11.17

Table 11.18

Table 11.19

Table 11.20

Table 11.21

Table 11.22

Table 11.23

Chapter 14

Table 14.1

Chapter 16

Table 16.1

Table 16.2

Table 16.3

Chapter 17

Table 17.1

Table 17.2

Table 17.3

Chapter 18

Table 18.1

Table 18.2

Table 18.3

Table 18.4

Chapter 19

Table 19.1

Table 19.2

Table 19.3

Chapter 21

Table 21.1

Chapter 22

Table 22.1

Table 22.2

Table 22.3

Table 22.4

Table 22.5

Table 22.6

Table 22.7

Table 22.8

Table 22.9

Table 22.10

Table 22.11

Table 22.12

Table 22.13

Table 22.14

Table 22.15

Table 22.16

Table 22.17

Table 22.18

Table 22.19

Table 22.20

Table 22.21

Table 22.22

Table 22.23

Table 22.24

Table 22.25

Table 22.26

Table 22.27

Table 22.28

Table 22.29

Table 22.30

Table 22.31

Table 22.32

Chapter 23

Table 23.1

Table 23.2

Chapter 27

Table 27.1

Chapter 28

Table 28.1

Chapter 32

Table 32.1

Table 32.2

Table 32.3

Chapter 33

Table 33.1

Table 33.2

Table 33.3

Table 33.4

Table 33.5

Table 33.6

Table 33.7

Chapter 34

Table 34.1

Table 34.2

Table 34.3

Table 34.4

Table 34.5

Table 34.6

Table 34.7

Table 34.8

Table 34.9

Table 34.10

Table 34.11

Table 34.12

Table 34.13

Chapter 35

Table 35.1

Table 35.2

Table 35.3

Table 35.4

Chapter 38

Table 38.1

Table 38.2

Table 38.3

Chapter 39

Table 39.1

Table 39.2

Table 39.3

Chapter 40

Table 40.1

Table 40.2

Table 40.3

Chapter 41

Table 41.1

Chapter 46

Table 46.1

Chapter 47

Table 47.1

Table 47.2

Table 47.3

Chapter 48

Table 48.1

Table 48.2

Table 48.3

Table 48.4

Table 48.5

Table 48.6

Table 48.7

Table 48.8

Table 48.9

Table 48.10

List of Illustrations

Chapter 2

Figure 2.1 Example of fixed rate bond showing its coupon payment dates and coupon rates pr...

Figure 2.2 Example of floating rate note coupon payment dates and varying coupon rates

Figure 2.3 Example of zero coupon bond price profile, from issue date to maturity date

Figure 2.4 Representative example of a bond certificate, with coupons attached

Figure 2.5 Participants’ holdings at a CSD, including a custodian’s holding. (Greyed-out p...

Chapter 4

Figure 4.1 Repo asset flows on the opening and closing legs

Figure 4.2 Example use of stock-based repo and special collateral

Figure 4.3 Treatment of initial margin/haircut on cash amount and bond quantity

Figure 4.4 Collateral substitution

Figure 4.5 Coupon payment flow; cash lender has not reused the collateral

Figure 4.6 Coupon payment flow; cash lender has reused the collateral

Chapter 7

Figure 7.1 Tri-party repo processing

Figure 7.2 Overnight DBV and Term DBV

Figure 7.3 Bilateral trading and ongoing counterparty credit risk

Figure 7.4 Central counterparty

Figure 7.5 GC Pooling trading, clearing and settlement processing

Figure 7.6 RepoClear processing

Chapter 9

Figure 9.1 Basic securities lending trade structure

Figure 9.2 Basic securities borrowing trade structure

Chapter 10

Figure 10.1 Dividend reinvestment plan arbitrage

Figure 10.2 Dividend tax arbitrage

Figure 10.3 Technical short situation, due to settlement failure of the purchase

Figure 10.4 Technical short situation, post-borrowing

Figure 10.5 Technical short situation, post-settlement of purchase

Figure 10.6 Short selling situation, pre-borrowing

Figure 10.7 Short selling situation, post-borrowing

Figure 10.8 Short selling situation, post-purchase

Figure 10.9 The role of the intermediary in securities lending & borrowing

Figure 10.10 Securities lending trade structure, including collateral

Figure 10.11 Deriving the required collateral value

Figure 10.12 Steps in confirming OTC trades

Figure 10.13 Initial exchange of lent/borrowed security and collateral

Figure 10.14 Issuance of settlement instructions via S.W.I.F.T.

