Protect and survive

Various initiatives are under way to encourage greater use of collateral and improve portfolio reconciliation. What are banks and technology vendors doing to meet industry targets? By Ryan Davidson

Collateral management to mitigate counterparty credit risk has seen a renewed focus following the demise or near failure of several derivatives dealers over the past year. The extreme volatility witnessed during the financial crisis has caused sharp changes in the market values of derivatives trades, meaning firms have needed to revalue them and adjust collateral to cover exposures. However, existing collateral management processes were shown to be flawed or inefficient following the collapse of Lehman Brothers last September, leading to a number of disputes. As a result, the derivatives industry is working on a series of initiatives to improve them.

Managing collateral is a significant operational challenge given the number of trades and agreements involved. According to the International Swaps and Derivatives Association's Margin Survey for 2008 (the latest one available as Risk went to press), the amount of collateral in use for over-the-counter derivatives trades was estimated at $2.1 trillion in 2007, up 60% from $1.3 trillion the year before. Respondents to the survey reported 149,322 collateral agreements in place, up from 132,732 in 2007. Sixty-three per cent of OTC derivatives trades were subject to collateral agreements at the end of 2007, compared with 59% in 2006 and 30% in 2003.

Isda wrote in the survey that "collateral coverage continues to grow, both in terms of trade volume subject to collateral agreements and of credit exposure covered by collateral. This reflects a long-term trend toward increased collateral coverage."

However, the financial crisis exposed a number of frailties in collateral management processes - in particular, surrounding the valuation of complex trades. "Additional sources of risk in the OTC derivatives space surfaced during the credit crisis that perhaps people didn't think about back when the contracts were originally created," explains Michael Clarke, global head of collateral management and client valuations at UBS and co-chair of Isda's collateral committee in New York. "Some of the products produced in the past few years are significantly more complex and potentially less liquid than the original vanilla derivatives that were invented 10 or 15 years ago."

This has led to a significant rise in the number of disputed collateral calls between counterparties since the credit crisis emerged in the fourth quarter of 2007 - particularly those involving credit derivatives referenced to residential mortgage-backed securities. And the issue has caught the attention of regulators and senior management of those banks involved in the disputes, putting pressure on market participants to resolve the problems.

The efforts to improve collateral management processes are being co-ordinated by the Operations Management Group (OMG), a collective of 16 dealers, buy-side firms and several industry bodies, including Isda. Working with the Isda collateral committee, the group has agreed a series of targets to improve collateral management processes, detailed in a succession of letters to the Federal Reserve Bank of New York, with the latest commitments outlined in a letter dated October 31, 2008 (see box).

"Isda has always had a collateral committee, but in the past nine months it has been more active than it has been in years. We have set up new working groups to work on initiatives to improve various aspects of collateral management across the industry," says Julian Day, head of trading infrastructure at Isda and staff contact for the association's collateral committee.

These initiatives include collateral infrastructure (for instance, developing the right technology to meet the targets), portfolio reconciliation and margin dispute resolution. One of the areas where the OMG has made most progress is portfolio reconciliation - essentially, ensuring firms agree on the trades they think they have conducted with each other, that descriptions of the trade match, and that there is agreement on valuation.

The major dealers had made a commitment last July to carry out weekly reconciliation of collateralised portfolios exceeding 5,000 trades by the end of 2008 - a target they say they have met. A further target has been set, with dealers required to perform weekly interdealer reconciliation of collateralised portfolios exceeding 500 trades by the end of June. Banks are also obligated to carry out daily uploads of collateralised portfolios to reconciliation platforms by the same deadline.

"For collateral management purpose, firms don't need to reconcile all trades every day because they don't necessarily have margin disagreements every day. The key thing is to have both counterparties' data uploaded daily so if there is a dispute, they are in a position to reconcile promptly," says Clarke of UBS.

This is a significant improvement from a year ago, when many firms only reconciled trades if there was a margin dispute - something that came back to bite financial institutions during the fourth quarter of last year, when some were trying to get clarity on their collateral positions at a time of near unprecedented shifts in markets. Clarke adds most of the large banks have already met or exceeded the June 2009 targets, and claims the portfolio reconciliation issue is under control among the major dealers.

Stockholm-based financial technology firm TriOptima says it has all 16 dealers within the OMG signed up to its triResolve portfolio reconciliation platform, along with regional banks and buy-side firms. The platform allows users to submit outstanding transactions covered by collateral agreements. The system then standardises the various data formats, compares the portfolios, and the results are made available online. When a collateral dispute arises, users can identify its source and communicate directly with counterparties online. So far, there are 10 million unique OTC derivatives positions on the system (counting both sides of each trade), accounting for 70-75% of all non-cleared OTC derivatives globally across all asset classes, TriOptima claims.

"The collapse of Bear Stearns and Lehman Brothers highlighted the importance of making sure you are managing your counterparty exposures prudently. Portfolio reconciliation on a proactive basis is a way to keep on top of this. By identifying underlying issues, you maintain the right levels of collateral," says Viktor Johannsson, business manager for triResolve in Stockholm. He adds most dealers had signed up to the portfolio reconciliation service by the time Lehman filed for Chapter 11 bankruptcy protection on September 15, meaning there were relatively few problems between interdealer participants.

