Collateral Access Management Optimisation Protection OTC Derivatives

OTC derivatives
The challenge of deriving clear benets

An in-depth look at regulatory changes
and their impact on institutional investors
A research publication from BNP Paribas
Managing editor
Franck Lambert, Head of marketing, BNP Paribas Securities Services
Contributing editors
Florence Fontan, Head of European affairs, BNP Paribas Securities Services
David Beatrix, Business development - market and fnancing services, BNP Paribas Securities Services
Mark Armstrong, Legal European regulatory affairs, BNP Paribas Corporate and Investment Banking
Nicolas Mehta, Head of OTC derivatives documentation, policy and development, BNP Paribas Corporate
and Investment Banking
Additional contribution
Jeremie Pellet, Head of regulatory affairs, BNP Paribas Corporate and Investment Banking
Florent Benhamou, Market risk products, BNP Paribas Securities Services
Cyril Ettori, Head of market and counterparty risk analysis, BNP Paribas Securities Services
Eric Roussel, Head of product management, trade and market solutions, BNP Paribas Securities Services
Special thanks
Jonathan Duff, Communications manager, BNP Paribas Securities Services
Mark Hillman, Head of marketing and communications, BNP Paribas Securities Services
Table of
contents
Executive summary
Part 1: Overview of the regulatory initiatives
affecting OTC derivatives
1.1 Dodd-Frank Act and EMIR: similar but
different
1.2 Ucits and Solvency II: increasing requirements on
the valuation of OTC derivatives
Part 2: The impact of regulations on investment
managers operations, fnancing needs and
counterparty risk exposure
2.1 Operational aspects of the introduction of cleared
OTC derivatives
Navigating the documentation provisions
Connecting to SEFs, affrmation platforms and trade
repositories
Renewing your approach to OTC derivatives valuation
Adapting your collateral management set-up
Choosing a clearing broker
2.2 New funding challenges
The rise of collateral requirements
Analysing your options for collateral optimisation and
transformation
2.3 A new paradigm for counterparty risk
The implications of CCP models
Upgrading the approach to counterparty risk measurement
Next steps
About BNP Paribas
Glossary
Contacts
contents
06
08
10
14
16
18
30
37
42
44
48
52
Executive
Summary
Over the years, over-the-counter (OTC) derivatives have
given institutional and corporate investors a fexible tool for
hedging a large range of risks. The swap market has grown
very large. Then the 2008 fnancial crisis occurred and
critics accused the OTC derivatives markets of triggering and
amplifying the crisis due to the swap markets sheer size.
Since the 2008 crisis, regulators have proposed a number of
initiatives aimed at making the market safer. Chief among such
initiatives are the Dodd-Frank Act in the US and the European Market
Infrastructures Regulation (EMIR) in Europe. The two are similar
in the way they treat OTC derivatives, particularly as they seek
to mitigate systemic risk and boost transparency. However, there
are a number of important differences that cannot be overlooked,
raising the thorny issue of transatlantic regulatory arbitrage.
In parallel, other regulations such as Europes undertakings
for collective investment in transferable securities (Ucits)
directive and Solvency II frameworks are forcing institutional
investors to be more risk-conscious when using OTC derivatives.
At the heart of their requirements is the valuation challenge
of complex instruments, with a clear objective to promote
independent, sophisticated and more frequent pricing.
Electronic execution and clearing are surely coming, in conjunction
with a requirement to mark derivatives to market on a daily basis.
In short, the barrage of regulatory initiatives will change the entire
OTC derivatives industry dramatically and institutional investors will
need to look closely at the impact of these initiatives on three areas:
Operations: frst, diverging documentation requirements on both
sides of the Atlantic will present legal challenges. Beyond that, front-
and back- offce teams will have to change the way they handle
cleared OTC derivatives (interface/connectivity with execution and
affrmation platforms among other things). At the same time, they
must upgrade existing internal procedures and systems to meet
more stringent requirements for un-cleared OTC derivatives. Middle-
offce teams may struggle to adapt their reporting capabilities
and valuation techniques for both cleared and un-cleared OTC
derivatives, often referred to as portfolio bifurcation. This forces
the issue for a hybrid yet state-of-the-art collateral management
set-up. As a result of these operational changes, many institutional
investors will look to outsourcing as a way to mitigate complexity.
Funding: collateral requirements will become more complex and
will ultimately rise due to new rules for collateral eligibility at CCPs
and the co-existence of cleared and un-cleared OTC derivatives.
This already worries investors, particularly in times of tight liquidity.
Executing brokers and clearers will increasingly be judged on their
skill in working with custodians to make the best use of collateral.
Counterparty-risk measurement: centrally cleared OTC derivatives
markets are deemed to be safer during times of adverse market
conditions. However, investors will have to learn how to do
business with a more diverse array of counterparties: dealers,
clearers and central counterparties (CCPs), and to consider the
best option to safeguard their collateral. Increasingly detailed
regulatory provisions will challenge asset managers, especially
in Europe, to measure counterparty risk at fund level.
Summary
7
1
2
3
Part 1:
Overview of the regulatory
initiatives affecting OTC
derivatives
9
1.1 Dodd-Frank Act and EMIR: similar but
different
From Pittsburgh to Washington and Brussels
A little more than a year after the collapse of Lehman Brothers, the
G20 countries met in Pittsburgh in September 2009. They passed a
resolution stating: all standardised OTC derivatives contracts should
be traded on the exchanges or via electronic trading platforms,
where appropriate, and cleared through CCPs by end of 2012 at the
latest. Principally, the resolution sought to allay systemic risk in
the market for OTC derivatives, and to make transparent (pre- and
post-trade) transactions that were widely perceived as opaque.
It sparked a lively debate on both sides of the Atlantic about how
best to overhaul and regulate the OTC derivatives markets.
The US Congress passed the Dodd-Frank Wall Street Reform
and Consumer Protection Act (Dodd-Frank Act) on 15 July 2010,
which was signed into law by President Obama on 21 July, 2010.
The implementation of the Dodd-Frank Acts derivatives reforms
(contained in Title VII), initially due to take effect on 16 July 2011,
has been delayed by the US regulators until later in 2012. Title
VII of the Dodd-Frank Act creates a new regulatory framework for
participants and products in OTC derivatives markets. It requires
most derivative products to be traded on execution platforms, cleared
through CCPs according to strict rules governing capital, margin,
reporting, record keeping and business conduct, or collateralized
on a bilateral basis, and reported to Swap Data Repositories.
On 15 September 2010, the European Commission published its
formal legislative proposal for regulation on OTC derivatives,
central counterparties and trade repositories: European Market
Infrastructures Regulation (EMIR). Like the Dodd-Frank Act,
the proposed European Union (EU) Regulation aims to fulfl the
commitments given at the G20 Pittsburgh summit: all standardised
OTC derivatives should be cleared through CCPs by the end of 2012
at the latest. Moreover, EMIR contains additional provisions related
to the confrmation process, collateral mechanisms, independent
valuation and reporting of OTC transactions to trade repositories.
The proposed EU Regulation is still in draft form and is subject to
amendment during the EU legislative process. Political agreement on
the fnal text is expected sometime in Q4 2011. Both the proposed
EU Regulation and the Dodd-Frank Act envisage that there will be
extensive regulatory standards that will signifcantly affect how
the two regimes operate. In the EU, the European Securities and
Markets Authority (ESMA) will have the important job of developing
most of these standards and rules (to be fnalised by the end of
June 2012, albeit this seems like a moving target). In the US, the
job falls mostly to the Securities Exchange Commission (SEC)
and the Commodities Futures Trading Commission (CFTC).
Objectives and spirit
The Dodd-Frank Act and EMIR share the same approach when it comes
to regulation of the OTC derivatives markets. Both seek above all to
10
Part 1: Overview of the regulatory initiatives affecting OTC derivatives
11
mitigate systemic risk and increase transparency. However, there
are signifcant differences between the two, and those differences
are growing as EMIR passes through the legislative process in
Brussels. The thorny issue of transatlantic regulatory arbitrage is
ever present. The Dodd-Frank Act tackles some things that EMIR
does not, but some of these will be addressed in a separate review
by the EUs markets in fnancial instruments directive (MiFID).
Notably, draft MiFIR (ie, the proposed amendments to MiFID will take
the form of a directive and a regulation) will cover pre- and post-
trade transparency requirements for OTC derivatives transactions
and the non-equity markets, and the mandatory trading of OTC
derivatives on organised trading facilities (OTFs) or derivatives
trading venues (DTVs). A draft legislative proposal on the latter is
expected from the European Commission in late October 2011.
Both the draft EU Regulation and the Dodd-Frank Act aim to
impose mandatory clearing and reporting obligations on a broadly
defned class of OTC derivatives (with notable differences for
some classes of derivatives). Both, however, allow regulators like
ESMA in the EU and CFTC in the US to decide which derivatives
are eligible and when the clearing obligation applies.
The draft EU Regulation is potentially less burdensome for certain
end-usersfor example, pension funds albeit that this is still
a moving targetin terms of the clearing obligation. Under the
Dodd-Frank Act, the clearing obligation applies to everyone trading
an eligible contract, although non-fnancial entities may escape
them when entering into certain hedging transactions. In the EU,
the clearing obligation applies to all fnancial counterparties.
Non-fnancial counterparties only become subject to the clearing
obligation when their positions exceed a specifed clearing threshold
yet to be defned by ESMA and certain hedges will be excluded.
The Dodd-Frank Act imposes margin requirements on dealers and
major swap participants entering into un-cleared transactions. At
the counterpartys request, the initial margin (Independent Amount)
must be segregated with an independent third party custodian.
The latest compromise draft of the European Regulation discussed
at Member State level requires fnancial counterparties to prove
that they can measure, monitor and mitigate operational and
credit risk (non-fnancial counterparties are exempt except
when the clearing threshold is breached). Derivatives contracts
entered into once the Regulation is in force must show that
collateral has been accurately and appropriately exchanged.
There is no mandatory requirement to segregate collateral in accounts,
only a requirement to distinguish such collateral if a request is made
by one of the parties prior to contract execution. However, the extent
of segregation is not clear. Neither is there any distinction made
between initial and variation margin. There are also questions as to
whether segregation is at CCP level and at clearing-member level.
The latest draft Regulation also considers permitting competent EU
authorities to exempt intra-group transactions from the collateral
requirements (such transactions are defned in the draft).
Both the Dodd-Frank Act and the proposed EU Regulation
envisage subjecting dealers to rules for registration and business
conduct. The US regime also extends registration, conduct of
business and margin/capital rules to major swap participants.
Both the Dodd-Frank Act and the proposed EU Regulation seek
to allow cross-border clearing by permitting the recognition or
exemption of non-domestic CCPs. It remains unclear, however,
how these provisions will operate in practice. The Dodd-Frank
Act requires compliance with all US rules providing trade
repository services across borders (including indemnifcation).
The proposed EU Regulation currently requires recognition of non-
EU repositories by ESMA, provided certain conditions are met.
Among these conditions is an international agreement with the
third country and co-operation arrangements. We do not know yet
what obligations EMIR and Dodd-Frank Act will impose when the
parties to a transaction are on different sides of the Atlantic.
The Dodd-Frank Act requires the execution of OTC derivatives contracts
subject to the clearing obligation on a swap execution facility (SEF) or
on a futures or securities exchange. The SEF or exchange will have to
make the derivative available to trade, with post-trade transparency
in real time for cleared derivatives and to position limits. In the EU,
as noted previously, these issues are being addressed separately as
part of the MiFID review. Until the European Commission publishes
its legislative proposal later in 2011, it is premature to state to what
extent the EU will mirror the relevant Dodd-Frank requirements.
The EU proposals currently have no equivalent to the US
push out rule restricting the derivatives activities of banks.
They also do not have an equivalent to the Volcker rule that
restricts banks from carrying out proprietary trading.
12
Rule making by
CFTC and SEC
European Comission
Prorposal
15 September
European Parliament
ECON vote on EMIR
24 May
Council agreement
on EMIR
20 June
EP vote on
EMIR
4th Quarter 4th Quarter
ESMA publishes
technical standards
May
MiFID review
EMIR
enforcement
31 December
Creation of
ESMA
1 January
Dodd-Frank Act
signed
21 July
CFTC temporary
exempt relief
14 June
Title VII Rulemaking
deadline
1st Quarter
Initial deadline
for rule making
16 July
Rules effective
date
4th Quarter
US
(Dodd-Frank)
Europe
(EMIR)
2010
31st Dec
G20
Deadline
2012 2011
DODD-FRANK ACT AND EUROPEAN MARKET INFRASTRUCTURES REGULATION: DIFFERENT SPEEDS
IIn Europe, EMIR is still under negotiation at the European Parliament. It is expected to be fnalised before the
end of 2011. EMIR is a European regulation, not a directive. This means it will pass directly into national law
without a period of national transposition by each EU member state. Despite this fast-track approach, however,
EMIR is not expected to come into force before the end of 2012 at the earliest as the European Commission,
with the support of ESMA and other European regulators, needs to adopt almost 30 technical standards.
In mid June 2011, the CFTC and SEC took actions that will likely defer most of the Dodd-Frank Act
requirements regulating swaps and security-based swaps. Temporary relief will give market participants
until the frst quarter of 2012 to complythe initial date was to have been July 2011. To date, the
SEC and CFTC have issued very few fnal rules, including how they even defne the term swap.
13
Scope
Broad range of OTC derivatives but limited to derivatives
on specifc underlyings (MiFID Annex I, Section C)
Out of scope/exempt: Spot foreign exchange (FX) transac-
tions, commercial forward FX transactions, some kinds of
