Isda's plans, sent to the Federal Reserve Bank of New York on June 2, are aimed at making collateral management practices more robust to reduce counterparty credit risk for over-the-counter derivatives trades. Areas the industry plans to address include portfolio reconciliation, collateral dispute resolution, handling of initial margin and standardised electronic messaging for margin calls.
The goals build on the work carried out by the Operations Management Group (OMG), which includes 15 major dealers, nine buy-side firms and three industry bodies, including Isda. The group aims to improve a variety of areas of the operational infrastructure for OTC derivatives, including trade processing, clearing and collateral.
Isda has added further collateral targets to the ones outlined in the OMG’s June 2 letter to the New York Fed and other US and European supervisors. Producing the roadmap by the end of May this year was one of the goals the OMG committed to in its previous set of targets outlined in a letter the New York Fed last October.
“The reason for creating the collateral roadmap is, if you go back to the October letter, the New York Fed asked that collateral be added to the range of targets. The New York Fed was pushing the OMG to come up with commitments and, given the nature of collateral being across asset class and that the issues they were concerned about – namely, risk management, legal, tax, and finance – were not limited to operations issues, we required more time to review the proposals before deciding what to commit to. We did promise to spend time creating the roadmap of what we believe we can commit to over time,” commented Arthur Magnus, head of global credit risk, client and reference data operations at JP Morgan in New York, and chair of the collateral roadmap working group within Isda’s collateral committee.
Isda's plan includes both short-term and longer-term goals for the industry to meet and these are expected to be updated annually. In the near term, the OMG dealers have committed to carry out daily reconciliations between themselves of collateralised portfolios in excess of 500 trades by the end of June. This is a step up from the previous target set in July 2008 to carry out weekly interdealer reconciliations for portfolios over 5,000 trades by the end of last year. To expand these efforts to the wider derivatives industry, there are plans to publish a feasibility study by the end of October for how to achieve portfolio reconciliation across more market participants than just the major dealers.
“In terms of implementation of portfolio reconciliation in the wider market, we will need to prioritise which portfolios need to be reconciled first, based on their size and the risk embedded in them. These portfolios will tend to sit with the larger buy-side firms and larger regional banks,” said Shaun Sheppard, European head of collateral management at Goldman Sachs and co-chair of Isda's collateral committee in London.
The OMG has committed to improve and formalise methods for handling disputes over collateral calls. It is approaching this in two phases because some of the methods are taking longer than others to reach industry consensus on, particularly those that involve a third party in the resolution process and are designed to resolve disputes over valuations of complex, illiquid instruments. The industry met its May 31 deadline this year to produce the first phase of proposals and send them out for comment from Isda members. The OMG aims to produce the phase-two draft by the end of June, which will be followed by a comment period and further discussion of the results with supervisors so that an agreed protocol can be finalised by September 30.
“The deadline of September for finalisation of the dispute resolution protocol is a fair deadline. We expect to get it done by then. The timing of implementation hasn’t been decided yet, but it could be late in 2009 or in 2010,” said Michael Clarke, the New York-based global head of collateral management and client valuations at UBS, and co-chair of Isda's collateral committee.
Isda also plans to investigate how to deal with other collateral issues the industry believes are important to address. One of these is to improve how dealers hold initial margin posted by buy-side investors for derivatives trades. The buy-side community has been keen to tackle this after some had their initial margin trapped in Lehman Brothers when the bank collapsed last September. By the end of June, the industry aims to publish a detailed paper on both the buy-side and sell-side views of this issue to the Isda collateral committee, the Managed Funds Association and the Securities Industry and Financial Markets Association. Following this, there is a commitment to produce a set of options by the end of September for how to resolve the problem.
Another issue is how to produce electronic messages for margin calls, interest payments and collateral substitutions. The industry believes this would be a more robust method than the current system of emails. The roadmap includes a target for the end of July to produce a draft of proposals for how to achieve this, with a final version to be published by the end of October.
All of these goals to make improvements to collateral processes fit into longer-term objectives identified in the roadmap. By the end of June 2010, the industry plans to publish a best practices document for collateral management. Among the topics this will cover are: timing and settlement of margin calls, valuation and calculation of margin, portfolio reconciliation, and dispute resolution. In addition, if the industry identifies any potential changes to the credit support annex, it will bring a list of these and any recommendations to the Isda legal and documentation groups by the end of April 2010.
How the OTC derivatives industry is going to approach tackling the commitments in the collateral roadmap will be explored in a feature in the upcoming July edition of Risk.