A former collateral manager at one European bank says his firm had introduced its portfolio reconciliation platform in February 2007, which enabled it to navigate the choppy waters in the wake of Lehman's collapse. "You knew where your position was with Lehman at all times and knew what you had to account for. Trades could be re-marked-to-market if they needed to be and you could see any unanswered collateral calls. Collateral reports could be passed on to the bank's risk management team," he notes.

With the major dealers signed up to portfolio reconciliation services, attention is now turning to the buy side. Some firms have not had the resources to implement collateral management systems, and so have relied on dealers to tell them how much collateral to post. This resulted in a large number of margin disputes during 2007 and 2008 (Risk December 2008, pages 40-421).

David Wechter, senior director, collateral product management at Toronto-based risk management software supplier Algorithmics, thinks improving collateral infrastructure at buy-side firms would provide them with greater operational confidence to confirm collateral calls. "Buy-side firms would benefit from implementing collateral operations and portfolio reconciliation systems to complement any exposure valuation tools they may have in place. It would reduce their reliance on banks to tell them exposures for collateralised trades and allow them to do their own margin calculations to validate calls being made for collateral," Wechter adds.

Indeed, London-based data provider Markit says it has seen an increase in buy-side firms signing up to its portfolio reconciliation platform, PortRec. "Through using the system, hedge funds can prove their assets exist and are correctly valued with independent verification. They can then also ensure they are collateralised to the right amount," explains Jeff Gooch, global head of portfolio valuations and co-head of global trade processing at Markit in London.

Portfolio reconciliation can reduce the number of margin disputes and speed up the resolution of conflicts, but the process for resolving disputes still needs to be improved. To that end, the OMG has pledged to draw up a list of improvements to the margin dispute process later this month.

"Although portfolio reconciliation ensures counterparties agree on the composition of their portfolios, they may still disagree about the value of reconciled portfolios, particularly those containing complex OTC derivatives," the OMG stated in a summary of its October 31 commitments. "Improving how valuation differences are addressed will help assure that the appropriate collateral amounts can be delivered in a timely manner."

Disputes can arise due to differences in methodologies for calculating securities valuations. Isda's original credit support annex documentation, published in 1994, suggests only one method for resolving disputes - a dealer poll. This involves asking several banks what they think an asset is worth and calculating the average. However, with liquidity drying up, assets trading at distressed prices and little visibility in the market during the financial crisis, this process was shown to be flawed.

"The dealer poll method was shown to not always work effectively during the crisis of the past year. There are several other methods being developed that parties could use as an alternative going forward," remarks UBS's Clarke.

These include an arbitration method, where both counterparties put forward a value they think is correct and then a third-party arbitrator picks one of the valuations but does not suggest any alternative. Another technique would be to have the two counterparties agree a value between their calculations of prices.

At Isda's annual general meeting in Beijing on April 22-23, the collateral committee will reveal some of its preliminary findings. This will include reports on the progress of portfolio reconciliation and proposals for ways to resolve margin disputes. On the latter, there is likely to be a consultation period before any new official documentation is drawn up. The OMG will try to avoid changing the original credit support annex documentation, as this will involve time-consuming bilateral renegotiations between counterparties. Clarke expects there will be a protocol-type adoption, where any two firms that have embraced the new methods could adopt the new set of practices.

Shaun Sheppard, European head of collateral management at Goldman Sachs and co-chair of Isda's collateral committee in London, says the focus in the coming months will be to meet the commitments the collateral committee has already made and to build on them, aiming to keep industry participants moving in the same direction. "Focus on the root causes of disputes will increase the integrity of portfolios, which will help to ensure trade events and settlements are correct, and reduce the overall risk inherent in the industry," he adds.

COLLATERAL TARGETS

The Operations Management Group - which includes 16 major dealers and several industry associations, including the International Swaps and Derivatives Association - has agreed a set of targets with the Federal Reserve Bank of New York to reduce risk associated with collateral management processes.

Targets that have been met

- Isda best practice portfolio reconciliation to be implemented between major dealers by December 31, 2008, including weekly interdealer reconciliation of collateralised portfolios exceeding 5,000 trades.

- Major dealers commit to collect and report monthly metrics regarding their portfolio reconciliation activities to regulators. The first report was published in February covering reconciliation activity in January 2009.

Targets still outstanding

- Major dealers to carry out weekly interdealer reconciliation of collateralised portfolios exceeding 500 trades by June 30, 2009.

- Major dealers to carry out daily uploads of collateralised portfolios to reconciliation platforms by June 30, 2009.

- By April 30, 2009, develop an improved approach to managing disagreements over the valuation of trades in order to reduce the severity of margin disputes.

- Isda will publish a road map for collateral management during May 2009, outlining goals and time frames for actions the industry should take in this area.

- The Isda collateral committee will establish monthly meetings of the full committee as well as establishing smaller collateral working groups to focus on specific topics that will meet more frequently as required. Updates will be provided to regulators, and supervisors will participate in some of these meetings.

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