physically settled commodity transactions
Applies to a broad range of OTC derivatives including any
agreement, contract or transaction that is, or in the future
becomes, commonly known to trade as a swap
Out of scope/exempt: Spot FX transactions, some types of
physically settled commodity transactions and certain
physically settled forward transactions in securities
Possibility for the Treasury secretary to exclude FX swaps
and forwards from the clearing obligation (but not the
reporting obligation)
Clearing
obligation
Mandatory clearing of eligible derivative contracts for
trades entered into between fnancial counterparties and
third country entities (including those which would be
exempted if EU entities)
Two ways to determine clearing eligibility: (a) Bottom-
up: CCP request and (b) Top-down: ESMA in consultation
with the ESRB (incentivise EU CCPs to clear; use of non-EU
CCPs)
Criteria:
(1) systemic risk reduction
(2) liquidity of contracts
(3) availability of pricing information
(4) ability of the CCP to handle contract volumes
(5) level of client protection provided by the CCP
EMSA to defne details in secondary legislation by 30
June 2012
Clearing obligation applies to anyone who enters into a
derivative subject to the clearing obligation; applies to trades
between US and non-US counterparties
In general, the rules do not apply to derivatives trades
that do not have a direct impact/connection with US
commerce (eg Foreign CCP, Foreign counterparty probably
excluded)
Mandatory clearing of swaps determined by the CFTC (for
swaps) and SEC (for security based swaps) as eligible
provided a central clearing house exists
Criteria: differ from the EU; for example, the US regulators
are required to take into account the effect on competition,
including clearing costs
CFTC can also restrict trading in non-cleared contracts
and stay the application of the clearing obligation
Non-cleared
trades
Bilateral trading of non-cleared trades possible, provided
general risk management measures are in place (eg
mitigation of operational and credit risk, including
requirements for electronic confrmation, portfolio
reconciliation, daily mark to market of outstanding
contracts, segregated exchange of collateral or appropri-
ate holding of capital)
Capital requirements directive (CRD) IV likely to impose
higher capital charges for non-cleared trades and 1-3% risk
weighting for CCP exposures
Stricter oversight of swap dealers and major swap
participants, including registration with the CFTC, BCR,
position limits and stricter capital and margin requirements
Customised trades may trade OTC, but must be reported to
a trade repository and likely to be subject to higher capital
and margin charges
Transactions between fnancial and non-fnancial
counterparties not exempt from the margin requirements,
but regulators have indicated that these provisions should
not apply to end-users
Secondary rule-making will defne capital and margin
requirements
Reporting
Financial counterparties and non-fnancial counterparties
that exceed an information threshold are subject to the
reporting obligation of OTC derivatives contracts to Trade
Repositories, no later than the working day following the
execution, clearing, or modifcation of the contract
Possibility for a counterparty to report OTC derivatives
contracts on behalf of another counterparty
When a trade repository is registered by ESMA for reporting
a particular type of OTC derivative, all those derivatives
previously entered into shall be reported to that repository
within 120 days
Each swap, either cleared or uncleared, shall be reported
to a registered Swap Data Repository as soon as technologi-
cally practicable after time of trade execution (appropriate
delay will apply for block trades)
Responsibility of reporting uncleared swaps to SDR will
depend on a hierarchy of counterparty types
Uncleared derivatives existing at enactment generally
must be reported to a registered trade repository or the
relevant regulator, under rules that must be adopted by
October 2011, within 30 days of the fnal rules or other time
period specifed in the rules
Timeline
Draft Regulation in the co-decision procedure and under
review by the European Parliament and Member States
For the Regulation to come into effect, both Parliament and
member states need to jointly negotiate and agree a single
text (expected for end 2011)
ESMA to draft technical standards by 30 June 2012
Technical standards need to be adopted by the Commission
to be legally effective
Regulation has direct effect (unlike a directive) and requires
no implementing legislation would enter into force 20 days
after offcial publication (anticipated end of 2012 but could be
earlier if politically expedient)
CCPs that have an existing national authorisation would
have two years to obtain authorisation
Other provisions do not take effect until implementing
regulatory standards are adopted (eg information and
clearing thresholds for non-fnancial counterparties)
EMIR generally unclear on the non-application of the new
requirements to existing trades (grandfathering provision)
CFTC/SEC to draft secondary regulations pursuant to
statutorily prescribed deadlines
General effective date is 360 days after date of enactment
(21 July 2010), but rulemaking is likely to extend beyond this
period
Most rules will provide opportunity for public comments for
30 days (some rules 45-60 days)
EU: EMIR
ACTS AND REGULATIONS: TRANSATLANTIC DIFFERENCES
US: Dodd-Frank
1.2 Ucits and Solvency II: increasing
requirements on OTC derivatives
valuation
Asset management
Since January 2009 (Ucits III 4th amendment), European asset
managers are required to use independent valuation sources
for all positions. The fnancial crisis of 2008 prompted some
countries to move ahead on their own without waiting for the
European Regulation to evolve. In France, the Autorit des
Marchs Financiers (AMF) published its own instructions as early
as 9th December 2008. Asset managers must now have internal
pricing capabilities for valuing the term fnancial instruments
(comprising OTC derivatives) they hold in their portfolios.
The Ucits IV directive, entered into force on 1 July 2011,
allows managers to invest in OTC derivatives, provided that
the OTC derivatives are subject to reliable and verifable
valuation on a daily basis (Article 50 of the Ucits IV
directive). Ucits IV also requires them to be able to monitor
at any time the risk of the positions and their contribution
to the overall risk profle of the portfolio (Article 51).
In July 2010 the Committee of European Securities Regulators
(CESR) published its own guidelines. These cover risk
management and the calculation of global exposure
and counterparty risk for Ucits (CESR/10-788). They will
change current market practices dramatically. The OTC
derivatives exposure must now be computed on the basis
of a commitment approach much more sophisticated
than computing mark-to-market exposure. Moreover, even
when a commitment approach does not apply, the guidelines
generally call for more advanced models of counterparty risk.
The use of OTC derivatives has spread widely since Ucits III
included them among eligible securities. The trend has even led
the European commission to create the term sophisticated Ucits
to designate these funds with innovative investment strategies. As
a result, the above requirements for independent, sophisticated
and more frequent pricing of OTC derivatives are having an impact
on very large areas of the investment community. Since its third
version, Ucits has become Europes fagship investment vehicle,
spreading globally as a brand. So the question of how to value OTC
derivatives interests more than just European asset managers.
Asset managers in Asia or hedge funds trying to use Ucits vehicles
to attract institutional investors are directly concerned.
14
Beyond EMIR and Dodd-Frank, the industry has witnessed mounting regulatory pressure
for more independent, sophisticated and frequent valuation. Which investors are most
affected? Which jurisdictions have the most detailed provisions?
Insurance
Insurance companies operating in Europe face slightly different
issues regarding OTC derivatives. The Solvency II legislation
places risk management at the heart of their operations. It
imposes an approach based on cash fow, requiring consistent
valuation of assets and liabilities and computation of stress-
tested values to obtain the Solvency Capital Requirement
(SCR) and Minimum Capital requirement (MCR).
Insurance companies traditionally tend to focus rather on the modelling
of their liabilities rather than their assets. The former are complex and
very specifc, while the latter can be evaluated at relatively low cost by
external parties. The new regulations will change this dramatically.
Insurance portfolios typically contain OTC derivatives such as interest
rate or credit default swaps and infation-linked instruments and
to hedge the guaranteed minimum returns in variable annuity
products. The new consistency requirement between assets and
liabilities will compel insurance companies to develop complex
data warehouses and look-through reporting. They will need to
improve their data cleansing processes in conjunction with asset
valuation processes. That is why we believe insurance companies
will further rely on their asset management departments to value
their fund assets. For valuations of their direct holdings in OTC,
however, they will tend to rely more on external providers.
15
SOLVENCY II IN A NUTSHELL
The European directive Solvency II must be applied from the 1 January 2014, by all insurance companies
based in Europe. It has the frst objective to place risk management at the heart of all insurance companies,
imposing a cash-fow based approach, and harmonising insurance sector practices. The second objective
is to protect policyholders through robust and comprehensive risk management practice.
The directive is composed of three pillars:
Pillar I, quantitative requirement on capital computation, has the most important impact in
terms of OTC valuation and reporting capabilities. It aims to make the market consistent in
terms of valuation of assets and liabilities and the computation of their stressed values to
obtain the Solvency Capital Requirement (SCR) and Minimum Capital requirement (MCR)
Pillar II, supervisor review, aims at better organisation of- and more operational
and governance controls over- investment management
Pillar III, disclosures: a comprehensive reporting approach to the regulator, the company board and the investors
Solvency II requirements also impact asset managers, in particular because Pillar I imposes on insurance
companies look-through reporting capabilities to analyse their underlying portfolio of funds. This results
in increasing pressure on asset managers to bring further transparency to their allocation.
Regulatory provision for OTC derivatives valuation is not new but it is now reaching a critical
point. This is particularly true in Europe, which is adding layers of provisions and requirements
at both the European and national levels. While EU legislation seems to be taking the lead,
the impact is already worldwide, especially for asset managers. Indeed, whether the need
arises from having to respect Ucits requirements or to help their insurance clients comply
with Solvency II, the pressure is on asset managers to fully understand the details and
intricacies of the new legislation.
Part 2:
The impact on investment
managers operations,
nancing needs and risk
exposure
17
18
2.1 Operational aspects of the introduction
of cleared OTC derivatives
Navigating the documentation provisions
Europe
The EU approach is in essence a principal model.
Today, the bilateral agreement adopted between two
counterparties dealing OTC derivatives is typically the master
agreement published by the International Swaps and Derivatives
Association (ISDA). It is composed of several components:
Master agreement: defnes the general terms
and conditions that will guide the relationship
(obligations, events of default, governing law)
Schedule: adapts the Master Agreement to specifc needs
of the parties and sets out any particular terms the
parties agree will apply to transactions between them
Conformation: sets out the term of a specifc transaction
Credit support annex/deed: relates to the fnancial
collateral that will be exchanged between the parties
(eligibility, frequency, haircuts, thresholds.)*
The new reforms will add to these documentation requirements.
Clients will now have to sign one or more clearing agreements
that bring into effect an additional agreement such as an ISDA
master agreement with a collateral annex for cleared transactions.
Transactions will continue at present to be entered into directly
between the client and the clearing member (or executing broker,
under a give-up relationship). Once the clearing broker has entered
into or accepted the transaction with the client, an equivalent
transaction must also be registered in the client account of the
clearing member at the clearing house. Of course, all this comes
on top of the master agreement with the executing broker.
This is backed up with security interest in favour of the client over
the receivable on that clients account with the clearing house.
This is designed to mitigate clients credit risk to the clearing
member under the cleared ISDA agreement and cleared credit
support annex (CSA). It does not, however, extend to any exposure
under the existing non-clearing ISDA and CSA, or indeed to any
other relationship between the client and the clearing member.
Cleared transactions also require the following documents to be put in
place:
Master give-up and back-loading agreement between
the executing broker and clearing member
Part 2: The impact on investment managers operations, fnancing needs and risk policies
Differing approaches in the EU and the US have fostered the adoption of different clearing of
OTC derivatives. What is the impact on documentation and how should investors approach it?
*Note that this is not put in place for all
counterparties.
19
Designation notice given by the clearing member to the
executing broker relating to the specifc client in question
Compensation agreement which addresses what would
happen between the executing broker and the client,
should the clearing member not accept the transaction
in question within the stated time frame.
Clearing fees and other auxiliary matters (as relevant) are set out in a
side letter.
United States
The US model, on the other hand, is an extension of the futures
model: a futures commission merchant (FCM), acting as agent and guarantor of
the clients margin and other obligations to the clearing house, faces the CCP.
The documentation would be a customer account agreement (developed from
the form used for existing listed derivative transactions) with an addendum
addressing specifc issues in relation to cleared OTC derivatives. These might
include termination and close-out mechanisms, and any porting arrangements.
Since these are likely to be standard for all CCPs, one agreement
should suffce (though there may also need to be CCP-specifc
appendices). Clearing fees and interest rates on cash margin are
set out in a separate side letter. In addition, there is an Execution
Agreement (similar to a give-up documentation suite) which can be
either bilateral (client and executing broker) or, subject to CMC rule-
making in this regard, trilateral (client and executing broker and FCM).
The tables below set out the proposed documentation
and documentary approaches for clearing OTC derivatives
with CCPs in US and Europe, respectively:
(Focus on LCH.Clearnet SwapClear IRS, ICE Clear Credit and CME IRS)
Contract label
Purpose