Figure 10.15 Treatment of cash collateral and rebate interest

Figure 10.16 Marking-to-market

Figure 10.17 Collateral substitution

Figure 10.18 Treatment of income on securities collateral

Figure 10.19 Return of collateral following return of lent security

Chapter 12

Figure 12.1 Ensuring availability of securities for lending

Figure 12.2 Ensuring a real borrowing requirement exists

Figure 12.3 Agency lending; exclusive lending programme

Figure 12.4 ICSDs – lenders, borrowers and anonymous lending and borrowing

Figure 12.5 Collateral types and responsibilities

Figure 12.6 Tri-party arrangements – representative structure

Chapter 14

Figure 14.1 Example of a futures sale

Figure 14.2 Example of a call option

Figure 14.3 Example of a put option

Chapter 15

Figure 15.1 Single trade with two streams of operational activity

Chapter 16

Figure 16.1 Firm X’s situation prior to execution of the interest rate swap

Figure 16.2 Interest rate swap contract

Figure 16.3 Interest rate swap: interest payment calculation components

Figure 16.4 Interest rate swap example payment profile

Figure 16.5 IRS trade processing actions

Chapter 17

Figure 17.1 Credit default swap contract

Figure 17.2 Credit default swap: premium payment calculation components

Figure 17.3 CDS trade processing actions

Figure 17.4 Physical settlement following credit event

Figure 17.5 Cash settlement following credit event

Figure 17.6 Basket default swap

Chapter 18

Figure 18.1 Profile and example of dates in a spot FX trade

Figure 18.2 Settlement of a spot FX trade

Figure 18.3 Profile of and example of dates in a forward FX trade

Figure 18.4 Profile and example of dates in a foreign exchange swap trade

Figure 18.5 Example foreign exchange swap cashflows

Figure 18.6 Foreign exchange swap processing actions

Chapter 19

Figure 19.1 The initial exchange of principal in a cross-currency swap

Figure 19.2 The periodic exchange of interest in a cross-currency swap

Figure 19.3 The return of principal in a cross-currency swap trade

Figure 19.4 Cross-currency swap processing actions

Chapter 21

Figure 21.1 Relationship between ISDA Master Agreement, Schedule and Credit Support Annex

Chapter 22

Figure 22.1 Relationship between legal documentation, trading, netting, exposure and collat...

Figure 22.2 How exposures arise in OTC derivative trades

Figure 22.3 Asymmetrical threshold

Figure 22.4 Collateral substitution

Figure 22.5 Dispute resolution procedure for exposure calculation

Chapter 24

Figure 24.1 Single trade with two streams of operational activity

Chapter 30

Figure 30.1 Example of compression methodology between three parties, using IRS

Figure 30.2 Counterparty risk before triReduce cycle

Figure 30.3 Counterparty risk after triReduce cycle

Chapter 31

Figure 31.1 triResolve processing sequence

Figure 31.2 Screenshot of trade statuses within triResolve

Figure 31.3 Screenshot of trade statuses within triResolve

Chapter 34

Figure 34.1 Receiving a margin call: sequential tasks

Figure 34.2 Accrued interest conventions

Chapter 35

Figure 35.1 Issuing a margin call: sequential tasks

Chapter 36

Figure 36.1 Legal distinctions in the collateral transfer methods of title transfer and sec...

Figure 36.2 Reuse of bond collateral

Chapter 38

Figure 38.1 Pre-novation parties

Figure 38.2 Post-novation parties

Figure 38.3 Partial novation

Chapter 39

Figure 39.1 Pre- and post-unwind trade situations

Chapter 40

Figure 40.1 Pre-offset and post-offset situation

Chapter 41

Figure 41.1 Credit default swap: pre- and post-credit event situation

Chapter 42

Figure 42.1 Collateral substitution

Figure 42.2 Collateral substitution: sequential tasks

Chapter 43

Figure 43.1 Coupon payment flow where collateral taker holds the collateral

Figure 43.2 Coupon payment flow where collateral taker reuses or rehypothecates the collate...

