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Collateral Management Market Practices and New Legislation

ImpactsMarch 30, 2016

SPONSORED BY:

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MODERATOR:

Gary CrawfordAssistant Vice President, MFSC Legacy SystemsMFS Investment Management

PANELISTS:

Mark DemoProduct DirectorAcadiaSoft, Inc.

Wayne ForsytheManaging Director, Collateral Management Services State Street Global Services

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What is collateral management?

• Definitions and parameters can have some variance from firm to firm

• General definition is:– Measurement of open exposure– Coordination of counterparty margin calls– Settlement and tracking of agreed eligible

collateral• Many products require collateral: Derivatives,

Agency MBS, Repo, Credit lines, Short Equity

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Overview

• Collateral Management has evolved over time• Prior to Financial Crisis in 2008, process was

heavily operational and back-office focused– Largely manual– Little to no STP

• Counterparty defaults in 2008 were a game changing event for the industry

• Impacts front, middle and back office

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Data overview

• Static Data requirements– Account / Counterparty definition– Legal terms (CSA/MSFTA/GMRA etc): Minimum

Transfer, Threshold, Rounding, Eligible Collateral, Concentration limits

– Standing Settlement Instructions (SSI’s)• Dynamic data– Trade MTM / Initial Margin (independent amount)– Settled collateral valuations

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Margin Calls

• Margin call management– Distribution email or electronic (AcadiaSoft)– Includes relevant details for call, including call

amount, MTM and collateral balance– Times specified in governing agreements

• Parties agree to amounts and allocation• Disputed calls are identified

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Correlated Processes

• Settlement: Custodians notified via SWIFT messaging– MT540/542/202/210

• Reconciliation– Collateral Balances– Underlying Portfolios (unilateral or bi-lateral)

• Substitutions

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Changing Landscape

• Critical component of Enterprise Risk Program• Market utilities are evolving– DTCC Margin Transit– AcadiaSoft– TriOptima

• Regulations are redefining the landscape– Un-cleared margin requirements– Agency MBS

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CPE CODE:

212

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Impact of Regulation

• Mandated exchange of initial margin based on open notional calculations (2016 – 2020)

• Mandated variation margin for:– Broker Dealer effective September 2016– All other parties effective March 2017

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2007 Credit Crisis

Roots of the new derivative rules can be traced back to the 2007 credit crisis

• Meltdown of US mortgage market

• Large numbers of defaults on individual loans

• Fannie Mae and Freddie Mac expanding their balance sheet to buy loans

originated by banks

• Purchased loans by Fan and Fred packaged into loan syndications and other

financial instruments (CLOs) and sold around the globe

• Rated AAA by the rating agencies

• Explosion of sub-prime lending products marketed by banks and syndicated

globally

• Risk transfer and offset facilitated by the derivatives market

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G20 Regulatory CoordinationIn response to the financial crisis that began in 2007, the G20 initiated a reform program in 2009 to

reduce the systemic risk from OTC derivatives. This program comprised of four elements:

• All standardized OTC derivatives should be traded on exchanges or electronic platforms, where

appropriate.

• All standardized OTC derivatives should be cleared through central counterparties (CCPs).

• OTC derivatives contracts should be reported to trade repositories

• Non-centrally cleared derivatives contracts should be subject to higher capital requirements

G20 called upon global regulators to reform their financial markets.

The Basel Committee on Banking Supervision (BCBS) and the International Organization of Securities

Commissions (IOSCO) stepped in to develop consistent global standards for margin requirements.