Execution or Client Executing Clearer CCP
or Clearing? Broker

FCM (Customer Clearing X X
Account Agreement)
FIA Addendum Clearing X X
Business Terms Side
Letter (or Schedule 2) Clearing X X
FIA Give-Up Agreement Execution/ X X (X)
Clearing
US APPROACH TO LEGAL FRAMEWORK
Signing parties
20
Connecting to SEFs, afrmation platforms and trade
repositories
It will take time before OTC trades can be as completely automated
as listed derivatives are. We anticipate the process for automating
OTC clearing will move forward in fts and starts in the early
days. With listed derivatives, in contrast, machines can currently
execute and control trades, run risk calculations, accept, reject
or reconcile trades without the need for human hands.
The diagram below illustrates the existing set-up for Chicago Mercantile
Exchange (IRS & CDS contracts) and the target for SwapClear (IRS
contracts.) Note that institutional investors will be required to
interact with swap execution facilities and affrmation platforms.
Adopting central clearing for eligible OTC trades will be a burden for all institutional investors.
While most participants expect to make their operations more effcient in the coming years,
looming regulatory deadlines will exert signifcant pressure sooner or later. Which operating
model will be needed? How similar will OTC clearing processes look to the familiar futures
commission merchant (FCM) model or the general clearing member (GCM) model?
It seems fair to say that the clearing industry could beneft from further
standardisation of documentation.
(Focus on LCH.Clearnet Ltd SwapClear IRS)
Contract label
Purpose