Chapter 46

Figure 46.1 Trade execution via a trade execution venue

Figure 46.2 Post-execution, post-novation

Figure 46.3 Central clearing and trade repositories

Figure 46.4 Bilateral clearing and trade repositories

Figure 46.5 Centrally cleared and non-centrally cleared trades

Chapter 47

Figure 47.1 Centrally cleared trades: the focus of this chapter

Figure 47.2 Bilateral trading and bilateral clearing

Figure 47.3 Bilateral trading and central clearing

Figure 47.4 In this example, both parties to a trade are clearing members at the CCP

Figure 47.5 Firm A is a clearing member, whilst Firm C is a client of a clearing member

Figure 47.6 Clearing member margin requirements

Figure 47.7 Default fund contributions

Figure 47.8 Initial margin

Figure 47.9 Variation margin

Figure 47.10 Possible structure of a clearing member’s domain of accounts at a CCP

Figure 47.11 Both Firm A and Firm C (via Firm M) are users of the same CCP

Figure 47.12 Firm A and Firm D are users of different CCPs

Figure 47.13 Clearing Member Agreement and Client Clearing Agreement

Figure 47.14 Central clearing trade and collateral lifecycle

Figure 47.15 Repo trade for collateral transformation purposes

Figure 47.16 Securities lending & borrowing trade for collateral transformation purposes

Chapter 48

Figure 48.1 Non-centrally cleared trades: the focus of this chapter

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e1

Foreword

The collateral management processes rapidly developed during the past decade; after the financial crisis of 2008 there was a significantly greater need to reduce counterparty credit risk in a more efficient way. Not only the market participants but also the regulators expressed this requirement. The G20 summit held in Pittsburgh in 2009 focused on the financial markets and world economy, following which a range of major new regulations were drafted. These were implemented in several phases and are better known as Dodd-Frank and EMIR regulations.

The main reason for a firm to implement a collateral management process is to reduce counterparty credit risk via the exchange of collateral; this is generally achieved via cash or securities. This hasn’t changed in essence since the financial crisis; however, the frequency, processes and products covered have changed. The regulations have had a huge impact on the used applications and processes, from additional trade reporting, trade reconciliations, daily margining, lower minimum transfer amounts, same day settlement, through to the exchange of initial margin with central counterparties.

As an industry expert I’ve experienced these developments directly, this is also the reason why I would like to share my personal view in this Foreword. Where ten years ago the process was executed by almost every market participant in Excel and Access on a weekly to monthly basis, the financial crisis was definitely the catalyst for change. Software vendors started to build systems supporting the gathering and storing of the most crucial information. This developed further to workflow systems with a high STP rate, often connected to trading systems. Connections were established via APIs, S.W.I.F.T. or SFTP with internally used systems, and with banks, custodians and other service software providers. Alongside such developments new systems assisting the workflow became part of the collateral architectural landscape; some generally accepted systems are triResolve and MarginSphere. (These additional applications will become of considerable benefit to the global collateral environment once adopted by a significant portion of market participants.)

Some years ago the collateral process was mainly focused on bilateral OTC Derivatives, with some additional Repo collateralisation. Now we see many different products subject to collateral, all supported by their own legal documents. Examples of the most frequently traded products in addition to those above are Centrally Cleared Derivatives, Mortgage-Backed Securities and Securities Lending. Additionally, the number of parties now required to exchange collateral has drastically increased due to greater regulation.

As author of this book, Michael Simmons has combined his industry knowledge, training experience and work experience with his enthusiastic interest in collateral management. This book will become essential reading for everyone working within collateral management (whether focused on repo, or securities lending, or derivatives – or all three topics), as it touches the necessary level of detail to gain a broad understanding of the products requiring collateral, as well as the collateral management process itself.

