1. Presented by:
Nikhil Gangadhar
Satish.S

2. About the topic:
•IMF Working Paper
•Dep’t: Monetary and Capital Markets Department
•Title: Counterparty Risk in the Over-The-Counter Derivatives
Market
•Prepared by Miguel A. Segoviano and Dr.Manmohan Singh
• November 2008
In this paper the area of interest in counterparty risk that may stem from
the OTC derivatives markets

3. Abstract
The financial market turmoil of recent months(in 2008) has highlighted
the importance of counterparty risk.
The paper discusses counterparty risk that may stem from the OTC
derivatives markets and attempt to assess the scope of potential cascade
effects.
This risk is measured by losses to the financial system that may result via
the OTC derivative contracts from the default of one or more banks or
primary broker-dealers. We then stress the importance of “netting”
within the OTC derivative contracts.
We summarize our results in the context of the stability of the banking
system and provide some policy measures that could be usefully
considered by the regulators in their discussions of current issues.

4. Few definitions for the clear understanding:
Over-the-counter : OTC or off-exchange trading is to trade financial
instruments such as stocks, bonds, commodities or derivatives, directly
between two parties. It is contrasted with exchange trading, which occurs
via facilities constructed for the purpose of trading (i.e. exchanges), such
as stock market.
Forwards and Swaps are prime examples of OTC contracts. It is mostly done
via the computer or the telephone. For Derivatives, these agreements are
usually governed by an International Swaps and Derivative
Association agreement. This segment of the OTC market is occasionally
referred to as the “Fourth Market“.
What makes OTC derivative market risky?
•Non-standard products are traded here.
•OTC derivatives have less standard structure and are traded bilaterally.
•OTC derivatives are significant in the asset classes such as interest rate,
foreign exchange, equities and commodities
• Counter-party risk and Credit risk

5. The International Swaps and Derivative Association suggested five main ways
to address the credit risk arising from a derivatives transaction, as follows:
• avoiding the risk by not entering into transactions in the first place;
• being financially strong enough and having enough capital set aside to accept
the risk of non-payment;
• making the risk as small as possible through the use of close-out netting
• having another entity reimburse losses, similar to the insurance, financial
guarantee and credit derivatives markets.
Obtaining the right of recourse to some asset of value that can be sold or
the value of which can be applied in the event of default on the transaction.

6. Importance of OTC derivatives in modern banking
•The OTC derivatives markets are large and have grown exponentially over
the last two decades
•The expansion has been driven by interest rate products, foreign exchange
instruments and credit default swaps.
•The notional outstanding of OTC derivatives markets rose throughout the
period and totalled approximately US$601 trillion at December 31, 2011.
•These institutions manage portfolios of derivatives involving tens of
thousand of positions and aggregate global turnover over $1trillion.
•International financial institutions have increasingly nurtured the ability to
profit from OTC derivatives activities and financial markets participants
benefit from them. As a result, OTC derivatives activities play a central and
predominantly a beneficial role in modern finance.
•The advantages of OTC derivatives over Exchange traded ones are mainly the
lower costs (in terms of government taxes and fees payable) and the ability for
sellers and buyers of these products to bilaterally negotiate and customize the
transactions themselves.

7. Equity Linked Derivative: Derivatives whose value derives from equity prices.
equity derivative is a class of derivatives whose value is at least partly derived
from one or more underlying equity securities.
Options and futures are by far the most common equity derivatives, however
there are many other types of equity derivatives that are actively traded. These
include:
•Equity future—traded on an organized exchange, in which counterparties
commit to buy or sell a specified amount of an individual equity or a basket of
equities or an equity index at an agreed contract price on a specified date.
•Equity option—gives the purchaser the right but not the obligation to purchase
(call) or sell (put) a specified amount of an individual equity or a basket of
equities or an equity index at an agreed contract price on or before a specified
date.
•Equity swap—in which one party exchanges a rate of return linked to an equity
investment for the rate of return on another equity investment.

