Central Clearing - Implications for Collateral Management

Central Clearing: Implications for Collateral Management

Kenny Nicoll

4th September 2013

Teach-in Central Clearing: Implications for Collateral Management 4th September 2013

EMIR Update

2

Teach-in Central Clearing: Implications for Collateral Management 4th September 2013 3

EMIR regulations are an attempt by the G20 to reduce systemic risk in the banking system

They aim to bring greater visibility of derivative positions and encourage standardisation

In September 2009, the G20 committed to introducing the following changes to OTC derivative markets:

1. All OTC derivatives should be traded on electronic platforms

2. All derivative contracts should be reported to Trade Repositories

3. Where possible, derivatives should be cleared through Central Counterparties (CCP)

4. Non-centrally cleared derivatives should be subject to higher capital requirements

EMIR is part of a globally co-ordinated effort to reduce risk in derivative markets:

Europe US

Electronic Execution MIFID Dodd-Frank Act

Clearing EMIR Dodd-Frank Act

Derivatives Reporting EMIR Dodd-Frank Act

Capital Requirements for CPP Exposures Basel / CRD Basel

Bilateral Margin for Non-Cleared Swaps Basel / IOSCO Basel / IOSCO

Source: Morgan Stanley


EMIR: Key Dates

Without an exemption in place, the impact of clearing could be as soon as Dec 2013 (front-loading date)

4

Source: European Securities and Markets Authority (ESMA)

Q1 2013 Q2 2013 Q3 2013 Q4 2013 Q1 2014 Q2 2014 Q3 2014 Q4 2014

CCP application closes

Earliest that the front-

loading period could start

(6m pre Go-Live) Clearing obligation starts for IRS

Front-loading date: Swaps entered into after this

point must be cleared following the go live date.


Liquidity Policy: an Overview

5


The key challenge for pension schemes is to establish a liquidity policy which allows for enough

collateral in the world of Central Clearing while maintaining portfolio efficiency

Liquidity Policy

Backloading

Exemption

Collateral Management

Product Mix / Portfolio

Effects

Monitoring and

Rebalancing


Backloading

7


Backloading: Voluntarily deciding to novate legacy IRS into Clearing

Backloading involves a tradeoff between credit risks and Clearing costs

• Risk transfer to Clearing House (e.g. LCH) reduces credit exposure vs swap counterparties

• Moving swaps into Clearing will carry cost implications with it (i.e. initial margin)

-200

-100

-

100

200

300

400

500

600

700

800

A B C D

Counterparty

IRS

(pv01)

Inflation swap

(ie01)

TRS

(pv01)

Repo

(pv01)

-400

-200

-

200

400

600

800

1,000

1,200

1,400

1,600

A B C D LCH

Counterparty

IRS

(pv01)

Inflation swap

(ie01)

TRS

(pv01)

Repo

(pv01)

Sample Portfolio: Impact of Backloading IRS on Risk Sample Portfolio: Risk per Counterparty


Variation Margin can be a source of cash, particularly where a scheme has a large number of

counterparties or significant in-the-money swaps

• Backloading in the money swaps can release cash (before initial margin impact in gilts)

• Alternative: remain bilateral and re-coupon IRS to release cash, although this incurs frictional costs

-60

-40

-20

0

20

40

60

80

100

120

140

A B C D

Counterparty

IRS Inflation TRS Repo

-60

-40

-20

-

20

40

60

80

100

120

140

A B C D LCH

Counterparty

IRS Inflation TRS Repo

Sample Portfolio: Mark to Market Impact of Backloading IRS Sample Portfolio: Mark to Market (£m) per Counterparty


Exemption

10


EMIR implementation timeline:

When does the Exemption window really start?