Guido Verkoeijen

Team Manager Cash & Collateral Management

APG Asset Management, The Netherlands

Acknowledgements

Once it became clear that the profile and importance of collateral management had risen significantly following the 2008 Global Financial Crisis, I sensed there was a growing need for a significantly greater understanding of collateral management amongst operations (and other) personnel working within the financial services industry.

In order to understand the subject to enable me to write such a book, I needed access to those that had insight on the subject.

In particular, I would like to thank Guido Verkoeijen for his explanations of both concepts and detailed points, and for his care and patience in reviewing a significant portion of the text.

I would also like to thank Hasse R. Brandt for his expertise and perspective on a range of topics, as well as time spent reviewing my draft chapters.

Other people that have contributed significantly are:

Arthur Thelen

Neil Schofield

Quentin Gabriel

Simon Lee

for which I thank them greatly.

Michael Simmons

About the Author

Michael (Mike) Simmons is an operations specialist, having spent his entire career focused on hands-on tasks, management and education relating to the various post-trade execution processes. Having spent over 20 years within a blue chip investment bank (S.G. Warburg and Warburg Securities) where he was the manager of Fixed Income (Bond) Operations, Mike then began writing and delivering training courses on behalf of a number of organisations, including the International Capital Market Association (ICMA). He is the author of two previous books, namely Securities Operations and Corporate Actions (both published by Wiley).

Mike’s interest in Collateral Management arose as a result of the Global Financial Crisis in 2008, where it became very apparent that the profile of the topic had increased dramatically, compared with pre-crisis. In addition to existing collateral-related transaction types such as repo and securities lending, the introduction of mandatory central clearing for OTC derivatives in all jurisdictions globally meant there was suddenly a hugely increased focus on collateral which impacts both buy-side and sell-side firms, and other organisation types such as central securities depositories, custodians, management consultants and software providers. Under such circumstances, Mike felt there was a real need for education of operations and other personnel in the topic of collateral management.

Today, as a freelance trainer and consultant based in the UK, Mike delivers training courses on a range of operational topics both in the UK and overseas. Courses include collateral management, the securities (equity and bond) trade lifecycle, corporate actions, repo, securities lending & borrowing, and OTC derivatives incorporating both centrally cleared and non-centrally cleared trades. He also wrote and frequently delivers the 5-day Operations Certificate Programme (a 5-day multi-subject examined qualification) for ICMA Executive Education.

Observations on the style and content of this book can be conveyed to the author by email to [e-mail].

Introduction

Note: within the main text throughout this book, terms and phrases in bold/italics are explained within the Glossary of Terms.

Within the financial services industry, on a daily basis cash and securities are lent to borrowers on a temporary basis. In order to mitigate (reduce) the lender’s risk of the borrower failing to return the lent cash or securities, other assets of value are given by the borrower to the lender. Such other assets are generically known as ‘collateral’.

Additionally, collateral plays a major role in mitigating counterparty risk associated with OTC derivative transactions, in products such as interest rate swaps and credit default swaps.

Transactions including cash lending, securities lending and OTC derivatives are executed by buy-side firms (including pension funds, insurance companies, asset managers and other corporate entities) and sell-side firms (including investment banks and brokers). Consequently, collateral is relevant to both the buy side and the sell-side of the business.

For a number of years prior to the autumn of 2008, collateral had been used for OTC derivatives with the passing of collateral between trading parties occurring, in some cases, weekly or every 2 weeks or even monthly. Up to that point in time, usually only the larger financial services firms identified exposures and then gave or received collateral as frequently as daily.

Then came the Global Financial Crisis and the financial industry turmoil in October/November 2008. Both during and since the downfall of Lehman Brothers, the profile of collateral management has risen dramatically, and firms of all sizes are now actively using collateral to mitigate exposures as a primary counterparty risk mitigation measure, on a daily basis.

The degree of complication within operations departments has consequently multiplied greatly. Successful processing of collateral within an organisation requires knowledgeable staff who understand the component parts that lead to safe and secure processing, and awareness of the pitfalls that can result in unacceptable exposures. The efficient and successful collateral department within a financial services firm demands a highly unusual mixture of knowledge and know-how of a number of connected financial services operational disciplines.