8. Credit Default Swap - CDS:
A swap designed to transfer the credit exposure of fixed income products between
parties. A credit default swap is also referred to as a credit derivative contract,
where the purchaser of the swap makes payments up until the maturity date of a
contract. Payments are made to the seller of the swap. In return, the seller agrees
to pay off a third party debt if this party defaults on the loan. A CDS is considered
insurance against non-payment. A buyer of a CDS might be speculating on the
possibility that the third party will indeed default .
The buyer of a credit default swap receives credit protection, whereas the seller of
the swap guarantees the credit worthiness of the debt security. In doing so, the
risk of default is transferred from the holder of the fixed income security to the
seller of the swap.
For example, the buyer of a credit default swap will be entitled to the par value of
the contract by the seller of the swap, if the third party default on payments. By
purchasing a swap, the buyer is transferring the risk that a debt security will
default.

9. Notional Value:
The total value of a leveraged position's assets. This term is commonly used in
the options, futures and currency markets because a very small amount of
invested money can control a large position.
For example:
one S&P 500 Index futures contract obligates the buyer to 250 units of the S&P
500 Index. If the index is trading at $1,000, then the single futures contract
is similar to investing $250,000 (250 x $1,000). Therefore, $250,000 is the
notional value underlying the futures contract.
To the audience’
S&P index stands for………?

10. Hedge Ratio
1. A ratio comparing the value of a position protected via a hedge with the
size of the entire position itself.
2. A ratio comparing the value of futures contracts purchased or sold to the
value of the cash commodity being hedged.
Eg:
• Say you are holding $10,000 in foreign equity, which exposes you to
currency risk. If you hedge $5,000 worth of the equity with a currency
position, your hedge ratio is 0.5 (50 / 100). This means that 50% of your
equity position is sheltered from exchange rate risk.
• The hedge ratio is important for investors in futures contracts, as it will
help to identify and minimize basis risk.

11. Credit derivative:
It is an OTC derivative designed to transfer credit risk from one party to
another. By synthetically creating or eliminating credit exposures, they allow
institutions to more effectively manage credit risks. Credit derivatives take
many forms.
For example:
A bank concerned that one of its customers may not be able to repay a loan can
protect itself against loss by transferring the credit risk to another party while
keeping the loan on its books.

12. Cascading effects of financial market turmoil in 2008
Loss of confidence in the market both currency and
instruments.
International investors withdrawing funds.
Banks related panics and recession coinciding.
Crash of stock markets.
Currency crises.
Sovereign defaults.
Transformation of investors to, being risk averse.
Problem of managing risks and allocating capital.
Effect of the crises on dependent currencies and world market.
Affect on International investors.,
etc……………………………

13. Introduction
Notional amounts of all categories of the OTC contracts reached almost $600 trillion
at the end of December 2007. These include foreign exchange contracts, interest rate
contracts, equity linked contracts, commodity contracts, and credit default swaps
(CDS) contracts.
Interest rate contracts continue to be the largest segment of this market comprising
66 percent of all OTC derivative market or about $400 trillion.
Growth in the credit derivatives segment has been the fastest and the volume has
more than doubled in the 2007 to about $60 trillion.

14. In order to quantify counterparty risk, we calculate (expected) losses absorbed
by the system under two different scenarios. For the estimation of (expected)
losses, they define
(i) The exposure of the financial system to specific financial institutions (FIs);
and
(ii) Propose a novel methodology to estimate the probability that given that a
particular institution (counterparty) fails to deliver, other institutions in
the system would also fail to deliver.
Counterparty risk largely stems from the creditworthiness of an institution.
In the context of the financial system that includes banks, broker dealers,
and other non-banking institutions (e.g., insurers and pension funds),
counterparty risk will be the cumulative loss to the financial system from a
counterparty that fails to deliver on its OTC derivative obligation.