Execution or Client Executing Clearer CCP
or Clearing? Broker

ISDA (including CSA) Execution X X
CCPs Clearing agreement, Clearing X X
including a cleared CSA
& cleared ISDA
Clearing deed of Clearing X X X
assignment
Clearing compensation Execution X X
agreement
Give up agreement Execution/ X X
Clearing
Designation Notice Execution/ X X
Clearing
Signing parties
EUROPEAN APPROACH TO LEGAL FRAMEWORK
21
Executing
broker
Swap Execution Facility
Execution
choice of CCP
Front
Ofce
Client
EB (self-
cleared)
or
FCM (EB)
FCM
(Client)
Clearing
1
Clearing
consent
Risk Risk
Give up Give up
Novation
Afrmation Platform
Afrmation
Allocation
choice of FCM
Trade
Support
2
CCP
Trade Repository
4
Post-trade
processing
5
3
Step 1: Execution and choice of CCP
The block trade is executed on a SEF (Swap Execution
Facility) by both parties (the Executing Broker and the
Client), including the choice of the CCP
The block trade is transferred to an Afrmation Platform
Step 2: Afrmation, allocation and choice of futures
commission merchant (FCM)
The Executing Broker (EB) alleges the block trade (and
selects an FCM if not self-cleared)
The Client afrms the block trade, allocates the trade
to Unique Client ID (e.g.funds) and selects one or
several FCM(s)
The trade is submitted for clearing to the CCP
Step 3: Clearing Consent
A Clearing Consent Request is sent by the CCP to the
clearing members (Client FCM and EB FCM)
The clearing members give their
Clearing Consents Give-up
Step 4: Intraday Clearing
The CCP runs its risk lters
After risk lters are passed, the novation and
conrmation of the trade occur simultaneously and a
clearing notication is sent to Client FCM, EB FCM and
the Afrmation Platform
Transaction is allocated in FCM Position Accounts
(PA) held by the CCP (for Clients: 1 PA per Unique
Client ID= legal entity)
Step 5: Post-trade processing
Netting
Reporting: the trade is integrated by the CCP into the
appropriate Trade Repository
Reconcilliation
Margining and payments
Notes:
On SwapClear, allocation will potentially be possible post
clearing (TBC)
On CME, Clearing Consent can be automated through a Risk
Filter engine parameterised by the clearing member
1
2
3
4
5
Front
Ofce
Middle
Ofce
Execution platforms
While the exact defnition and mandatory obligations of SEFs are
still being worked out, the Dodd-Frank Act mandates that all clear-
able swaps be executed on SEFs. MiFID 2 will likely include a similar
provision for Europe. We expect it to set out an obligation to deal on
organized trading facilities (OTFs). Existing platforms like Bloomberg,
Tradeweb, and Market Axess are all seeking have the SEF label. They
need it to comply with US regulations and to attract liquidity on their
systems.
Afrmation and conrmation platforms
Most sell-side frms are already connected to electronic affrmation
platforms (mainly ICE Link for CDS and Markitwire on IRS),
which are used to match the economic terms of a transaction
immediately after execution. They are used extensively for swaps,
although use can vary widely between contracts, and ease the
electronic confrmation given the existing STP functionalities
between the affrmation and confrmation platforms.
Yet the use of electronic affrmation is still optional, and small/
medium sized asset managers do not commonly affrm their trades
electronically. The vast majority perform only a small number
of OTC trades per month, and if they compare the relatively
small operational risk with the signifcant investment cost, they
have little incentive to connect to the electronic platforms.
22
Tomorrow, in a world where eligible OTC contracts will
have to be executed on organised trading facilities and
cleared through a CCP, electronic trade matching and
automation in general will not be an option anymore.
Asset managers will have to communicate electronically with
their counterparts whether it is by connecting to execution
platforms when they exist or to affrmation platforms.
Execution platforms are still developing and as we have seen
the exact regulatory framework is not yet fnalised. It is hence
early days to know the exact remit of both execution platforms
and affrmation platforms. We can however expect affrmation
platforms to expand further in the feld of non-cleared trades.
In any case, following the encouragement by both regulators
and ISDA, the industry is moving towards more Straight Through
Processing (STP) and electronic affrmation. For bilateral trades
(non-cleared OTC) the EMIR proposal explicitly states that where
available trade confrmation should be made via electronic means.
Institutional investors will have to adapt despite the complexity
of setting-up and maintaining connections to those platforms.
Connection to Swap Data Repositories/Trade Repositories
Swap Data Repositories (in the US)/Trade Repositories (in the EU) have
been pushed by regulators on both sides of the Atlantic. New rules
being drafted will govern the content of such databases, along with how
fast and how frequently participants report their positions to regulators.
We predict that industry pressure to delay the reforms will push
these requirements into 2012 for the US and 2013 for the EU.
Nevertheless buy-side entities will have to wait until these rules are
fnalized to see their positions reported to the various repositories.
In the US, the Dodd-Frank Act states that cleared swaps other than
large notional swaps (ie block trades) must be reported as soon
as technologically practicable after the time of trade execution.
While the defnition of the entity responsible for reporting cleared swaps
is still under debate, the responsibility for the reporting of non-cleared
swaps to the Swap Data Repositories falls on the counterparty which
has the highest rank in a hierarchy of counterparty types*. This should
solve part of the reporting issues for fnancial and non-fnancial entities.
If this rule stands, a buy-side partys positions will be reported
to the trade repository (TR) by its dealer for bilateral trades. On
cleared trades, we anticipate that the reporting of cleared trades
will be performed by the clearers on behalf of their fnal clients.
In Europe, all OTC derivatives transactions will also have to be
reported to a trade repository no later than the business day following
execution, clearing or modifcation. A counterparty may delegate this
reporting to its clearing broker, the CCP or an external agent. We expect
a number of institutional investors to make use of these options.
At the moment, industry initiatives for trade repositories
stand at different stages depending on the asset class:
*Section 729 of Dodd-Frank Act sets
a hierarchy of counterparty types for
reporting obligation purposes, in which
SDs [Swap Dealers] outrank MSPs [Major
Swap Participants], who outrank non-SD/
MSP counterparties, which would solve
part of the reporting issues for fnancial
and non-fnancial entities (as per the
Dodd-Frank defnition).
23
Fixed income products and especially credit derivatives
have historically been the asset classes moving fastest
towards electronifcation. The trend gained momentum in
the past decade as operational risk grew in tandem with the
booming market. Today almost all credit derivative trades
are confrmed electronically in the DTCC from both the sell
and buy sides. DTCC even built a Global Repository for OTC
Credit Derivatives within its Trade Information Warehouse.
This was achieved by adding copper records to the existing
gold records (legally binding transactions confrmed
electronically). The copper records are single-sided, non-legally
binding transactions, and comprise more bespoke contract
submissions that are not eligible for electronic confrmation.
On interest rates, TriOptimas Interest Rate Trade Reporting
Repository (IRTRR) has been active since early 2010. Major
sell-side dealers submit their positions to the repository. After
March, 2011, however, the ISDA launched a new request for
proposal (RFP) for an Interest Rate Repository that would match
the CFTCs new list of operating standards. DTCC was selected in
early May 2011. What will TriOptima IRTRR become when DTCC
starts operating? Good question, since participants will not relish
maintaining links with two repositories for the same asset class.
For equity derivatives, DTCCs Equity Derivatives
Reporting Repository was launched in August 2010.
For commodity derivatives, in June 2011 DTCC (in a joint-
venture with EFETnet) won the bid (issued by the ISDA)
to establish a Commodity Derivatives Trade Repository
For foreign exchange derivatives, a request for
proposal (RFP) issued jointly by ISDA and AFME will
aim at setting up a Forex Derivatives Repository.
Iberclear and Clearstream also announced in December 2010 the
creation of REGIS-TR with Iberia and Telefonica as pilot clients.
While DTCC is in a good position to setup a global trade repository
across all asset classes, there is a strong possibility that each
regulator will request the creation of trade repositories for its
respective geographical zone. Yet it remains unclear how EMIR and
DFA will respond. The monitoring of systemic risk is one of the top
regulatory priorities, but there is no guarantee that regulators will
choose to monitor it in the same way. As a result it could be diffcult
for a given trade repository to comply with both frameworks.
The frequency of reporting is also set to increase. Under
the CFTCs proposed rules, all swaps must be reported in
real time to the Swap Data Repository except block trades,
which are subject to a 15-minute delay in reporting.
Can internal organisations, procedures, and systems respond
adequately given this constraint? We do not yet know. More
disquieting still is the question of how much such speedy actions
will cost. Level 1 measures for EMIR are not yet approved so the
frequency requirement is still up in the air. The draft proposal,
however, already requires both cleared and non-cleared trades to be
reported. It adds that ESMA will be responsible for recommending
in detail how to avoid double reportingthis is to be part of its
proposition for level 2 measures. This is a similar objective to the
one pursued by CFTC with its hierarchy of counterparty types.
Lastly, how to report daily valuations to those trade repositories raises
new questions. Currently only static data are reported by participants.
Over time, we expect regulators to require additional information
so as to better measure the exposure between participants.
Renewing your approach to OTC derivatives
valuation
Most institutional investors have developed internal valuation
resources for simple OTC derivatives. IRS, CDS or plain vanilla
options still represent the vast majority of the traded exposure and
the characteristics of these instruments are relatively standard.
The valuation model is straightforward to implement and market
data is easy to get from data providers like Bloomberg, Markit,
Reuters and others. These internal solutions, however, often do not
follow the processing of trades all the way through. Nor are they
adapted to the latest regulations. Moreover, insuffcient market
data regarding, say liquidity, can complicate the valuation of even
simple products. This happened frequently during the 2008 crisis.
CCPs prices will help but not enough
In the era of reform now dawning, CCPs will provide valuations of
cleared OTC Derivatives on a next day basis. This will not remove
the need for independent, third-party valuation, however, even for
cleared OTCs. Indeed, possible discrepancies between different CCP
algorithms may require price reconciliation. These price discrepancies
will probably recur frequently and require quick resolution.
Lets take the example of pricing for Interest Rate Swaps. Here the
timing of the reference data snapshot may vary from one CCP to
another, so discrepancies will arise. In this case, internal valuation
could solve the problem by harmonising all prices on a single curve.
Discrepancies can also arise naturally from a hedging strategy
comprising cleared and non-cleared products. In this case
24
Converging regulations are pushing institutional investors to value their assets, in particular
OTC derivatives, in an independent, more sophisticated and more frequent manner. Are asset
managers and corporates prepared to meet this challenge and what issues should they be
considering?
Connection to SEFs, adoption of affrmation and confrmation platforms, management of
reporting to trade repositories the sell side may be familiar with CCP clearing and its pro-
cedures, but institutional investors are not. They have much less experience in CCP-related
operational processes. They are about to face a new reality. Entering the complex clearing
world will require institutional investors to turn towards expert operational partners, be it
their clearer or their middle-offce service provider.
25
different methodologies and market data for cleared and non-
cleared trades could render the entire strategy less effcient.
Non-cleared OTC derivatives and structured products will compel
buy-side institutions to develop a robust valuation process, suited
to the complexity and the transparency requirements for the
instruments in question. Asset managers will have to take into
account several alternative pricing sources, including counterparties,
in-house valuations and independent third parties, so as to
ensure the robust pricing approach required by regulators.
Vendors can help as long as they are transparent
Institutions should beware the temptation to hold down in-house
pricing costs by relying exclusively on external vendor prices to
challenge their counterparties. Here they must avoid the black-
box effect. This means that vendors should report their own price
computations transparently and disclose the market data used
for the valuation, together with the mathematical sensitivities
associated with the price. The vendor should also allow for the
counterparty to challenge the price whenever necessary, with the
former enlisting experts to explain the gap between two prices.
In-house is possible but not straightforward
Those who decide to perform valuations in-house must pay particular
attention to the technical challenges posed by complex OTC derivatives.
Independent valuation requires specifc expertise in data
management and generates related costs. Scarce or non-
observable data such as correlations, volatility surfaces or exotic
currency prices can be complicated to obtain. Sometimes, the
sell side itself may be the only source. It is closer to the market
where the price formation occurs. At the same time, over-reliance
on sell-side data can compromise the independence of buy-side
OTC prices. Additional data sources are required, which is why
buy-side companies ask for an external valuation service.
In-house OTC valuation resources must also be fast. Ucits IV, EMIR
and other upcoming regulations will require daily computation.
Production, controls and reporting must all operate effciently
for an in-house system to work with the required frequency.
The effciency of OTC valuation relies on team expertise but also
on the performance of a system capable of embracing powerful
booking and trade management capacities together with the latest
generation of pricing engines. Front-to-back STP platforms such
as Murex, Simcorp or Calypso provide those functionalities and
can synchronise with risk and collateral management modules.
But the substantial investments required to implement such
systems can encourage partnering with an expert provider, who
will help to meet the regulatory requirement effciently.
Institutional investors to embrace more sophisticated
pricing methodologies
The more precise the pricing of the contract is, the more optimised the
call for collateral will be. As a result, we expect increasing demand
for second generation improvements in the pricing process.
Such sophisticated pricing methodologies are already
widely used by sell-side frms and it is now a matter of
time before institutional investors adopt them.
One of the main ways to achieve the expected level of
accuracy is to factor counterparty risk properly.
Counterparty risk has to be taken into account to evaluate the
collateral-driven margin calls. In practice, this means the Credit
Value Adjustment (CVA) has to be computed at the portfolio
level and the incremental CVA must be refected in the pricing
of each transaction. The CVA computation relies on an advanced
probabilistic approach and fnely calibrated credit market data.
The CVA also has to be computed on a pre-trade basis, which
is quite a challenge for almost all buy-side companies.
Moreover the credit crunch in 2008 highlighted the need for valuation
methodologies to account for the nature of collateral (if any) that
applies to OTC transactions dealt under a Credit Support Annex (or
equivalent collateral agreement). Thus discounting methodologies
that take into account overnight interest rate swaps (OIS) spreads
are increasingly popular and are progressively replacing the LIBOR-
based methodologies. Central counterparties themselves are moving
to OIS discounting methodologies in their swap-clearing activities.
Adapting your collateral management set-up
Although the volume of bilateral trades will decrease in favour
of cleared trades, portfolio bifurcation will nonetheless imply
a duplication of the processes. The existing bilateral process
will remain in place, but a second path will be needed to route
the cleared trades to the adequate clearing agreement.
26
Regulation and evolving market practices will require a profound rethink of the valuation
processes and systems for pricing OTC derivatives. Pricing from CCPs will help but will not
suffce. Sourcing alternative prices and adopting the sell-side pricing methodologies is the
way forward. Yet, given the complex nature of the instruments, those who buy and sell OTC
derivatives are probably better off delegating those increasingly complicated tasks to exter-
nal partners.
From a collateral management perspective, the introduction of central clearing will give rise
to portfolio bifurcation. Once cleared, OTC trades will refer to clearing agreements, while
bilateral OTC trades will continue to refer to ISDA Credit Support Annexes (or local jurisdiction
collateral agreements). What will be the impact on collateral management operations and
which areas should be looked at?
27
This will have a substantial impact on the way back offces work.
They will now need clearers reports to perform tasks they used to
handle independently, such as processing upfront fees, swap coupon
payments, position reconciliations, clearing-fee payments and credit
event processing on CDSs. Yet they will also continue to process
non-cleared trades as they do under the current OTC model.
The clearers reports will also be used by the accounting and
collateral departments. They will serve to register each positions
mark-to-market and collateral value (the independent valuation
of OTC trades has been discussed in a previous section).
Although inspired by the bilateral processes, the clearing path
will have specifc requirements for collateral processing:
Counter valuation ex-post margin call payment
For bilateral transactions, the independent valuation of trades is
performed prior to the feed of the collateral systems. It is the basis
for the exposure calculation to agree or dispute the margin calls. For
cleared transactions, disputing the clearers margin calls will take a
slightly different form, even though this independent valuation can
still make sense from a control point of view. The client will frst pay/
receive the margin calls calculated by the clearer, and afterwards
have the option to contact the clearer in case of disagreement.
Disagreements should in theory remain rare, given the
expected level of automation in the cleared OTC world, and
the calculation of mark-to-markets by the CCPs. This should
therefore provide a valuation consensus to all participants.
Adaptation of systems to new constraints
The modelling of a clearing agreement can differ substantially from
the usual bilateral collateral agreement. In bilateral agreements,
the eligibility criteria usually apply indifferently to independent
amounts and variation margin. But in the cleared OTC environment
initial and variation margins may be treated differently.
Organising information ows
For bilateral transactions, many communications between
counterparties concerning, say, margin calls or positions are
made through emails. For cleared transactions, however, the
workfow will rely on the clearers automated reporting capability.
Volumes of collateral exchanges are likely to be higher if the
regulator sets standards on thresholds and minimum transfer
amounts at a near-zero level for the majority of participants.
Its not just the cleared trades
Notwithstanding the adaptation of the collateral processes to central
clearing requirements, the industry has already staked out areas of
bilateral collateral management that will affect everybody involved
in OTC derivatives activities. Among them are the growing number
28
of collateral agreements, the increased frequency of calls, and the
need to resolve disputes in a timely manner. Effcient collateral
management procedures have become a major concern for everyone,
fnancial or non-fnancial, involved in OTC derivatives activities.
A collateral roadmap and best practices have been issued in 2010.
The ISDA, market participants and industry associations have jointly
confrmed their commitment to enhance bilateral risk management in
a letter sent to the Federal Reserve and supervisors of the ODSG (OTC
Derivatives Supervisors Group) on 31 March 2011. The main points are:
Implementation of the Dispute Resolution Convention and Market
Polling Procedure, and improvement of dispute reporting
Proactive portfolio reconciliation, which is considered
as good market practice for dispute prevention (58% of
the 2011 ISDA margin survey respondents indicated that
they regularly perform portfolio reconciliations)
Electronifcation through the use of standard messages
in order to increase straight-through-processing
Portfolio compression
Some of these commitments are oriented more towards dealers
holding huge derivatives portfolios. Nonetheless, institutional
investors usually follow broader trends, especially when
they hold substantial OTC positions. They increasingly learn
from the sell-side and beneft from its best practices.
Already today, the growth in the number of counterparties is making
collateral management fendishly complex. This is particularly
true for asset managers with a signifcant number of funds under
management. The number of transactions and the frequency
of margin calls are increasing drastically. Moreover, they are
spread among a much broader array of collateral eligibilities.
The performance of the collateral management system often
lies at the heart of the problem. Its task is great. It must model
collateral conditions effciently for each collateral agreement,
it must import data from many sources in a timely and effcient
manner, it must monitor the effective settlements of collateral
transfers. Moreover, collateral management of OTC derivatives
demands specifc staff expertise and carries its own unique costs.
The day is soon coming when further signifcant investment
in personnel and systems will be needed. The stringent
processes of central clearing, dispute resolutions on bilateral
positions, OTC portfolio reconciliations, electronic messaging,
and the need to monitor market evolution will demand it.