The combination of new players in and the increased frequency of collateral management around the globe means that basic knowledge of the subject is in short supply and in big demand: many of the positions advertised currently by financial services firms are collateral management jobs. Risk management professionals need an excellent understanding of this topic in order to appreciate whether counterparty risk is in fact being mitigated. Lawyers negotiating legal documentation necessary to be signed prior to trading should ideally understand the overall collateral process. Those working within central securities depositories and custodians should appreciate the topic if they are to understand and comply with the securities and cash movements instructed by their clients. Consulting firms also need to understand the subject if they are to provide expertise into financial services firms. Software firms need to become aware of the topic if they are to provide collateral management systems that meet their clients’ collateral objectives.

Collateral management is applicable to financial institutions globally.

TARGET AUDIENCE

This book is targeted towards those wishing to gain an all-round understanding of collateral management, from an operations (processing) perspective. Therefore, those that will find this book of value include:

those that are entirely new to collateral management

those currently working within a collateral department and who wish to gain an all-round understanding of collateral processes

existing operations personnel that wish to broaden their all-round knowledge

staff who instruct the movement of cash and securities collateral

recipients of instructions to effect the movements of cash and securities assets

trade confirmation personnel

static data workforce

corporate actions personnel

reconciliation analysts

risk managers

credit controllers

legal document negotiators

management consultants

business analysts

software engineers.

This book describes the essential day-to-day and detailed practices that 1) a collateral professional requires, and 2) are necessary for a firm to achieve counterparty risk mitigation in a secure fashion and without introducing further risks.

Furthermore, this book is designed to enable readers to make a very positive connection between the conceptual need to minimise counterparty risk, and what must be done in practice in order to achieve counterparty risk mitigation.

OBJECTIVES AND STRUCTURE OF THE BOOK

The objective of this book is to demystify the subject of collateral management by breaking the subject into logical components, explaining the issues relating to each component and at the same time conveying the accumulated effect and the overall picture.

In order to aid the reader’s understanding, approximately 150 diagrams are contained within the text. Furthermore, the text contains example calculations to facilitate the reader’s complete understanding.

Towards the end of the book, the reader will find an extensive Glossary of Terms containing over 600 words and phrases relating to the subject of collateral management.

The book is structured to be read chapter-by-chapter, from the beginning to the end. However, in recognition that some readers may prefer to target certain parts of the book (e.g. Part 3: Securities Lending & Borrowing and Collateral), each Part has been written as a standalone topic.

The book is divided into four parts. Part 1 begins with a number of fundamental but important concepts; firstly, an explanation of elementary collateral principles, following which the features relating to types of collateral are described.

Thereafter, the three main transaction types which necessitate collateral are described, namely:

Part 2: Sale & Repurchase (Repo) Trades and Collateral

Part 3: Securities Lending & Borrowing and Collateral

Part 4: OTC Derivatives and Collateral

Part 4 is significantly larger than Parts 2 and 3, consequently there are three sections to Part 4:

Part 4a introduces the subject of derivatives in general, OTC derivatives in particular, examples of OTC derivative transaction types, and important characteristics of OTC derivative-related collateral

Part 4b refers to the legal documentation pertaining to OTC derivatives

Part 4c explains the OTC derivative-related regulatory requirements which were introduced following the 2008 Global Financial Crisis, and in particular the impact on collateral management.

I have written this book entirely independently; the views expressed within are my own and not the views of any organisation with whom I have been associated, whether as an employee or as a trainer or as a consultant.

Although every effort has been made to remove errors from the text, any errors that remain belong to me. If readers have comments on the content and style of the book, I would welcome such comments; I can be emailed at [e-mail].

Michael Simmons

PART 1Introductory Elements

CHAPTER 1Fundamental Collateral Concepts

This chapter is designed to provide an overview of many of the essential aspects of collateral and of collateral management – each topic will be expanded and explained fully within the relevant chapter.

What is collateral? Collateral refers to an asset of value that is given by one entity or firm (party A) as security for an amount owed to another entity or firm (party B).