15. Thus, in order to estimate the potential cumulative loss in the system,
we need to quantify two variables
(i) The exposure of the financial system (EFS) to a particular
institution or institutions that would fail to deliver; and
(ii) The probability that given that a particular institution
(counterparty) fails to deliver, other institutions in the system
would also fail to deliver.
Eg…………………………..

16. Risk in derivatives stems from various other variables :
Price changes, volatility, leverage and hedge ratios, duration, liquidity,
and counterparty risk.
Gross market values do provide some measure of the financial risk
from OTC derivatives. These are all the open contracts that are either
in a current gain (or loss) position at current market prices and thus, if
settled immediately, would represent claims (or liabilities) on
counterparties.
Gross market values are correlated to the notional amounts of the
derivative contracts: the larger the notional amount, the larger the
gross market value from price changes, all other things being equal.
Although gross market values capture the economic significance,
these values are not netted.

17. Netting:
1. Settling mutual obligations at the net value of a contract as opposed
to its gross dollar value.
2. Reducing the transfer of funds between subsidiaries to a net amount.
Netting often occurs in situations in which one of the participants is
experiencing extreme financial difficulty, such as bankruptcy. Netting
will be specific to the master agreement of the institution; thus it
is possible that OTC derivatives may not be offset against repo positions.
Thus counterparty risk will be discussed only in the context of “un-
netted” and “unassigned” liabilities of an institution.

18. WHAT WAS ENVISAGED BY MOVING OTC DERIVATIVES TO CCPS
Since Lehman’s demise and AIG’s bailout, regulators have been searching for a
way to unwind SIFIs, but as yet, with limited success. Some new institutions,
or CCPs, are being proposed that will inherit the bulk of derivative portfolios
of existing SIFIs. It is envisaged that a critical mass of SIFI’s derivative-related
risks will be moved to CCPs so that this regulatory effort can bear fruit.
A key incentive for moving OTC derivatives to CCPs is higher
multilateral netting, i.e., offsetting exposures across all OTC products
on SIFIs’ books. Intuitively, the margin required to cover the exposure
of the portfolio would be smaller in a CCP world.
However, if there are multiple CCPs that are not linked, the benefits of
netting are reduced, because cross-product netting will not take place
(since CCPs presently only offer multilateral netting in the same asset
class and not across products).

19. Just to read
Of all the financial institutions that got government aid during the financial panic of 2008, none was less morally
deserving than AIG. The insurance group imploded due to reckless bets it had made through what was essentially an
in-house hedge fund. Nor were many bailouts bigger than the $182 billion combined commitment that the Federal
Reserve and the Treasury Department made to AIG during the Bush and Obama’s administrations. Yet no bailout was
more necessary, given the cascading disaster that AIG’s failure could have let off in the U.S. and European financial
systems.
You hardly hear anything about the AIG bailout these days, in contrast to the debate that still rages over General
Motors, Chrysler, Fannie Mae and Freddie Mac. Could it be that, all things considered, the AIG bailout is working
pretty well? Actually, yes. The firm used $140 billion of the $182 billion available from the government, divided
between Fed loans and Treasury equity purchases. The bulk of that has returned to the government, with interest.
This has occurred because, having spent the past two years selling excess assets and modernizing its core insurance
businesses, AIG is profitable again. The firm’s only remaining debt to the Fed is a $9.3 billion loan, against which the
central bank holds collateral valued at almost twice that. So it’s highly unlikely taxpayers will take a loss — and quite
likely they’ll turn a profit.
The remaining federal commitment consists of the Treasury Department’s majority share of AIG stock. There’s good
news on that front, too: On Wednesday, Treasury announced that it plans to sell $6 billion of its stake. Cleverly,
Treasury sold about half of that amount back to AIG; this gave Treasury an alternative to merely dumping shares on
the market and so boosted the price it could command on behalf of taxpayers. Wednesday’s sale reduced the taxpayers’
stake in AIG to $35.8 billion, at the current price of roughly $29 per share.
Treasury still has to shed more than a billion shares, or 70 percent of the company. The current bull market facilitated
the latest sale; it can’t last forever. Still, Bernstein Research, a Wall Street firm, recently described AIG as ―a
recapitalized and de-risked firm, on a stable footing and pursuing a thoughtful renewal.‖ Since the government paid
$28.50 each for its shares, all it needs to break even is for AIG’s stock price to stay about where it is now. Given the
firm’s restructuring, that seems feasible.
. As with other bailouts, the true cost-benefit analysis can never be known, since we’ll never know exactly how big a
catastrophe it averted.
On balance, though, the risk of disaster was sufficiently high, compared to the – so far — modest costs, that the AIG
rescue deserves to be labeled, if not a success, then certainly a gamble worth taking.