The complexity of the different cleared and non-cleared OTC processes and the growth in
processing volumes will strain existing back-offce and collateral-management systems.
Serious system and procedure upgrading will be required. For these reasons, outsourcing
the collateral operations to a specialist provider who benefts from economies of scale will
appeal to institutional investors. As a general observation, the custodian who keeps the assets
safe is also best-placed to keep collateral safe and to provide collateral agent services.
29
Choosing a clearing broker

As mentioned earlier, the clearing broker will help institutional investors
adapt to the new workfow for cleared OTC derivatives. The broker
will also serve as the go-between with CCPs. Eligibility criteria for CCP
membership will be strict but the selection process for appointing
a clearer is still critical. Here are some key factors to consider:
Expertise in legal aspects and market practices: the
ability to help with legal documentation should be a
given; more important, a clearers legal expert must
anticipate future legal questions, not only todays.
Operational expertise: the clearer must provide operational
support to build connections and adapt processes to central
clearing and SEFs. It must also make the necessary upgrade on
existing platforms such as ICE Link, DTCC, Markitwire, CLS
Excellent credit rating: whereas the credit rating for execution
will become less important, it remains predominant
in choosing a dealer who is also acting as clearer.
Reporting: reporting to local authorities the complete range
of trades (cleared, non-cleared) with the appropriate level of
information, the right format and frequency is a cumbersome
task. And yet it ranks as one of the top concerns of buy-side frms.
Quality of relationship: investment frms see the
quality of their relationship and partnership with
their clearer as a key element of success.
Cost: while not the main driver in the decision to appoint
a clearer, the question of cost, in particular cost structure,
is central. The cost structure needs to be crystal clear
and ultimately easy to understand, whether based
on a fat fee per trade or the number of deals.
The institutional investor should choose a clearing broker that can tick all of these boxes.
In practice, only a few players will be able fulfl all these criteria. Furthermore, the clearer
should be part of an organisation that can provide key additional services, such as collateral
fnancing and protection, as we explore in sections 2.2 and 2.3.
While institutional investors are not expected to connect directly to CCPs, they will need
to fnd a way to interact with a clearer who is connected to the CCPs on their behalf. What
selection criteria should investors use?
30
2.2 New funding challenges
The rise of collateral requirements
According to the 2011 ISDA margin survey, the number and
estimated value of collateral agreements has increased signifcantly
over the past years, with respective cumulative annual growth
rates (CAGR) of 26% and 28% since 1999. The fgures below show
149,518 collateral agreements reported by respondents in 2010
(of which 90 percent are ISDA agreements), while the estimated
amount of collateral in circulation in the OTC derivatives market
at the end of 2010 was approximately USD 2.9 trillion.
The decreases in the number of agreements and collateral
in circulation are mainly due to counterparty consolidation
and reduction in counterparty exposures. However it seems
reasonable to expect that if volumes of OTC transactions
remain at the current levels, the introduction of CCPs will
lead to an increase of collateral to be delivered.
The advent of cleared OTCs with competing CCPs and the splitting of portfolios between
cleared and non-cleared contracts will increase the complexity of collateral management
procedures. It also implies the following funding challenges:
Higher collateral costs due to the generalisation of initial margin
requirements and systematic same-day collateralisation (T+0
instead of T+1 for the OTC contract still un-cleared)
Lost benefts of exposure netting at portfolio level . Eligible trades executed
with a counterparty will be transferred to a clearer, under a clearing contract.
Non-eligible trades will remain bilateral , under a collateral agreement.
Fragmentation of the collateral requirements across multiple clearers and bilateral
counterparties
As a result, the continued use of OTC contracts will generate higher funding require-
ments for corporations, pension funds and asset managers. All this while liquidity remains
scarce.
How much bigger will collateral funding requirements be?
Beyond collateral optimisation procedures, what options should institutional investors
consider?
31
ISDA MARGIN SURVEY 2011 GROWTH OF COLLATERAL AGREEMENTS REPORTED BY RESPONDENTS AS OF YEAR END, 1999-2010
ISDA MARGIN SURVEY 2011: GROWTH IN VALUE OF TOTAL REPORTED AND ESTIMATED COLLATERAL, 2000-2010 (USD BILLIONS)
1999 2000 2001 2002 2004 2003 2005 2007 2006 2008 2009 2010
200,000
150,000
100,000
50,000
0
C
o
l
l
a
t
e
r
a
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o
r
t
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d

b
y

r
e
s
p
o
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e
n
t
s
Key:
reported agreements
4,000
3,500
3,000
2,500
2,000
1,500
1,000
500
0
2001 1999 2000 2002 2003 2004 2005 2006 2007 2008 2009 2010
V
a
l
u
e

o
f

t
o
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a
l

a
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d

e
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t
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m
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t
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d

c
o
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t
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a
l