11

Source: European Securities and Markets Authority (ESMA)

Q1 2013 Q2 2013 Q3 2013 Q4 2013 Q1 2014 Q2 2014 Q3 2014 Q4 2014

15 Sep 2013

Portfolio Reconciliation

Dispute Resolution

Portfolio Compression

EMIR protocol

CCP application closes

15 Mar 2013

RTS now in force

CCP application window

opens

15 Mar 2014

National Competent Authority (NCA)

decision to authorise CCPs

Q4 2013

First CCPs authorised:

Clearing Member

obligations

Front loading period starts

(6m pre Go-Live)

Jan 2014 (estimated)

Trade reporting obligation to

trade repositories

Summer 2014

Clearing obligation starts

(subject to CCP authorisation)


Exemption Timeline:

Importance of the exemption window is relative to the amount of hedging planned for that period

Legacy Cleared Exempt

Start of Pension

Scheme Exemption

Front-Loading Window

prior to Go Live Date

End of Pension

Scheme Exemption

August 2015

(if not extended)

Size of

Hedge: 50% 10% 40%

Timing:

• Most likely date for mandatory Clearing is Summer 2014

• Likelihood is that pension scheme exemption will be extended beyond August 2015

• Backloading decision is important where legacy swaps make up a high proportion of the overall hedge

• Exemption window serves to extend legacy status for hedges enacted in exemption period



13


What is changing?

In a Cleared world, collateral requirements involve both non-Cleared & Cleared portfolios

Collateral amount is changing as initial margin now required

14

Cleared

%

Non-Cleared

% Portfolio

Initial Margin

Variation Margin

Initial Margin

Variation Margin

Total Collateral Requirements

Required

Collateral


In a Cleared world, more collateral will be required due to initial margin requirements

Also, variation margin on cleared swaps must be met in cash. Hence the ability to source

cash is important.

15

Other Assets

(LDI & non-LDI) Collateral

Non-Cleared

%

Cleared

%

Investment

Portfolio

LDI Portfolio

VM VM

IM

Collateral

Requirement

Other Assets

(LDI & non-LDI) Collateral

Investment

Portfolio


Gilts

Gilts

Top Up fund

Cash for VM

Initial Margin

(LCH)

Other assets

Other assets

MTM gains

Before After Clearing

Key Points:

• Mark to Market (MTM) gains: These will sit in a

cash account unless swept into other assets

• Other assets: Using other assets to replenish the

Cash VM and Top Up Fund will pull the portfolio out

of balance. Periodic review needed

• Initial Margin: Sourced from other assets and

posted in gilts

• Cash for VM: Initial margin is often used as proxy.

Used to cover MTM moves

• Top Up Fund: this is required to replenish the Cash

VM fund. When exhausted it must be replaced by

transforming other assets.

The mix of collateral required will also change as a result of Central Clearing

The diagram below shows the impact of initial margin on an overall investment portfolio


Product Mix and Portfolio Effects

17


Product Mix: Under Central Clearing, there are several choices available to an LDI portfolio

manager when sourcing risk. The different options have different initial margin (and hence

collateral) treatment on a standalone basis.

18

Best Initial

Margin

Treatment

Worst Initial

Margin

Treatment

Gilts

Legacy swaps

Bilateral swaps (under EUR 8bn)

Gilt repo

Cleared ‘real portfolios’ (see following two slides)

Cleared interest rate swaps, Cleared inflation swaps

Bilateral swaps (over EUR 8bn in 2019), TRS etc


Bloomberg now has an initial margin calculation tool

(using an approximate LCH methodology).

• The graph, left, shows the initial margin

requirement for IRS at various tenors (5-50 years)

[red line]

• LCH has yet to release the calculation methodology

for inflation swaps

-

10.0

20.0

30.0

40.0

50.0

60.0

70.0

5 10 15 20 30 40 50

Bp

s x

Ris

k

Tenor (yrs)

Initial Margin multiples (of pv01) by tenor

for single trade only

IRS per Bberg

Product Mix: Estimating initial margin requirements is not a trivial task

Trades with different tenors will be treated differently. This is also true at portfolio level

Key points:

The pv01 multiples vary with tenor, so applying a

simple multiple is at best an approximation

It is necessary to know the mix of rates / inflation in

the liabilities and the duration for the scheme


-200,000

-100,000

-

100,000

200,000

300,000

400,000

500,000

600,000

700,000

800,000

0-10 yrs 11-20 yrs 21-30 yrs 31-40 yrs 41+ yrs

Ris

k in

pv0

1 a

nd

ie

01

Tenor buckets

pv01 ie01

Sample portfolio of 94 ZC Interest Rate Swaps (IRS) and 76 ZC Inflation Swaps (total liability hedge c. £4bn):