20. WHAT IS ACTUALLY HAPPENING AND WHY DOES THIS GIVE RISE TO
SUBSTANTIAL RISKS?
Recent developments have diverged substantially from this “first-best” solution. A
CFTC draft proposal has lowered the capital threshold for a CCP(central counter
party) to $50 million, which will encourage new entrants in this business.
Furthermore, end-user exemptions along with not moving certain products like the
foreign exchange OTC derivatives to CCPs may not only dilute the intended
objectives, but actual outcomes may be sub-optimal relative to the status-quo.
CCPs will require collateral to be posted from all members. In essence, both parties
should post collateral to CCPs; no exceptions or exemptions. This is also called two-
way CSAs (Credit Support Annexes).
Thus moving transactions to CCPs would make the under-collateralization obvious
and require large increases in collateral. The amount of capital needed to be raised
will depend on how the collateral requirements are assessed by CCPs and the
regulators (e.g., entity type, rating, or riskiness of the portfolio that is offloaded to
CCPs) and how firms choose to raise the required collateral.

21. Systemically important financial institutions (SIFI) are Financial institutions that are
deemed systemically important to the global economy in the sense that the failure of
one of them could trigger a global financial crisis. The prevention of their collapse
and the limitation of the consequences of a collapse are important as a means of
protecting the financial system.
This section highlights key issues that need to be understood when moving a sizable
part of the OTC derivatives positions at SIFIs to CCPs. These issues include
(i) interoperability of CCPs which would allow multilateral netting of positions
across SIFIs residual positions;
(ii) sizable collateral needs;
(iii) unbundling netted positions;
(iv) duplicating risk management;
(v) likely regulatory arbitrage;
(vi) concentration of systemic risk;
(vii) decrease in rehypothecation of collateral
(viii) backstopping by central banks; and
(ix) more SIFIs to supervise.

22. Interoperability of CCPs
Interoperability, or linking of CCPs, allows a SIFI to concentrate its
portfolio at a CCP of its choice, regardless of what CCP its trading
counterparty chooses to use. Thus, at the level of each CCP, CCPi may hold
or have access to collateral from another CCPj that may go bankrupt in the
future, so that losses involved in closing out CCPj’s obligations to CCPi can
be covered.
However, legal and regulatory sources indicate that cross-border margin
access is subordinate to national bankruptcy laws. Thus it is unlikely that
CCPi in a country would be allowed access to collateral posted by CCPj
registered in another country.

23. Sizable collateral requirements
Without interoperability, the 10 largest SIFIs will continue to keep systemic risk
from OTC derivatives on their book and regulatory efforts will introduce more new
entities (CCPs) that will hold systemic risk from OTC derivatives.
Thus, collateral needs will be higher in the proposed world. Most of the major
SIFIs’ derivatives books are largely concentrated in one ―business‖ (a legal entity)
to run the derivatives clearing business so as to maximize global netting.
A Tabb Group study (November, 2010) also estimates under-collateralization in the
OTC derivatives market at around $2 trillion and suggests that due to end-user
exemptions a significant part of this market will not reach CCPs.
ISDA(int’l swaps and derivatives association) has also acknowledged the sizable
collateral needs resulting from moving derivative positions to CCPs, despite their
(earlier) margin surveys indicating that most of this market is collateralized.
The sizable collateral needs imply that CCPs may not inherit all the
derivative positions from SIFIs.

