Collateral optimization and Risk Management: a buy side perspective - Enrico massignani
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Transcript of Collateral optimization and Risk Management: a buy side perspective - Enrico massignani
www.generali-investments-europe.comFor professional investors only www.generali-investments-europe.comFOR PROFESSIONAL INVESTORS ONLY
Collateral Management Forum - Vienna, March 29th 2015 Enrico Massignani
Head of Risk Management
Collateral optimization and
Risk Management:a buy side perspective
www.generali-investments-europe.comFOR PROFESSIONAL INVESTORS ONLY2
IMPORTANT INFORMATION
The information contained in this document is only for general information on products and services provided by Generali InvestmentsEurope. It shall under no circumstance constitute an offer, recommendation or solicitation to subscribe units/shares of undertakings forcollective investment in transferable securities or application for an offer of investments services. It is not linked to or it is not intendedto be the foundation of any contract or commitment. It shall not be considered as an explicit or implicit recommendation of investmentstrategy or as investment advice. Before subscribing an offer of investment services, each potential client shall be given everydocument provided by the regulations in force from time to time, documents to be carefully read by the client before making anyinvestment choice. Generali Investments Europe, periodically updating the contents of this document, relieves itself from anyresponsibility concerning mistakes or omissions and shall not be considered responsible in case of possible damages or losses relatedto the improper use of the information herein provided.
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CONTENT
The collateral purpose
3
Address the counterparty, market and credit riskchallenge to develop risk management measuresagainst market distress
Assess operational risk throughout the collateralmanagement process
Q&A
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THE COLLATERAL PURPOSE
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Starting from the obvious...
...collateral is an asset used to secure an obligation of case by a counterparty
...it’s a guarantee that the counterparty will honour it’s obligation in due time
...it reduces or neutralize losses in case of couterparty default
collateral = counterparty risk mitigation
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THE COLLATERAL PURPOSE
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Post financial crisis .....
...Regulators see collateral as one of the preferred tools to mitigate systemic risk
in the financial system. For this reason they are imposing collateralization either
directly (eg. OTC clearing at CCPs) or indirectly (higher capital charges for
uncollateralized credit exposure).
...Market participants use collateral:
to gain easier access to financing
to obtain much more favorable financing conditions
to reduce capital charges
collateral = money
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THE COLLATERAL PURPOSE
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The financial industry has adapted quickly: collateral optimization, collateral
transformation, collateral management as a profit center.
All these practices have now powerfull incentives to be optimized around the
profitability function.
eventually market participants may be distracted away from the
basic original purpose of collateral: counterparty risk mitigation
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CONTENT
The collateral purpose
7
Address the counterparty, market and credit riskchallenge to develop risk management measuresagainst market distress
Assess operational risk throughout the collateralmanagement process
Q&A
www.generali-investments-europe.comFOR PROFESSIONAL INVESTORS ONLY
MARKET DISTRESS AND COLLATERAL
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Market distress is generally
characterized by fly to quality
behaviour, credit quality
deterioration and defaults on
obligations.
All the above factors have
large impact on the collateral
management process
Market risk
Credit risk
Counterparty risk
Increase in price
volatility
Increase in price
volatility
Change in
correlations
Change in
correlations
Downgrades
Counterparty
downgrade or
default
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MARKET DISTRESS AND COLLATERAL:MARKET RISK
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Increase in price
volatility
Increase in price
volatility
Change in
correlations
Change in
correlations
• Margin calls
• Substantial increased
need of cash and other
eligible collateral
• Netted collateralized
exposures become
more volatile
(“Netting risk”)
• Market value of the
collateral and of the
collateralized
obligation may
sharply move in the
opposite direction
(“Mismatch risk”)
• Deflation of the asset
book as primary
source of collateral
(“ Availability risk “)
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MARKET DISTRESS AND COLLATERAL:CREDIT RISK
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• Collateral calls
• Substantial increased
need of eligible collateral
• Generalized reduced
availability of eligible
collateral
• Posted collateral
becomes ineligible
(“Eligibility risk”)
• Quality deteriorarion
of asset book as
primary source of
collateral
(“Availability risk”)
Downgrades
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MARKET DISTRESS AND COLLATERAL:COUNTERPARTY RISK
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• Increased cost of
novation
• Increase of netted
collateralized exposures
• Increased price pressure
on low grade collateral
• Increased operational
risk
• OTC contracts
novation (“Novation
risk”)
• OTC contracts
unwinding and
collateral liquidation
(“Unwinding risk”)
• Need to reopen
unwinded OTC
contracts
(“Reopening risk”)
Counterparty
downgrade or
default
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MARKET DISTRESS AND COLLATERAL:SOME ADDITIONAL OBSERVATIONS (1/2)
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Collateralized OTC derivative exposures are particularly impacted by market risk
and counterparty risk.
Hedging and netting is usually optimized on latest correlations and by
counterparty.
A sharp change in asset price volatility and correlations may cause large
unexpected increase of netted collateralized exposures.
Contracts novation or reopening with different counterparties may result in
suboptimal netting and different collateral eligibility standards
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MARKET DISTRESS AND COLLATERAL:SOME ADDITIONAL OBSERVATIONS (1/2)
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Collateral transformation transactions tend to be particularly affected by market
and credit risk.
Being their purpose to transform lower grade collateral into higher grade, there’s
a structural material mismatch between the secured obligation and the
correspondent collateral
Finally, market distress cause a sudden increase of collateral management
operational activities, wich increase the probability of related operational risk
events.
