Isda to review collateral dispute process

A subset of the International Swaps and Derivatives Association's collateral committee - the dispute resolution working group - has produced a draft report outlining improvements to the process. The group plans to submit the report to Isda members and the Federal Reserve Bank of New York by the end of May.

Arguments over collateral arise for a variety of reasons, including differences between counterparties' portfolio compositions, the timing of when firms book trades, or valuation methodologies. But the crisis has increased the number and size of disputes.

"Significant amounts of money can be involved in disputes," said one head of collateral at a major dealer. "Small differences in valuation methodologies can add up to large sums when you aggregate large numbers of trades. Meanwhile, firms can have very different approaches to pricing highly structured credit trades, which can result in big differences in valuation."

In the original Isda credit support annexe documentation, which set out the terms under which collateral is posted or transferred between derivatives counterparties, only one method is suggested to resolve disputes: a dealer poll. This involves asking several dealers to value a trade and averaging the result. However, some observers believe this method has become outdated and impractical.

"Industry participants feel that to go out and get quotes from four major dealers to value a disputed transaction within one business day is not really practical. To get one third party to volunteer to price a transaction may be difficult - let along four - and to do that within that timeframe is not realistic," said Lauren Teigland-Hunt, a managing partner at New York-based law firm Teigland-Hunt.

A three-week consultation process will take place after the release of the working group's report. Following this, initiatives such as drawing up best practice guidelines for resolving disputes over margin calls will be considered, as will producing a more formal Isda protocol on the issue.

"The first phase will address the more basic and straightforward issues that should resolve the large majority of disputes. Many of the recommendations will be a formalisation of some of the practices the industry already uses," states another head of collateral at a large bank.

The best practices under consideration include firms reconciling the details of trades in their portfolios and allowing for a specified degree of tolerance in valuation differences. When there is a major gulf between valuations, they could agree to post collateral up to an undisputed amount, so that at least some of the potential collateral level would be covered. Trading desks of both counterparties could then be granted a certain amount of time to informally discuss the trade valuations and come to some agreement on the rest of the collateral.

Several specific methods have been suggested for dispute resolution in the first consultation period. These include the two parties negotiating a compromise amount of collateral that will be somewhere in between their estimations. Alternatively, they could reference an independent data source to value the trade, such as an index, rather than using the parties' own calculations. A more extreme proposal would be for one party to exit the transaction and the trade to be assigned to another counterparty if they can't agree on its value. Otherwise they could terminate the trade, which would only be used as a last resort if firms are unable to find a way to resolve the dispute.

A second set of methods for resolving disputes is also being drawn up by the working group, which it plans to send out for consultation by June 30. Several ideas are being considered that will take longer to develop as they concern more complex, structured derivatives. These may include a more detailed successor to the current dealer poll methodology.

Nothing is set in stone, however, said Michael Clarke, global head of collateral management and client valuations at UBS, and co-chair of Isda's collateral committee in New York.

"All of the methods have benefits, but also some drawbacks," he said. "There is extensive industry discussion over what would be the right approach. Dispute resolution is really trying to solve a very broad problem, from one-off, illiquid, highly structured trades that are difficult to value, through to vanilla trades that are easy to value but exhibit small differences between firms that are individually insignificant but in aggregate add up to a material value. We are really trying to deal with these two vey different ends of the spectrum."

See also: Isda AGM: Collateral use continues to rise
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