24. Unbundling of netted positions
The SIFIs are reticent to unbundle ―netted‖ positions, as this results in deadweight
loss and increases collateral needs. Since there is no universally accepted formal
definition of a ―standard‖ contract (or contracts that are ―clearable‖ at CCPs), there
is room for SIFIs to skirt this definition despite the higher capital charge associated
with keeping non-standard contracts on their books, since the netting benefits may
be sizable relative to the regulatory capital charge wedge. This can be expected of
SIFIs where risk management teams build high correlations across OTC derivative
products for hedging purposes.
Adverse impact on risk management
In an environment where CCPs compete, unlimited loss sharing may not be a viable
business model because market participants are likely to choose CCPs with the
lowest loss sharing obligations in their rules, everything else being equal.
Yet, pushing CCPs to clear riskier and less-liquid financial instruments, as the
regulators are now demanding, may increase systemic risk and the probability of a
bailout. Banks may also provide loans as collateral and not lose clients/business.

25. Regulatory arbitrage likely
Gaps in coordinating an international agenda will result in regulatory arbitrage by
SIFIs.
Following Senator Lincoln’s ―push out‖ clause under Dodd-Frank Act, SIFIs’ banking
groups can keep interest rate, foreign exchange, and investment grade CDS on the
banking book. Other OTC derivatives like equities, commodities, and below
investment grade CDS have to be outside the SIFI’s banking book. This will also lead
to ―unbundling‖ of positions (or a move to another jurisdiction like the U.K. that skirts
the Lincoln ―push out‖).
Concentration of systemic risk via “risk nodes”
Regulators are ―forcing‖ en-masse sizable OTC derivatives to CCPs. This is a huge
transition, primarily to move this risk outside the banking system. If the intended
objective(s) are achieved, these new entities should be viewed as ―derivative
warehouses,‖ or ―risk nodes‖ in financial markets, and not under the
payment/settlement rubric.

26. CB backstop (or taxpayer bailout)
A CCP may face a pure liquidity crisis if it is suffering from a massive outflow of
otherwise solvent clearing members, in which case the risk is that it will have to
realize its investment portfolio at low prices. Assume an external shock where
everyone is trying to liquidate collateral simultaneously. This will lead to a
problem if the CCP has repo’d out the collateral it has, cannot get it back, and for
whatever reason does not want to pay cash to the members (i.e., effectively
purchasing the securities at that price).
In these circumstances, a central bank (CB) would be repo-ing whatever
collateral the CCP would ultimately get back. In such instances, it would be more
sensible to require the bank members (e.g., JPMorgan, Credit Suisse) of the CCP
to access the CB and then provide the CCP with liquidity.

27. Decrease in re-hypothecation
The decrease in the ―churning‖ of collateral may be significant since there is demand from
some SIFIs and/or their clients (asset managers, hedge funds etc.), for ―legally segregated
accounts‖ for the margin that they will post to CCPs. Also, the recent demand for
bankruptcy remote structures—another form of siloing collateral—that stems from the
desire not to legally post collateral with CCPs in jurisdictions that may not have the central
bank’s lender-of-last-resort backstop (i.e., liquidity and solvency support)will reduce re-
hypothecation (see Box 2).
Supervision of more SIFIs
Regulators will have to supervise more SIFIs, as CCPs will effectively be SIFIs.
Furthermore, existing SIFIs (i.e., large banks/dealers) will retain OTC derivative positions
since nonstandard contracts will stay with them. End-user exemptions and (likely exempt)
foreign exchange contracts will not migrate to CCPs. SIFIs may keep some
nonstandard/standard Combination on their books due to netting benefits across products
and not move them to CCPs despite higher regulatory capital charge. Post-Lehman there has
not been much progress on crisis resolution frameworks for unwinding SIFIs; thus creating
more SIFIs need to be justified. However, policies and regulations in these areas are
evolving