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MARKET DISTRESS AND COLLATERAL:SOME EXAMPLES MITIGATION MEASURES (1/6)
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Risk type Mitigation
Market
Netting Risk
Mismatch Risk �
Availability Risk
CreditEligibility Risk �
Counterparty
Novation risk �
Unwinding Risk �
Re-opening Risk �
Some obvious ones:
• Collateral diversification requirements• Counterparty diversification limits
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MARKET DISTRESS AND COLLATERAL:SOME EXAMPLES MITIGATION MEASURES (2/6)
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Risk type Mitigation
Market
Netting Risk �
Mismatch Risk
Availability Risk
CreditEligibility Risk
Counterparty
Novation risk �
Unwinding Risk
Re-opening Risk
Establish maximum levels of OTC contract exposures under stressed
market risk scenarios Asses OTC contract exposures with tail risk mode correlations, as well as on a
pure gross (un-netted) basis, in order to quantify potential need of collateral.
Establish preset limits to be monitored and escalated.
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Establish minimum levels of unpledged eligible assets under stressed
market risk scenariosStress test the asset book free for hypothecation, to simulate eligible collateral
availability under severe market risk scenarios. Combine with OTC contract
exposures under stressed scenarios results. Establish preset minimum limits to
be monitored and escalated.
Risk type Mitigation
Market
Netting Risk �
Mismatch Risk �
Availability Risk �
CreditEligibility Risk
Counterparty
Novation risk
Unwinding Risk
Re-opening Risk
MARKET DISTRESS AND COLLATERAL:SOME EXAMPLES MITIGATION MEASURES (3/6)
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Apply migration risk stress tests to posted/received collateral
Such tests help to understand how much of the current collateral may become
ineligible and would have to be replaced .
Risk type Mitigation
Market
Netting Risk
Mismatch Risk
Availability Risk
CreditEligibility Risk �
Counterparty
Novation risk
Unwinding Risk
Re-opening Risk
MARKET DISTRESS AND COLLATERAL:SOME EXAMPLES MITIGATION MEASURES (4/6)
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Establish minimum levels of unpledged eligible assets under migration risk
scenarios Stress test the asset book with migration risk. Identify the assets that would be
free for hypothecation. Quantify how much would be eligible for collateralization.
Establish preset minimum limits to be monitored and escalated.
Risk type Mitigation
Market
Netting Risk
Mismatch Risk
Availability Risk �
CreditEligibility Risk
Counterparty
Novation risk
Unwinding Risk
Re-opening Risk
MARKET DISTRESS AND COLLATERAL:SOME EXAMPLES MITIGATION MEASURES (5/6)
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Stress test counterparties credit risk
Credit deterioration of a counterparty triggers the need of contracts novation to
other counterparties in order to reduce specific ctp exposure.
Netting risk limits (slide 12) need to be reassessed. Eligibility may change due to
different CSA agreements
Risk type Mitigation
Market
Netting Risk �
Mismatch Risk
Availability Risk �
CreditEligibility Risk
Counterparty
Novation risk �
Unwinding Risk
Re-opening Risk
MARKET DISTRESS AND COLLATERAL:SOME EXAMPLES MITIGATION MEASURES (6/6)
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CONTENT
The collateral purpose
20
Address the counterparty, market and credit riskchallenge to develop risk management measuresagainst market distress
Assess operational risk throughout the collateralmanagement process
Q&A
www.generali-investments-europe.comFOR PROFESSIONAL INVESTORS ONLY
OPERATIONAL RISK AND COLLATERAL MANAGEMENT
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On buy side organizations collateral management has transformed...
...from
An activity «remotely» performed in
the mid-backoffice
With weekly or even monthly
frequency
Related to very few transactions
to
An integrated front-to-back process
With daily frequency
Concerning a material and
increasing portion of assets and
transactions
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OPERATIONAL RISK AND COLLATERAL MANAGEMENT
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Complexity and scale has dramatically increased and operational risk as a consequence.
How to address it? A few questions that need an answer:
• Are the involved departments and decision makers (Top Management, Front,
Risk Manag., Middle-BackOffice, Legal, Compliance) properly engaged and
trained?
• Is your infrastructure (systems, procedures, contracts) properly designed to
support the collateral management process lifecicle?
Finding an answer to these question is just the starting point.
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OPERATIONAL RISK AND COLLATERAL MANAGEMENT
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Implementation risk rises the stake.
Level of integration is a critical feature:
• Similarly to any transaction processing process, low level of system and
information integration rise exponentially the probability of painfull operational
risk events.
• On the other side, integration implies considerable investment and
implementation time.
Fundamental to make sure that the organization is aware of the
trade offs to make proper design decisions
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THE OPERATIONAL RISKS, UNDER TAIL CONDITIONS
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Collateral management is tool to protect in case of counterparty default.
To accoplish such purpose it should work very well during defaults occurrences
and in general credit crises.
Fortunately they are infrequent events! For the CM process though means that
there are very few occasions to properly test if it works as expected during such
occurrences
Ex ante approach should be applied here. In particular:
Verify wether the organization is ready :
• to secure collateral ownership and disposal on counterparty default.
• to roll OTC derivative exposure to another ctp
Some regular tests may be one of the best options to perform such assessment
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CONTENT
The collateral purpose
25
Address the counterparty, market and credit riskchallenge to develop risk management measuresagainst market distress
Assess operational risk throughout the collateralmanagement process
Q&A
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THANK YOU
Q&A