(
U
S
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b
i
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i
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)
Key
Reported
Estimated
32
The need for sourcing collateral therefore represents a primary
concern surrounding the Regulation and the mandatory
clearing of OTC derivatives. There are three main reasons:
First, institutions that will be in the scope of the regulation
will be required to post initial margin on cleared trades.
Second, on cleared OTC trades, CCPs will limit the collateral
eligible for initial margin and even restrict variation
margins to very liquid collateral, that is cash only.
Third, collateralizing non-cleared trades, will be mandatory in
Europe and most likely in the US (see table below with the CFTC
proposed rule on Margin Requirements for Uncleared Swaps for
Swap Dealers and Major Swap Participants as of 28th April 2011).
Transaction
parties
Swap Dealer
to
Swap Dealer
Swap Dealer
to
Major Swap
Participant
Swap Dealer/Major Swap
Participant
to
nancial entity
Swap Dealer/Major Swap Participant
to
Non nancial entity
Margin
requirement
Mandatory collateral
99% 10 days Initial Margin
or Alternative method
Variation Margin
Zero threshold
100 000 USD MTA
99% 10 days Initial Margin
or Alternative method
Variation Margin
Zero threshold except for
certain types of fnancial
entities (under comment
sollicitation)
Initial Margin, Variation Margin and
threshold at discretion
Collateral conditions to become much more stringent
For bilateral trades, the broker may accept a one-way
collateral agreement if it can get the negotiated spread of
the OTC contract to compensate for its additional risk.
For cleared OTC derivatives, in theory, the model no longer allows
counterparties to negotiate better conditions: all counterparties
are treated equally by the CCP rule book. Rules regarding
acceptable collateral are strict: mainly cash and highly rated
bonds. It is unlikely this policy will change and in practice it
means an equity fund may be forced to pay the clearer in cash.
In practice, especially outside the US, clearers will have the option
to adopt a more fexible approach. This is very likely when it comes
to large investors or at least signifcant clients, whose business is
strategic enough for the clearer to decide not to adopt the CCPs
restrictive criteria. In such cases, clearers would post the full
collateral called by the CCP on behalf of its client but not request
the corresponding amount from the latter. The adoption of such
arrangement is likely to remain limited to a handful of key names
and only few investors will be in a position to beneft from it.
For the majority of investors, especially asset owners or pension
funds with liability-driven investment (LDI) strategies, the move
to cleared OTC trades will make a big difference. Initial margin
requirements for their OTC positions are likely to be substantial
given their long maturities and their outright exposure. The following
table uses LCH SwapClear and ICE Clear Credit (formerly known as
Ice Trust) as examples. Notice that initial margin can reach almost
10% of the notional amount for an interest-rate swap with a 30-year
33
maturity. Moreover they tend to be fully invested with large pools of
securities and little cash and the eligibility restrictions on variation
margin will mean raising cash through collateral transformation.
This heightens the impact on performance and returns.
EXAMPLES OF INITIAL MARGIN REQUIREMENTS BY CCPS ON IRSS AND CDSS (SINGLE TRADES)
Notional 10 000 000 EUR
Pay/Rec Pay Fix/Receive Float
Worst case over 5Y/Holding Period 7 days
Maturity Initial Margin % of notional
(EUR)
2Y - 38,782 -0.4%
5Y - 106,617 -1.1%
10Y - 265,091 -2.7%
15Y - 507,335 -5.1%
20Y - 676,963 -6.8%
25Y - 827,997 -8.3%
30Y - 977,475 -9.8%
Notional 10 000 000 EUR
ITRAXX.EUROPE.13V1-5Y
Direction Initial Margin % of notional
(EUR)
Buy - 136,452 -1.4%
Sell - 215,004 -2.2%
ITRAXX.EUROPE.CROSSOVER.13 V2-5Y
Direction Initial Margin % of notional
(EUR)
Buy - 462,700 -4.6%
Sell - 695,070 -7.0%
Central counterparties whet their appetite
Quite naturally, central counterparties (CCPs) like what
they see on the regulatory horizon. The reforms will open
up proftable opportunities in global markets.
Some of the worlds leading CCPs have been quick to size the
opportunity. In the US, ICE Clear Credit has already expanded its
substantial business clearing credit default swaps to the inter-
dealer market. In Europe, ICE Clear Europe, Eurex and Clearnet
SA have also cleared CDS trades. ICE Clear Europe, with dealers
frmly behind it, has processed almost 95% of Europes inter-dealer
volume. CME is looking to handle interest rate swap (IRS) clearing,
and SwapClear, part of LCH.Clearnet Ltd, is eyeing the US market.
These recent CCP initiatives should not lead us to forget that
as far back as 1999, OTC dealers went into partnership with
LCH Clearnet to create SwapClear, the inter-dealer clearing
service for interest rates swaps. The impact however was
comparatively modest. Todays new CCPs solutions look to
satisfy the entire range of buy-side needs, namely clearing trades
between clients and dealers and not just between dealers.
Competition between CCPs will lead to collateral fragmentation,
thus increasing further collateral funding costs for institutional
investors. This raises the issue concerning the ideal number of central
counterparties. The presence of more than one CCP per market (or
even per OTC product) may reduce systemic risk. However, experience
in cash equities markets highlights diffculties arising from multiple
CCPs. Developing a harmonious approach to risk management has
been anything but straightforward in those markets. While we do not
expect such concerns to rile the OTC derivatives markets the way they
have in the world of equities, competition is coming, and competition
of this sort tends to be disruptive, at least in the short term.
34
Analysing your options for collateral optimisation
and transformation
None of this makes choosing an OTC derivatives clearer any
easier. Indeed, contrary to the listed derivatives world where
participants can appoint a third-party clearer independently
from the execution brokers, all CCPs that currently offer to clear
OTC products require the clearing layer to be performed by an
entity who is also a trading participant (see chart next page).
Historically, CCPs have developed strong relationships with trading
participants that were self-clearing their eligible positions to mitigate
counterparty exposure. LCH clearnets Swapclear proved its capacity
to handle the Lehman bankruptcy, thanks to the partnership with its
trading members who liquidated the defaulting members positions. A
major event of default generally triggers intense market stress, making
the liquidation procedure even harder for the clearer (in the case of
client default), or the surviving members (in the case of clearer default).
Last but not least, the strong risk management framework
needed to manage third-party clearing, added to the technical
nature of OTC products, makes it natural for OTC dealers to enter
into OTC clearing services. For these reasons, a model where
the clearing, risk management and liquidation functions are
integrated within the same entity or group is likely to be the most
effcient and ultimately less risky for institutional investors.
Unless the industry comes up with an alternative, this requirement
leaves institutional investors with three main options, as illustrated in
the chart below. Either they decide that each of their dealers will also
handle clearing (option 1), thus entirely giving up potential netting
effects, or they mandate one or a few of their dealers to act as their
clearing agent with their other dealers. The approach is likely to vary
depending on the size of business institutional clients need to handle.
Institutional clients with larger volumes of cleared OTCs, who typically
work with between fve to ten dealers, will want to consolidate the
clearing but not with one single clearer, so as to get a compromise
between netting effects and counterparty risk diversifcation (option 2).
Investors with smaller volumes and also tighter collateral funding
capabilities will seriously consider the option to consolidate with
one single clearer (option 3) who can demonstrate excellent
rating while allowing them to maximise netting benefts and
thus help reduce the cost of collateral signifcantly.
Tension is expected around the question of collateral sourcing. In a situation of scarce liquidity,
stricter eligibility rules and increased amounts of collateral locked in with CCPs, not all
institutions will be treated equally. As often in competitive markets, the laws of natural
selection will apply: large counterparties will be able to take advantage of their size to grow
bigger, and smaller institutions will fnd it harder to obtain the fexibility they need.
35
A model in which the CCP calculates margins required to OTC
clearers at each fnal client level is likely to emerge. There is
one other possibility: regulations may authorise an OTC clearer
to net positions against the CCPs across all its clients. This last
model, inspired from the listed derivatives world, may not be
the one preferred by the regulators as it would not guarantee
the portability principles and the segregation of margins of a
clearers client in case another client of that clearer defaults.
However positive the netting effect, and putting aside the benefts
of proper management of back-loading, institutional investors will
look for additional sources to reduce their funding requirements.
OTC clearers who can also act as custodians will be able to bring
that additional level of sourcing, using transformation solutions.
Because they have access to the clients full range of assets, custodians
can measure a clients liquidity and credit profle at any moment.
There is no need to pre-fund a collateral account, adding needed
fexibility to the process. We expect institutional investors to turn
towards OTC clearers who can also act as custodians to maximise the
benefts of collateral transformation. It helps that many custodians
already have fnancing, securities lending or repo capability.
Last but not least, an adequate allocation of assets to the
various collateral requirements can help optimise the funding
aspect, so that the collateral posted to counterparties and
clearers is the cheapest to deliver at any point in time.
Practically, the collateral optimisation process
will require institutional investors to:
Centralise all collateral requirements across
various activities in one place
Centralise all eligibility criteria in one system, to avoid situations
where the frst counterparty requesting collateral is the
frst served, but allocate effciently the available collateral,
depending on the restrictions imposed by each counterparty
Optimise the collateral allocation or transformation,
depending on cheapest-to-deliver criteria, revenue
opportunities and re-hypothecation possibilities in
the respect of concentration/correlation limits
BACKLOADING
Market participants anticipate that the provision for mandatory
backloading of trades dealt before the entry in application of the
Regulation will be removed. Yet clients may backload voluntarily
some of the trades in order to optimise the collateral aspect.
Indeed, the frst cleared trade will depend on an enforcement date of the
regulations, regardless of the clients general hedging strategy. This frst
cleared trade, on a stand-alone basis, may imply signifcant collateral
requirements. To avoid this, the client could decide to backload part of
its portfolio to achieve a delta-neutral position and the netting effect.
A sound strategy for backloading of trades, through the use of
algorithms that would choose the best backloading scenario, could
prove to be benefcial to the level of margin required by the clearer.
36
The organisation of many institutions where operations and systems
are often separated from listed derivatives, OTC derivatives, repo,
securities lending, and the segregation between front- and back-offce
teams and systems will act as obstacles to the required seamlessness
of the process. Working with a collateral agent is set to become the
most viable option institutional investors will want to explore.
The volumes of collateral required will increase and at the same time a growing portion will
be tied up in CCPs, thus making resource even scarcer. In this context, investors will have to
optimise three main options:
1 Choose a set-up with far fewer clearers than executing brokers so as to maximise the
netting effect
2 Seek clearers who can work with custodians and help transform collateral
3 Work with a collateral agent to achieve maximum collateral optimisation
Astute backloading management will also help reduce collateral needs in the short term.
37
2.3 A new paradigm for counterparty risk
The implications of the CCP models
The Lehman Brothers bankruptcy made the entire buy-side
community more sensitive to the need to protect collateral. So-
called independent amounts often turned out to be commingled
with other assets or re-used by their prime broker. Clients who did
not safeguard collateral with a third-party custodian realised how
vulnerable those assets were. According to the 2011 ISDA margin
survey, large dealers rehypothecated 73,6% of collateral.
New US and EU legislation will endeavour to provide safeguards.
CCPs will henceforth make facilities available for each member
to hold its client positions and assets (including collateral)
completely segregated from its house or proprietary
positions. This will protect clients collateral from exposure to
losses from the clearing members proprietary account.
The debate focuses now on how much protection indirect participants
to the CCP will receive. There are four segregation models currently
on the table, from which clients may choose, as follows:
Clients Clearing member CCP
Clearing member clients
omnibus account
Client 2
initial margins
Client 1
initial margins
Clearing member
initial margins
omnibus account
Clearing member
segregated account
Baseline model omnibus account
This model is currently used by CCPs with an active futures
derivative business. It allows a larger mutualisation of defaults
and is therefore less costly in terms of margin calls.
This is the current Futures Commission Merchant model in
the US: if a client is unable to pay on a margin call, the FCM
(ie the clearing member) is supposed to cover the clients
positions. If the FCM is unable to pay, the CCP can use the
other customers collateral for the necessary funds.
Market reforms will raise new risks. Institutional investors will encounter risk from executing
brokers in their role as counterparty. There will also be heightened risk from CCPs and, to
a lesser extent, clearers. What segregation model should investors favour and what is the
best compromise between protection and operational effciency?
38
Clients Clearing Member CCP
Client 2
initial margins
Client 1
initial margins
collateral
collateral
Clearing member
initial margins
omnibus account
Clearing member
segregated account
Same omnibus
account, but CM
clients collateral is
legally attributable
to each customers
contracts.
Legally segregated, operationally commingled (LSOC) model
There is one key drawback to omnibus accounts. They may expose
any customer to the risk of default by the clearing member or
by another of its customers if the FCM is unable to pay.
The legally segregated but commingled model was
suggested by CFTC in its December 2010 consultations.
This model seeks to capture the advantage of individual
segregation without disrupting operational processes.
Clients assets are held in the same omnibus account, but collateral
is legally attributable to each customers contracts. That collateral
is on loan to a customer, and is treated as belonging to the customer
at the CCP level, but as a debt at the clearing member level.
If the clearing member becomes insolvent when a customer
defaults, the CCP would transfer open positions to another clearing
member. It should have suffcient information to identify the
collateral which is attributable to each non-defaulting customer.
This model offers high protection for clients but increases
costs for the CCPs users, particularly large dealers.
Client 2
initial margins
Client 1
initial margins
collateral
collateral
Clearing member
initial margins
omnibus account
Clearing member
segregated account
Same omnibus
account, but clearing
member clients collateral
is legally attributable
to each customers
contracts.
And the CCP could only use the clearing member clients assets if all
other clearing member default funds and its own capital have been used
Moving customers to the back of the waterfall
(the waterfall model)
This model was proposed as option 3 by CFTC in December 2010. As
in option 2, clients assets are held in the same omnibus account, but
their collateral is legally attributable to each customers contracts.
39
However, non-defaulting clients collateral is only at risk in very large
defaults, when other clearing member default funds are needed.
Client 2
initial margins
Client 1
initial margins
collateral
collateral
collateral
collateral
Clearing member
initial margins
Clearing member
segregated account
Full physical segregation (the individual segregation
Model)
This last model ensures total legal segregation of a clients collateral
property. Assets are held separately from those of other clients, both
at the CM and at the CCP. As a consequence, collateral attributable
to any non-defaulting customer is not available as a CCP default
resource. This model offers the highest degree of protection for
clients but the lowest mutualisation of risks at the CCP level. As
a result, the CCP will be compensated by higher margin calls.
Individual segregation at the customer account level will
also increase operational complexity for CCPs.
Which model is best for you?
These four different models come with different costs. The
models range from a simple pass-through to complete
transformation. Only individual managers or corporate policy
can determine the right balance between cost and protection.
The Baseline Model is cheaper in terms of collateral
requirement from the clearers perspective. It is also offers
the least protection and portability for non-defaulting clients.
A signifcant portion of the collateral posted by the clients
is kept by the clearers and is not refected at the CCP level.
Moreover the CCP has recourse to all collateral posted by the
clearer in the omnibus account in case of clearer default.
The LSOC and Waterfall Models offer much more protection than the
Baseline Model. They are similar operationally in that all collateral
between the clearer and the CCP fows into a single omnibus
structure. However, they demand different levels of effort by the CCP
to guarantee client segregation and portability when defaults occur.
In the case of clearer default, all the collateral
attributable to each fnal client must be identifed
and transferred to another clearer.
In the case of double default (client default triggering a
clearers default), the collateral attributable to each non-
defaulting client at the CCP must be identifed, segregated from
the defaulting clients and transferred to another clearer.
The LSOC model guarantees that the non-defaulting clients
collateral is not used by the CCP as a resource to cover its
losses. However, the Waterfall Model differs substantially by
permitting the surviving clients collateral to be used to cover
losses once the CCP has exhausted its other resources.
This last feature makes it harder to monitor counterparty risk
In terms of exposure measurement to counterparty risk, since
the CCP could draw on a clients collateral in extreme cases.
Thus the LSOC model seems to strike the right balance between
operational simplicity and client margin protection.
The buy-side will assess the risk of its OTC bilateral counterparties the
way it always has. And not all OTC trades will be eligible for central
clearing. An OTC clearer may be entitled to additional margin from its
fnal client. That will depend on the clearers credit risk assessment of
its clients. The client may also be called upon to provide the clearer
with a buffer to cover CCP intraday margin call requirements.
Clients should take steps to safeguard this buffer should a clearer
default. A tri-party arrangement, where a custodian acts as a
collateral agent between client and clearer, may be one solution.
The fnal buy-side client would be wise to consider the agents
robustness and technological capability in making his choice.
Last but not least, CCP clearing may go a long way toward protecting
OTC derivatives markets from systemic risk. This hardly means,
however, that systemic risk should merely be passed along to central
counterparties. Central counterparties must be properly regulated.
Their eligibility must depend on their proven ability to manage
risk for products that are suffciently standardised and liquid.
40
Regulation should help promote the balance between mutualisation of risk and asset protection.
It should also take account of the OTC markets distinct characteristics, notably that it is less
liquid than the market for listed derivatives. The point is to offer clients and their clearing
members the fexibility to choose the model that suits them best. While corporates and
institutional investors must look at the choice of model from their own perspective, LSOC
seems to strike the right balance between operational simplicity and client margin protection.
Regulations are increasingly pushing for monitoring counterparty risk in real time. In parallel ,
the co-existence of cleared and non-cleared OTC derivatives is increasing the number of
counterparties to deal with.
What approach should institutional investors adopt?
Upgrading the approach to counterparty risk
measurement
The need to monitor counterparty risk exposure is not new but
regulators have considerably increased the requirements around
the topics, while expanding the scope of institutions concerned.
As we saw in Part 1, be it with Solvency II for insurance
companies, or AIFM and Ucits IV for asset managers, all
41
Be it for regulatory purposes or collateral optimisation, active counterparty risk measurement
is becoming more complex but more desirable than ever. Like the decision for the optimal
segregation model vis vis clearers, the strategy regarding counterparty risk measurement
has become a critical business issue for corporate and institutional investors. As for many
of the issues discussed in this paper, the question is whether they will see the task ft for an
in-house team or if its better delegated to an external partner.
institutional investors, not only banks, have now to take risk
management very seriously. Practically, this means computing
and monitoring counterparty risk exposure in real time.
For instance, regulatory provisions related to asset management
have reached such a level that frms actually need to look for
more sophisticated methods and then apply them more broadly
and more frequently. Indeed, as outlined in a consultation paper
issued by the Committee of European Securities Regulators, even the
methodology most asset managers have to use for computing daily
risk exposure at fund level, often called commitment methodology,
may not be up to the task of measuring complex strategies.
With the limitations of the commitment methodology exposed,
attention is turning towards the more sophisticated approaches
used on the sell side. Indeed, banks and broker-dealers use another
type of approach that measures forward-looking exposure. The
potential future exposure (PFE) method, which includes both
netting and diversifcation effects, is consistent with the market
risk approach. This method also factors in collateral balances and
the risk profle of each asset and makes a strong case for buy-
side managers to consider using sell-side industry practices.
Tomorrow, as investors deal not only with bilateral counterparties
or prime brokers but also with clearers, collateral agents,
executing brokers and CCPs, the number of counterparties
to monitor will be higher. Actively managing counterparty
credit risk limits will help optimise collateral levels. So
will accurately measuring the counterparty risk itself.
It should be noted, however, that this will require better reporting,
not to mention validated production procedures. The structural
challenge to managing counterparty risk lies in evaluating the
credit quality of counterparties independently. This is especially true
for small- and medium- sized institutions. Large institutions can
use their own expert credit analysts, whereas smaller institutions
will tend to rely more on information from the rating agencies.
Next
steps
43
Impacts Actions
Operational