28. HOW TO GET BACK ON TRACK: TWO ALTERNATIVES
In view of the remaining risks described above, there is a need for alternative
policies. We offer two such options below. These options are only two of many, and
should not be seen as precluding other suggestions to address the systemic risk at
SIFIs.
Taxing Derivative Liability Positions of SIFIs
In order to summarize the derivatives risk to the financial system, we measure the
exposure of the financial system to the failure of a SIFI that is dominant in the OTC
derivatives market, according to the SIFI’s total ―derivative payables‖ (and not
―derivative receivables‖).
Derivative payables represent the sum of the counterparty’s contracts that are
liabilities of the SIFI. Similarly, derivative receivables represent the sum of the
counterparty’s contracts that are the assets of the SIFI.
At present, a SIFI’s derivative payables do not carry a regulatory capital charge and
are not reflected in risk assessments.

29. On the other hand, derivative receivables are imbedded in credit risk and there is
already a capital charge/provision for potential non-receivables. By using
derivative payables as a yardstick, we thus provide a readily available metric to
measure systemic risk from derivatives, compared to other sources that focus on
derivative receivables.
The five largest European banks had about $700 billion in under-collateralized risk
in the form of derivative payables as of December 2008. The U.S. banks had
around $650 billion in derivative payables as of end-2008, as dislocations were
higher then. The key SIFIs active in OTC derivatives in the United States are
Goldman Sachs, Citi, JP Morgan, Bank of America, and Morgan Stanley. In
Europe, Deutsche Bank, Barclays, UBS, RBS and Credit Suisse are sizable
players.
It is useful to note that the International Swap and Derivatives Association’s
(ISDA) master agreements allow SIFIs to net (or offset) their derivative
receivables and payables exposure on an entity. Thus, if Goldman has a positive
position with Citi on an interest rate swap and a negative position with Citi on a
credit derivative, ISDA allows for netting of the two positions.

30. CCPs as a Public Utility Infrastructure
As noted above, regulatory efforts to move the OTC derivatives market to CCPs
with appropriate collateralization are meeting with limited success due to the
complexity of the market, excessive opacity, and other vested interests of the
financial industry.
Given the systemic importance of CCPs, it would appear appropriate for regulators
to at least consider approaching them as a public utility infrastructure.
For example, moving most OTC derivatives to closely regulated exchanges would
reduce systemic risk and enhance transparency, while also reducing spreads on
many products.
However, the large banks have fought hard to keep their most profitable business
line opaque, and have been supported in this by some large end users. SIFIs who
originate the OTC derivative transactions are passing on the risks, but not the
profits, to CCPs. Regulators have allowed this to happen―recently they agreed that
―third‖ party marks/quotes will not be required to price derivatives moving to CCPs.

31. Thus the bid/ask spread of SIFI transactions will remain opaque and will not be
available real time. Altogether, the bespoke nature of much of the OTC derivatives
market and the ―compromise‖ between regulators and SIFIs provides the argument
for the current policy of transferring only certain parts of this market to a
fragmented set of CCPs. Quantity restrictions are also not being implemented, as
these would limit the growth of OTC derivatives, which are often seen as beneficial
in that they ―complete‖ markets.
However, the welfare benefits of derivatives markets are somewhat speculative. In
particular, the costs of financial, sector ―pollution‖ (Haldane, 2010) may be large
since systemic tail risk is created by the markets and does not arise from
fundamentals. The social costs of future financial crises will continue to be
correlated with the high rents in the market.
The importance of CCPs is apparent since key regulators are willing to provide
liquidity support in certain situations (e.g., ECB and the Fed). Such a backstop may
lead to moral hazard that may manifest itself, for example, in CCPs not requiring
full collateral from their clearing members/clients, quite possibly with the
acquiescence of regulators.