The purpose of collateral is to provide assurance to party B that, in the event that party A does not fulfil its legal and contractual obligations relating to an underlying transaction, party B may legally sell the collateral in order to recover the full value owed by party A.

The generic and commonly used terms for such parties are collateral giver or transferor (party A) and collateral taker or transferee (party B).

For the collateral taker to be properly secured, the collateral asset must be of recognisable value in the open market place and be highly liquid, thereby enabling the collateral taker to quickly and easily convert the collateral to ready cash (should the need arise).

The underlying transactions that give rise to the giving and taking of collateral are many and varied, and in everyday life include, for example, mortgages on residential properties where the lending entity (e.g. a bank) lends cash to the homebuyer with the lender’s legal right to take possession of the property should the homebuyer fail to abide by the terms of the mortgage agreement and make the necessary repayments. In this situation, the property itself is the collateral which the lender can sell in order to recover the cash it originally lent plus interest owed.

In the world of financial services, the underlying transaction types that give rise to the giving and taking of collateral fall into two main categories (note: the transaction types listed below are described fully within later chapters):

Transaction Types Involving Loaning of Assets

The common theme in this category is the lending of assets by one party to its counterparty, where the lender has an immediate risk of not having the lent asset returned. To mitigate the lender’s risk, collateral is given by the asset borrower. Such transaction types include:

sale & repurchase (repo)

transactions

securities lending & borrowing

transactions.

Transaction Types That Accumulate Value Over Time

The common theme in this category is that two parties enter into a derivative transaction that typically has a duration of many years – up to 50 years is possible. This means that each party has exposure to its counterparty on an ongoing basis throughout the transaction’s lifetime. It is important to understand the nature of each transaction type in order to appreciate the associated risks, and the role collateral plays. Although each such transaction begins with equal value to both parties, as time passes the value of a transaction at a particular point in time will fall to the advantage of one party and therefore to the disadvantage of the other party. As time progresses, the transaction value can fluctuate significantly, where on a particular day party A will have the advantage and the next day party B will have the advantage. For these transaction types, the disadvantaged (non-exposed) party is required to provide collateral to the advantaged (exposed) party, in recognition of the risk that should the disadvantaged party go out of business during the lifetime of the transaction, the advantaged party will (it is assumed) need to replace the original transaction at ‘current’ market rates, thereby incurring greater costs compared with the original transaction. Such transaction types are generically known as OTC derivatives and include:

interest rate derivative transactions (e.g.

interest rate swaps

)

credit derivative transactions (e.g.

credit default swaps

)

foreign exchange transactions (e.g.

foreign exchange swaps

and

cross-currency swaps

).

OTC Derivative trades have historically been executed directly between the two trading firms, and are said to have been traded on a bilateral basis. Another way of describing such transactions is to state they have been privately negotiated, rather than being executed via a derivative exchange (as occurs with exchange-traded derivatives).

Common to all the above-mentioned transaction types is the fact that collateral is given and/or taken. The type of collateral that may be given and taken is usually documented in a legal agreement between the two trading parties, ideally finalised (signed by both parties) before trading commences. The form that collateral normally takes is cash or bonds (debt securities), as such assets are subject to either zero fluctuation in value (cash) or limited fluctuation in value (highly rated bonds). Equity securities (shares) are less commonly used as collateral due to their fluctuating and sometimes unpredictable values.

A party that has given cash collateral normally earns an agreed rate of interest on the cash (assuming a positive interest rate environment), from the collateral taker.

Both bonds and equity are classified as securities which, when given as collateral are usually subject to a haircut; having established the current market value of a security, the relevant haircut percentage is deducted in order to identify the security’s collateral value. Conversely, major currencies given as collateral usually have no haircut applied and therefore usually retain 100% of their ‘market’ value.

It is in a firm’s own interest to monitor collateral values on an adequate frequency in order to determine whether a current exposure exists; for example, a bond received as collateral yesterday and whose value yesterday covered the lender’s risk, may today have a value which is below the value of the lent asset, and the lender now has an exposure. The lender’s exposure must be mitigated by the lender requesting additional collateral (a process known as a margin call) from the borrower. Conversely, should the value of collateral rise relative to the value of the lent asset, the borrower has an exposure (i.e. too much collateral with the lender) and should make a margin call to request the lender to return the excess collateral.