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Key Principles of Margin Reform• Initial Margin

• IM and VM processed separately• IM must be exchanged by both parties without netting of

amounts collected by each party (ie gross basis)• IM can be calculated on a model or scheduled basis (or

combination of the two)• IM coverage should have a 99% confidence over a 10 day period• Initial margin will be held at a separate (3rd party) bank

• Variation Margin• Thresholds for variation margin will be eliminated• Standard MTA• Standard collateral eligibility• Standard collateral haircuts

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BCBS-IOSCO-Minimum Standards Minimum Standards for Margin RequirementsTopic Variation Margin Initial Margin

Type of Risk Current exposure Potential future exposure

Covered Entities All financial firms and systemically important non-financial entities

Product Scope All products Excludes FX forwards/swaps and physically settled FX associated with principal Payments on cross currency swaps

Threshold Zero €50 million – group consolidated basis

Exchange frequency Daily

Minimum Transfer Amount <=€500,000 <=€500,000

Eligible Collateral Cash, High quality government bonds and central bank securities, High Quality corporate bonds and covered bonds,

Equities included in major stock indices, Gold

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BCBS-IOSCO-Key Considerations

When clients are impacted: • Any covered entity belonging to a group

whose aggregate month-end average notional amount (“AANA”) of non-centrally cleared derivatives for March, April, and May exceeds the threshold, is in for IM as of Sept 1 the same year

• Count all uncleared derivatives including physically settled FX forwards and swaps in AANA even though they are not subject to IM margin rules

• Investment funds are considered distinct legal entities as long as they are not supported by other funds or advisor for insolvency purposes

• Everyone subject to new variation margin rules on March 2017

AANA VM IM

€3T Sep 2016 Sep 2016

€2.25T Mar 2017 Sep 2017

€1.5T Mar 2017 Sep 2018

€750B Mar 2017 Sep 2019

€8B Mar 2017 Sep 2020

<€8B Mar 2017

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Industry Response• ISDA established Working Group for Margin Reform (WGMR)• http://www2.isda.org/functional-areas/wgmr-implementation/• Standard Initial Margin Model (SIMM)

A key component of the WGMR Implementation Program is the Standard Initial Margin Model (SIMM)TM project, which is focused on developing a common initial margin (IM) methodology that can be used by market participants globally. Unlike the calculation of variation margin, which is based on day-to-day valuation changes that are often directly observable, initial margin calculations very much depend on the choice of model and the assumptions used. Under the framework set by the WGMR, firms can use their own internal models to calculate initial margin, as long as they meet certain criteria and obtain regulatory approval. These models have the potential to differ significantly, raising the possibility that counterparties will arrive at a different initial margin figure for the same trade. The result would be a surge in the number of disputes – and no obvious way currently in place to quickly resolve them. The SIMM provides an open, transparent, standard methodology that will be available to all.

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Industry Response (continued)• In addition to the SIMM workstream, several ISDA WGMR implementation

workstreams were formed to address all areas necessary for broad market compliance with new rules for both IM and variation margin (VM), including:

• portfolio integrity, • collateral management process changes, • data, • dispute resolution, and • legal documentation to govern collateral and segregation relationships.

• The ISDA WGMR Oversight Committee coordinates the work of all the above workstreams

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Regulation Changing the Margin Process

Regulatory Changes

• Two Way IM Posting

• Increased Collateral Segregation

• Multiple CSAs under a single ISDA master agreement

• Standard thresholds, mtas, collateral eligibility and haircuts

Impacts• New margin Agreements (Reg IM

and Reg VM)

• New Margin Call Calculations for Tri-Party

• Increased margin calls

• Increased collateral movements and substitutions

• Increased margin call disputes

Overall impact of regulations on market participants is to make trading more expensive and to trap risk locally rather than let it spread accross the globe in times of stress

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CPE CODE:

903

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Mark DemoProduct DirectorAcadiaSoft, Inc.Phone: 646-780-0067Mark.Demo@AcadiaSoft.com

Wayne ForsytheManaging Director, Collateral Management Services State Street Global ServicesPhone: 949-932-4668JWForsythe@statestreet.com

Questions?

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CPE CODE:

133PLEASE SUBMIT YOUR CODES AT THE CONCLUSION OF THE WEBINAR.

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