32. By contrast, organizing CCPs as utilities encompasses both
(i) a government backstop and
(ii) a carefully engineered and regulated infrastructure that emphasizes safety and
transparency.
By ensuring that users of OTC derivatives (both the large dealers and end
users) bear the full social costs of those products, the utility model could reduce
the extent of financial ―pollution‖ and also limit the excess rents currently earned
by major participants in the market at the expense of the broader economy.
However, given that CCPs are not being treated as utilities, the size of the public
backstop provided is very high, compared with a suboptimal amount of systemic
risk reduction. This raises the question whether the public at large is being well
served by the present non-utility regulatory models.

33. SOME POLITICAL ECONOMY CONSIDERATIONS
CB backstopping of CCPs is shifting the potential taxpayer bailout from Wall Street
to
entities. This transition is increasingly opaque to the ordinary taxpayer, especially
since moving derivatives from SIFIs’ books to those of CCPs is mired in convoluted
arguments and impenetrable technical jargon. However noneconomic considerations
have been instrumental in pushing the regulatory efforts forward, some of which are
highlighted below.
 The ECB favours a CB liquidity backstop but not the United Kingdom.
The ECB’s view is that in order to have an account with a Euro-zone CB, a CCP
should be incorporated and regulated in the Euro-zone (and not, for instance, in the
U.K.).
Some have suggested offering CCPs access to a ―standing credit facility‖ at CBs.
But even if a CCP does not have a CB account, the relevant authorities could still
decide to bail out the CCP if it is deemed too systemically important to fail. Put
differently, using public money to bail out a CCP is a policy decision, independent of
whether the CCP has routine access to central bank liquidity.

34. In distressed market conditions, access of CCPs’ members to CB overnight
credit may not be sufficient to ensure that the CCP remains liquid, as the liquidity
transfer from the CB to the CCP (via CCP members) may not materialize as CCP
members may hoard liquidity for precautionary reasons, perhaps reflecting
uncertainty over CB actions. Thus CB backstopping and associated funding, if
provided, might be based on the condition that funds are passed through the CCP
member banks (i.e., increasing their liability to CB) to CCPs.

35. Managing counterparty risk with OTC derivatives collateral management
Managing credit risk remains a top priority of financial institutions and
corporations, thrown into sharp focus by recent market events. As participants in
OTC derivative transactions come under increasing pressure to mitigate
counterparty risk, many have returned to the original risk management tool:
collateralization.
The use of collateral in OTC derivatives has grown dramatically over the past
eight years. While it is unclear how potential regulatory changes will impact this
trend, the number of collateralized derivative trades is expected to show
consistent growth.
Demands for more frequent reconciliation and access to pricing utilities are
adding new levels of complexity to the additional volume. These trends create a
clear need for more advanced collateral management platforms to replace the
increasingly stressed and outmoded spreadsheet-based systems.

36. Impact of Regulatory Changes on Use of Collateral
The widely anticipated regulatory changes are likely to have some impact on the
use of collateral in OTC derivatives trading. A move toward central clearing for
'standardized OTC instruments,' for example, would eliminate the need for some
trades to be collateralized bilaterally.
As the vast majority of OTC positions are not standardized, however, such
measures would be unlikely to seriously reduce collateral use.
Ahead of such regulatory change, the financial industry has taken a proactive
stance towards mitigating counterparty risk. In its June letter to the Federal
Reserve, International Swaps and Derivatives Association (ISDA) defined three
key pillars for collateral management:

37. •To rapidly put in place robust Portfolio Reconciliation practices to detect
significant trade population and valuation differences that could give rise to
disputed collateral calls. The Fed 16 dealers have already made strides towards
reconciling portfolios on a daily basis.
•To set out a Roadmap for Collateral Management focusing on independent
amount risk issues; electronic communications that will standardize margin calls;
portfolio reconciliation; CSA review; and the development of best practices for
collateral management. Many of these recommendations are on track for
implementation by year-end.
•To develop a new Collateral Dispute Resolution process for the industry.
Collateral Management Is Growing in Complexity as Well as Scale
While mitigating counterparty risk, several of the ISDA recommendations place
greater demands on collateral management systems.
Daily portfolio reconciliations alone necessitate more robust collateral
management capabilities.
Over time, the ability to sustain continued growth and understand counterparty
risk on a global basis will require greater interoperability—significantly reducing
the ability of collateral systems to remain in silos. Ultimately, these
interconnections will promote enterprise wide collateral management