Securities collateral currently held by the collateral taker may today have been sold by the collateral giver. The collateral giver requires return of the original collateral so as to facilitate settlement of its sale on its due date (value date). Under such circumstances the collateral giver usually has the right to substitute the original collateral with one or many replacement pieces of collateral with either securities or cash (dependent upon the transaction type). The collateral taker must ensure it does not become exposed by returning the original collateral without simultaneous receipt of replacement collateral. This process is known as collateral substitution.

Securities collateral currently held by the collateral taker may have an income payment becoming due; this is known as a coupon payment in the case of a bond, and a dividend payment in the case of equity. The legal agreement between the two parties usually states that an equivalent payment must be made by the collateral taker to the collateral giver, when the payment falls due.

As exposure will have ceased upon termination of the underlying transaction, any collateral outstanding at that time must be returned to the collateral giver. With this in mind, it is important to appreciate that the tenure (duration) of a transaction can vary significantly dependent upon the transaction type; see the descriptions earlier in this chapter. For example:

Transaction Types Involving Loaning of Assets

–

repo

transactions and

securities lending & borrowing

transactions are typically short-term, with a usual lifetime of a matter of days or weeks

Transaction Types That Accumulate Value Over Time

–

OTC derivative

transactions are typically long term, with a lifetime of multiple years in many cases.

For its own protection, a firm involved in any and all such transactions must be prepared to 1) identify exposures and 2) mitigate exposures, at the relevant frequency, through the process of collateral management.

CHAPTER 2The Nature and Characteristics of Collateral Types

This chapter is targeted at readers that have had no exposure or limited exposure as to how cash and bond assets are handled within the financial services industry. The chapter is designed to provide an overview of the two primary collateral types, namely cash and bonds. In particular, the nature of bonds must be understood in order to appreciate their behaviour as collateral. Furthermore, the way that cash is paid and received and the way that bonds are delivered and received must be well understood in order for a firm to avoid incurring exposures.

The two most common types of collateral used within financial services are cash and bonds.

2.1 CASH COLLATERAL: OVERVIEW

2.1.1 Introduction

The most commonly accepted currencies as collateral are US Dollars (USD), Euros (EUR) and British Pounds (GBP).

If a firm’s exposure is in for example USD, and USD cash collateral is taken from the counterparty, there is no foreign exchange (FX) risk, as there is no conversion to be made between currencies. Conversely, if that same firm has the same USD exposure, but receives another currency (e.g. EUR) as collateral, the firm is exposed to FX currency rate movements thereafter and this could result in collateral taken having a lower value than the firm’s exposure. Should such exposure occur, the exposed firm would need to make a margin call on its counterparty in order to cover the shortfall and mitigate its exposure.

To clarify, either the original collateral giver or the collateral taker could be exposed due to exchange rate movements.

2.1.2 Eligible Collateral

The legal documentation signed between the two trading parties (preferably in advance of executing the first trade between the parties) should specify the currencies acceptable as collateral to each party. Generically, acceptable collateral is known as eligible collateral.

If a firm that needs to give collateral attempts to remit a currency outside of the legally documented eligible currencies, the taking firm is not obliged to accept that currency and is within their rights to refuse acceptance.

2.1.3 Haircut

Providing cash given/taken is in an eligible currency, no haircut should be applied. For example, if party B has an exposure of USD 5,000,000.00, party A should pay USD 5,000,000.00 of cash collateral, meaning 100% of the exposure amount and no more than that amount should be paid (because zero haircut is applicable).

Therefore, the market value of a major currency cash amount is equal to its collateral value, providing the exposure and the collateral are in the same currency. (Note: other currencies may be classified as eligible collateral, but the involved parties may have agreed that a certain percentage haircut is to be applied.)

2.1.4 Settlement

Generically, cash payments are made by a firm by initially appointing a cash correspondent (or nostro) for a particular currency, then issuing a settlement instruction to that nostro for individual cash payments.

Deadlines are applied by nostros for the receipt of settlement instructions relative to the due date (or value date