Documentation Signing new set of documentation for cleared OTCs with
clearing broker
Signing a collateral agreement
Connecting to SEFs Build a technical connection to new or existing execution
platforms, or enter into relationship with a dealing desk
that has links with the execution platforms, to search for
best execution
Register as a market participant, completing the legal
documentation required by both the platforms and the
regulators
Connecting to affrmation/
confrmation platforms
Build a connection to existing affrmation platforms
Review the operational model and process
Consider using an external service provider to manage
the entire scope of connection and process the trades on
behalf of institutional investors
Connecting to trade
repositories
Connect to trade repositories depending on the regulation
Back-offce adaptation Defne a policy on the interfacing with clearers
Defne the internal distribution of data to relevant
departments
Adapt back offce, accounting and collateral infrastructure
and organisation
Connect to trade repositories depending on the regulation
OTC derivatives valuation Counter-check CCP prices, using robust valuation process
and independent sources
For complex instruments, delegate to 3rd party middle-
offce providers
Use Credit Value Adjustment pricing process at portfolio
level, prior to trade execution
Collateral management
set-up
Review the clearers reporting/ask for customisation
Adapt collateral management infrastructure and
organization
Implement a portfolio reconciliation process
Adapt the dispute procedures to the Dispute Resolution
Convention and Market Polling Procedure
Increase STP level with counterparties and custodians
For big portfolios, defne a portfolio compression strategy
Clearer selection Evaluate credit rating
Check quality of relationship
Check operational expertise
Negotiate fees and cost structure
Negotiate risk policy (intraday margining and credit
limits)
Funding
Clearer selection,
collateral optimisation and
transformation
Choose a set-up with fewer clearers than executing
brokers so as to maximise the netting effect
Seek clearers who can work with custodians and help
transform collateral
Work with a collateral agent to achieve maximum
collateral optimisation
Counterparty
risk
Collateral protection Defne the best collateral segregation structures with
clearers and third-party custodians
Counterparty risk
measurement
Adapt counterparty risk processes to the portfolio
bifurcation, with differentiated treatment of cleared OTC
derivatives
Faced with such wide-ranging changes in the structure of the OTC
derivatives market, institutional investors now need to focus on a
large number of issues. These fall within three areas: operational,
funding and counterparty risk, as shown in the table below.
About
BNP Paribas
45
46
About BNP Paribas
The bank for a changing world
BNP Paribas is a leader in global banking and fnancial
services and one of the worlds strongest banks.
Present across Europe through all its business lines, the Group
has four domestic retail banking markets in France, Italy,
Belgium and Luxembourg. It has one of the largest international
networks with operations in more than 80 countries and
205,300 employees, including 162,500 in Europe, 15,200
in North America and 12,500 in Asia (30 June 2011).
BNP Paribas holds key positions in its three core businesses:
Retail banking
Corporate & Investment Banking
Investment Solutions
BNP Paribas Corporate & Investment Banking (CIB) provides tailor-
made fnancing, advisory and capital markets services to its clients. It
is a globally recognised leader in many areas of expertise including,
among others, structured fnancing and derivatives across a variety
of asset classes. BNP Paribas is a European powerhouse in capital
markets with a strong franchise elsewhere around the world. BNP
Paribas also has a solid corporate advisory franchise in Europe
and Asia. In total, CIB employs 19,800 men and women including
7,000 client-facing staff, present in over 50 countries and serving
14,000 clients (9,800 corporates and 4,200 fnancial institutions).
BNP Paribas Securities Services provides integrated solutions for
all operators involved in the investment cycle: sell-side, buy-side
and issuers. Having one of the industrys most comprehensive
array of services and an on-the-ground presence spanning all
continents means we can meet and anticipate our clients needs -
wherever and whatever their specifc activity. Our network is one
of the most extensive in the industry, covering over 100 markets,
with our own offces in 32 countries. We service over 6,000
funds globally, with USD 6,975 billion of assets under custody
and USD 1,244 billion under administration (30 June 2011).
A leader in the derivatives industry
With a dedicated and experienced team of 100 collateral
management and OTC derivatives reconciliation specialists, together
with best-of-breed technology, BNP Paribas manages one of the
worlds largest collateral fows and number of counterparties.
As member of the International Swaps and Derivatives Association
board and as participant in CCPs for OTC derivatives clearing,
BNP Paribas actively contributes to shaping the industry and is
consistently recognised as an award-winning derivatives house:
Equity Derivatives House of the Year (Risk
Magazine 2009, Euromoney 2010)
Structured Products House of the Year (Risk Magazine 2011)
BNP Paribas offers its clients a large dedicated team:
80 collateral management specialists
20 OTC derivatives reconciliation specialists
8 years experience in collateral management on OTC derivatives
We are uniquely positioned to actively participate
in market developments and bring you a deep
understanding of processes and complexities.
47
BNP Paribas Securities Services
Other broker-
dealers
Other broker-
dealers
Other
clearers
Other
clearers
Other
clearers
Other
clearers
BNP Paribas
CIB
BNP Paribas
CIB
Other broker-
dealers
BNP Paribas
CIB
BNP Paribas
CIB
BNP Paribas
Securities Services
BNP Paribas
Securities Services
BNP Paribas
CIB
Other broker-
dealers
BNP Paribas
CIB
BNP Paribas Securities Services BNP Paribas Securities Services
Joint reporting on cleared trades for clients of
BNP Paribas CIB and Securities Services
Non-cleared OTCs
Trading
Clearing
Reporting
Post-trade
Listed derivatives Cleared OTCs
Order management
Trade support
Independent valuation
Collateral services
Asset protection
Custody
Execution
A complete solution for derivatives needs:
Glossary
Backloading
The action of clearing already existing bilateral OTC derivatives positions.
Collateral management
Typically, two parties enter into an OTC transaction under an Agreement
(ISDA framework mainly) that specifes the contractual relationship
between the two parties. As part of this Agreement, a specifc document
(Credit Support Annex/Deed under the ISDA framework) stipulates
that some collateral will be exchanged between them to mitigate
counterparty risk. Collateral, in the form of cash or securities, is
mainly exchanged on the basis of the variation in the value of the
exposure between the parties (value of all OTC contracts under the
Agreement). This is often referred to as Variation Margin. In addition,
Independent Amounts can be requested by one of the parties.
Commitment approach
The method used to calculate the exposure of a portfolio by adding
the value of direct positions to the value of the underlying positions
for all derivative transactions associated to the portfolio. For
example, the exposure associated to a CDS for 1 million of stock
translates into an exposure of the same amount - instead of only
the one associated with the collateral posted to take the position.
Excess margin
This represents an additional amount coming on top of the margin
call as established by the CCP or by usual valuation method.
Financial entity
This type of entity, defned in the CFTC proposed rule as of 28 April
2010, is a counterparty that is not a swap dealer or a major swap
participant. A fnancial entity is: (1) a commodity pool as defned
in Section 1a(5) of the Act, (2) a private fund as defned in Section
202(a) of the Investment Advisors Act of 1940, (3) an employee-
beneft plan as defned in paragraphs (3) and (32) of section 3 of
the Employee Retirement Income and Security Act of 1974, (4) a
person predominantly engaged in activities that are in the business
of banking, or in activities that are fnancial in nature as defned
in Section 4(k) of the Bank Holding Company Act of 1956, (5) a
person who would be a fnancial entity described in paragraph
(1) or (2) if his activities were organised under the laws of the
United States or any State thereof; (6) the government of any
foreign country or a political subdivision, agency, or instrumentality
thereof; or (7) any other person the Commission may designate.
49
Grandfathering/grandfather clause
A legal term used to describe a situation in which an old rule
continues to apply to some existing situations, while a new rule
will apply to all future situations. It is often used as a verb: to
grandfather means to grant such an exemption. Frequently,
the exemption is limited; it may extend for a set period of
time, or it may be lost under certain circumstances.
Independent Amount
The collateral that is delivered by end-users to dealers to protect them
from credit exposure. It can be any amount that the parties agree,
but it is typically expressed as a fxed currency amount, a percentage
of the notional principal amount, or a computation of value-at-risk.
Independent Amounts can be defned at the level of the portfolio
of transactions between two parties, or can be defned uniquely for
each individual transaction. It can also be zero. (See initial margin.)
An Independent Amount is additional collateral over and above
variation margin, which provides additional protection for the
party receiving it, and usually depends on the credit quality
of the party paying it. Independent Amounts are a common
practice in the Alternative Investment environment between
clients who often post IA to dealers/prime brokers.
Some clauses in the contract refer to the frequency of the
margin calls (maximum frequency is daily), thresholds,
minimum transfer amounts, collateral eligibility, notifcation
times, and what happens when two parties cannot agree.
Initial margin or inital margin requirement
The collateral that is deposited by the clearer at the CPP when
an OTC derivatives transaction is agreed between two parties
and then cleared by a CCP. What is called independent amount
in the case of non-cleared OTC transactions becomes an initial
margin requirement in the case of cleared transactions.
Major swap participant (MSP)
A non-swap dealer entity (1) holding a substantial position in any
of the major categories of swap or security-based swaps (excluding
positions held for hedging or mitigating commercial risk), or (2)
having positions creating substantial counterparty exposure that
could have serious adverse effects on the fnancial stability of the
United States banking system or fnancial markets, or (3) using high
leverage relative to the amount of capital such entity holds and
not subject to capital requirements established by an appropriate
federal banking agency; also, holding a substantial position in
any of the major categories of swap or security-based swaps
50
Glossary
Margin call
An investor receives a margin call from a broker or clearer
(cleared OTC) if one or more of the securities it has bought
(with borrowed money) decreased in value past a certain
point. The investor is then forced either to deposit more
money in the account or to sell off some of its assets.