38. Understanding OTC derivatives collateral
Collateral for OTC derivatives is most commonly provided under an ISDA Credit
Support Annex (CSA) or similar arrangement. Where collateral has been posted by
a counterparty under a collateral arrangement, the company will generally have the
right if the counterparty defaults to liquidate such collateral and apply the proceeds
to amounts payable by the failed counterparty under the derivative contract.
Where the company has posted collateral and the failed counterparty is holding the
collateral, under the terms of the standard CSA, the counterparty must return the
posted collateral if it defaults. If the collateral is not returned immediately, the
company can set-off and withhold payment of any amounts payable by the
company to the failed counterparty up to the amount of the collateral.
Rights to liquidate or set-off against the collateral for derivative contracts are
protected by certain safe harbours under the US Bankruptcy Code and, for
example, will generally not be subject to automatic stay (such set-off rights will be
especially valuable if the company has a bilateral master netting agreement with the
counterparty as it would be able to set-off payments across all derivatives
agreements with the counterparty).

39. Complications can arise, however, where a bankrupt counterparty holds collateral
in excess of the company's obligations to it. In that case, a key question is whether
such excess collateral remains property of the company or is part of the bankruptcy
estate of the defaulting counterparty, in which case the company may only have an
unsecured claim for the return of its collateral.
One consideration is whether the company has granted re-hypothecation rights to
the counterparty (that is, the contractually negotiated right of a secured party under
a CSA to sell, pledge, assign, invest, use, commingle or otherwise dispose of the
posted collateral). If so, and if the counterparty has commingled the collateral with
its own assets or transferred such collateral to a third party, the company's right to
return will be subordinated to the third party's rights in the collateral and may be
treated as an unsecured claim.
Similar concerns can arise even if the company has not granted re-hypothecation
rights, but the collateral has not been segregated and identified on the books of the
counterparty as collateral of the company posted for the benefit of the counterparty
as a secured party under the CSA.
These issues may be addressed by changes to the structure of the collateral
arrangement and improvements to the underlying collateral documentation.

40. CONCLUSIONS
Present efforts to move OTC derivatives to CCPs involve the following:
i. A significant increase in overall collateral needs.
ii. Some netted positions will need to be unbundled.
iii. Duplicating risk management teams (at CCPs) which already exist at large
banks.
iv. Public authorities will have to supervise more SIFIs, as CCPs will effectively be
SIFIs. Furthermore, existing SIFIs (i.e., the large banks/dealer) will retain OTC
derivative positions (nonstandard contracts, end-user exempted positions, foreign
exchange contracts, ―netted‖ positions, etc).
v. Regulatory arbitrage will increase—stemming from commodity caps in the U.S.,
and from the ―push out‖ clause in the Dodd-Frank act.

41. vi. Re-hypothecation, or churning of collateral will decrease, as much of the
collateral at CCPs will be segregated at the client’s request or, in bankruptcy
remote structures.
vii. Derivative warehouses will be created that are more akin to ―concentrated risk
nodes‖ in global finance.
viii. CCPs will be viewed under the payment/settlement rubric. They will thus
likely garner CB support and taxpayers could well be on the hook again to bail-out
CCPs.
These regulatory steps seem unlikely to adequately reduce systemic risks or excess
rents from OTC derivatives, and the likelihood of future taxpayer bailouts appears
to remain significant. Taxing derivative payables would be a good alternative (or a
complementary solution while regulations are finalized). Explicitly recasting the
OTC market infrastructure as a public utility might be another option, although this
would need to be accompanied by stronger steps to eliminate cross-border
regulatory arbitrage.

42. QUESTIONS???

43. THANK YOU