Derivatives

ECD Exchange Cleared Derivatives: Credit

PREPARED FOR: SII Eliminating Counterparty Risk in OTC Derivatives

DATE: 26th January 2009

Background: Credit

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2008 Credit Focus

FED (Federal Reserve Bank) focus on credit markets for the last few years

OMG (Operations Management Group) has representatives from all the dealers, industry associations and some buy-side firms. The OMG is a senior level, strategic group whose general mission is to examine and effect fundamental change in current front-to-back processes for all OTC derivative products.  It agrees on market best practise and sends letters to the FED on a periodic basis, outlining the industry’s commitments to strengthening operational efficiency and thereby reducing risk in the global credit and equity derivatives markets

Political drive from ECB (European Central Bank), EC (European Commission), FED for solutions

Very topical with the current market difficulties, credit crunch and banking instability

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Historical developments in CDS Market - Summary

Legal agreements – bilateral ISDA Master, CSA often lengthy negotiations, different jurisdiction and laws. Partially mitigated by DTCC matrix (unilateral)

Trade confirmation – move from long form paper to short form and since electronic platform DTCC

Novation – the number of novations left the market opaque in terms of who the actual contractual counterparty is. ISDA addressed this with several protocols. From January 2009 all novations needs to be agreed on Trade date via an electronic platform eg. TZero.

Collateral – collateral management, posting liquid assets, negotiating thresholds bilaterally in CSA

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Driving forces behind changes in the OTC market

Self-regulation of market participants– Cost of operational inefficiencies (confirmation, settlement, collateral)

– Counterparty risk due to opaque novations

– Manual work was not scalable, growth in volume = overhead s= lower profit

Regulators– FED increased focus on CDS market already long before the current credit crisis

– Targets to reduce number of unconfirmed trades

– Signed up to by broker / dealer but also affects buy-side

Risk– The highlighted risks and the possibility of bank default and domino effect has

driven the market to understand and manage their exposures and risks better. Counterparty exposure is looked at closely.

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Size of Global Credit Markets (Source BIS 2008, OTC Market Derivatives activity in the first half of 2008)

Whilst there has been a noticeable

slowing in the OTC credit markets rate

of growth, the absolute size is still

substantial at over fifty trillion USD.

ECD: Credit Markets

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Overview

The possibility of the CCP (central counterparty) model will open-up credit products to a broader audience

ECD also removes the fear of individual counterparty default and may increase the utilisation of credit products by market participants

Product offers users access to credit markets in order to hedge without exposing themselves to individual counterparty risk as this is transferred to the CCP

All the market participants and regulators have recognised the need for these products

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Exchanged cleared derivatives ECD vs exchange traded derivatives ETD

These are exchange cleared rather than exchange traded products

Advantage of ECD over ETD– ECD retains all the flexibility of OTC product

– ECD eliminates counterparty risk

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Collateral Management and Pricing

The current collateral management process is complex. Uncovered exposures can arise from counterparties not delivering the collateral to cover their positions

In the current risk environment banks are not as secure as once considered as shown with Lehman Brothers. The benefit of a CCP over an individual counterparty cannot be understated

Margin movements will be made daily directly with the exchange / clearing house. Not the current multiple counterparty movements needing to be agreed bilaterally and made with multiple counterparties

SPAN will be used to calculate the margin requirement and an initial and variation margin will be used

Rather than using current OTC independent models and having to agree pricing differences with counterparties, exchange daily pricing will be provided setting a common standard

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Buy-side Participation in ECD Market, advantages and disadvantages over OTC

Advantages

Removal of counterparty risk

Costs are much reduced as clearing fees are minimal compared to the OTC costs

Offer high level of confidence to investors that the fund can gain exposure to the instruments for hedging default exposures without taking on counterparty risk.

Collateral management. The collateral management with multiple counterparties including complicated valuations and disputes is removed and replaced by a exchange / clearing house span margining calculation. Daily pricing is provided setting a common standard.

Disadvantages

Cost of operational implementation

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Buy-side considerations

Depending on the offering the buy-side will need a clearer for their business. However they will normally have this arrangement in place as it is needed for participating in the current ETD markets

Buy-side firms either need to invest in technology, process and people to support this business or otherwise find a 3rd party as an outsourced agent to deliver the operational structure on their behalf

Question whether other funds can take advantage of new ECD products and benefit from hedging with the new CCP structure

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2009 Looking Forwards

Continued focus on credit markets

Delivery of ECD credit offerings; Index, Single names

Expansion to other OTC asset classes including– Equity, TRS, variance swaps

– Rates, IRS, RPI

Continued political drive from ECB, EC, FED resulting in probable regional solutions and jurisdictions

Increased focus on risk reduction measures and support of new initiatives by market participants

Questions?

Disclaimer

Disclaimer, the personal views expressed by presenter may not represent those of HSBC Group