Non fnancial entity
A counterparty that is not a swap dealer, a major swap participant, or a
fnancial entity.
Portfolio compression
A process that reduces the overall size (notional value) and the number
of line items in credit portfolios, without changing the risk parameters
of the portfolio. The method includes a selection of multiple trades
having equivalent terms and a determination of the net notional
and net coupon. Replacement trades are created, the combined net
notional and combined net coupon of which respectively equal the net
notional and the net coupon of the multiple trades being replaced. A
position-matching method is implemented for portfolio compression.
An implied spread is calculated for each position of a portfolio.
Positions with an implied spread outside desired bounds are corrected.
A buyer and a seller are selected, the buyer having the position with
the highest implied spread value of all net long positions and the
seller of all net short protection positions. The created trade has a
notional value equal to the smaller of the net default exposure and
a spread mirroring the implied spread but with a smaller position.
Swap dealer (SD)
Entities commonly understood to be dealers or market-makers
of swaps or security-based swaps, or regularly enter into
swaps with counterparties as an ordinary course of business,
or that make a market of swaps or security-based swaps.
Transformation solutions
Solutions that allow the substitution of assets not eligible as collateral,
via fnancing or collateral upgrade, to assets that are eligible as collateral.
Variation margin
Variation margin is paid by clearing members on a daily or
intraday basis in order to reduce the exposure created by carrying
highly risky positions. By demanding variation margin from its
members, clearing organisations are able to maintain a suitable
level of risk and cushions against signifcant devaluations.
51
Sources: www.investopedia.com, www.ftadviser.com, www.wikipedia.org
Contacts
Contacts
53
Helene Virello, Head of collateral management services
and OTC independent valuation services
Helene.virello@bnpparibas.com
+33 1 57 43 85 24
BNP Paribas Corporate and Investment Banking
Gavin Dixon, Global head, market initiatives and OTC clearing
Gavin.dixon@bnpparibas.com
+44 20 7595 8417
The services described in this document are offered through a joint venture between BNP Paribas Securities Services
(Securities Services), a wholly owned subsidiary of BNP Paribas S.A., and the Global Equities and Commodity Derivatives
and Fixed Income business lines of BNP Paribas S.A. (BNPP). BNP Paribas Securities Services is incorporated in France
as a Partnership Limited by Shares and is authorised by the Autorit de Contrle Prudentiel (the ACP) and supervised by
the Autorit des Marchs Financiers (the AMF). BNP Paribas S.A. is incorporated in France with limited liability and is
authorised and supervised by the ACP for the conduct of its investment business in France. It is also subject to authorisa-
tion and regulation in other jurisdictions as described further below.
This document is CONFIDENTIAL AND FOR DISCUSSION PURPOSES ONLY and has been prepared for professional investors
by BNPP and Securities Services. This document contains general information only and recipients should note that in
providing this document, BNPP and Securities Services are not providing any fnancial, legal, tax, regulatory or other type
of advice. This document does not constitute an offer or a solicitation to engage in any trading strategy or to purchase
or sell any fnancial instruments (Financial Instruments). Given its general nature, the information included in this
document does not contain all of the elements that may be relevant for a recipient to make an informed decision in
relation to any strategies or Financial Instruments or services discussed herein. For the avoidance of doubt, the provision
of any information in this document by BNPP and Securities Services does not represent the formation of an agreement
between BNPP, Securities Services and any recipients. Any strategies or Financial Instruments discussed in this document
could involve the use of derivatives, which are complex in nature and may give rise to substantial risks, including the risk
of total loss of any investment. BNPP and Securities Services make no representation as to whether any of the strategies
or Financial Instruments discussed herein may be suitable for recipients fnancial needs or individual circumstances.
Recipients must make their own assessment of the risks inherent in, and the suitability of, any such strategies and/or
Financial Instruments, using such professional advisors as they may require. BNPP and Securities Services accept no liability
for any direct or consequential losses arising from any action taken in connection with the information contained in this
document.
This document is a marketing communication and does not constitute independent research or fnancial or other advice.
Information contained in this document may have been obtained from third party sources believed to be reliable. BNPP
and Securities Services make no representation, express or implied, that any such third party information is accurate or
complete. Any opinions and/or estimates contained herein constitute the judgment of BNPP and/or Securities Services and
are subject to change without notice. BNPP, Securities Services and their respective subsidiaries and affliates accept no
liability for any such opinions or estimates or any errors or omissions contained within this document.
This document is prepared for eligible counterparties and professional clients only, is not intended for retails clients and
should not be circulated to any such retail clients (as such terms are defned in the Markets in Financial Instruments
Directive 2004/39/EC). It may not be reproduced (in whole or in part), delivered or otherwise communicated to any other
person without the prior written consent of BNPP and Securities Services. BNP Paribas London Branch (registered offce:
10 Harewood Avenue, London NW1 6AA; tel: [44 20] 7595 2000; fax: [44 20] 7595 2555) is authorised and supervised by
the ACP and is authorised and subject to limited regulation by the Financial Services Authority. Details of the extent of our
authorisation and regulation by the Financial Services Authority are available from us on request. BNP Paribas London
Branch is registered in England and Wales under no. FC13447.
www.bnpparibas.com
BNP Paribas & BNP Paribas Securities Services (2011). All rights reserved.
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Collateral Access Management Optimisation Protection OTC Derivatives

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