PV01 and IE01 across tenor buckets

Portfolio Effects:

Effect of combining rates and inflation in a ‘real’ portfolio


Scenarios

1. Rates (IRS) only (2.0m total

pv01 net*)

2. Inflation only (1.3m total ie01

net*)

3. Real portfolio (1.3m pv01 and

1.3m ie01 net*)

4. Both rates (2.0m pv01 net*)

and inflation (1.3m ie01 net*)

* Curve risk is a factor .0 mio

10.0 mio

20.0 mio

30.0 mio

40.0 mio

50.0 mio

60.0 mio

70.0 mio

80.0 mio

IRS only Inflation only Real All IRS and ILS

IM r

eq

uir

em

en

t

1

IM requirement under 4 different scenarios:

2 3 4

Portfolio Effects: IM requirement constitutes a sea change in portfolio construction

Best execution will become a portfolio decision rather than being solely based on best price

Observations (initial margin required)

• Inflation is a driving factor (#2).

•Real portfolio (#3) is risk reducing

• The whole portfolio (#4) is below inflation only (#2) – due to

the real portfolio effect

Impact on Product Mix (cleared and non cleared)

Real effect: Better to source both inflation and rates through

swaps, rather than inflation swaps combined with (non

cleared) gilt repo


Monitoring and Rebalancing

22


Given the implications of Central Clearing, it is vital for schemes to develop a clear system for

monitoring portfolio efficiency and ensuring enough collateral is available when needed

Inputs into Decision-Making

Process:

• Backloading and exemption

choices

• Capability: are the various

legal documents (e.g. GMRA)

in place to allow flexibility?

• Product Mix (use of cleared

and non-cleared sources of

risk)

• Portfolio Effects

Outputs:

• Monitoring framework & liquidity

triggers

• Collateral waterfall (order in

which assets transformed into

collateral)

• Re-investment order for MTM

gains

• Portfolio review: periodic

rebalancing of assets back to

“ideal portfolio”

Trustee

Investment Manager

Advisor

Set Monitoring and

Rebalancing Policy


Conclusion

24


Several options exist for pension schemes in a Centrally-Cleared world concerning what to clear

and when. These have credit risk, collateral and portfolio implications. Putting a solid

framework in place is an important step in retaining control of the transition process

Liquidity Policy

Backloading

Exemption


Product Mix / Portfolio

Effects

Monitoring and

Rebalancing


13-15 Mallow Street London EC1Y 8RD Telephone : +44 (0) 20 7250 3331 www.redington.co.uk

Contacts

Robert Gardner Founder & Co-CEO

Direct Line: 0207 250 3416

[email protected]

26

Kenny Nicoll Director

Direct Line: 0203 326 7111

[email protected]

Tom McCartan Vice President

Direct Line: 0203 326 7139

[email protected]

Greg Fedorenko Associate

Direct Line: 0203 326 7122

[email protected]

Disclaimer

For professional investors only. Not suitable for private customers.

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Appendix:

Summary of EMIR Protocol

27


Regulatory Technical Standards come into effect on 15 September 2013

They concern risk management of non-cleared OTC derivatives

ISDA: EMIR Portfolio reconciliation, dispute resolution and disclosure protocol (the “EMIR Protocol”)

Amends ISDA (and non-ISDA) to comply with EMIR requirements (19th July 2013)

Breach of Protocol does not give a right to terminate or constitute an event of default

Portfolio reconciliation:

All non cleared OTC derivatives outstanding as at 15 Sept 2013 to be reconciled

Reconciliation of key terms including valuation

Frequency determined by number outstanding: 500+ daily; 51+ weekly; 1-50 quarterly

Dispute resolution: Applies to all non cleared OTC derivatives.

FCs and NFCs: procedures in place to identify, record and monitor disputes.

Disputes not resolved in 5 business days to be dealt with by specific process

FCs required to report to regulator any disputes in excess of 15 days or €15m

Portfolio compression: (not part of EMIR Protocol) unilateral requirement

Applies to all non cleared OTC derivatives.

FCs (and NFCs) with more than 500 OTC non cleared with a counterparty

Procedure to regularly (at least twice per year) conduct a portfolio compression exercise.

Central Clearing - Implications for Collateral Management

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