3. Teach-in Central Clearing: Implications for Collateral Management 4th September 2013 3
EMIR regulations are an attempt by the G20 to reduce systemic risk in the banking system
They aim to bring greater visibility of derivative positions and encourage standardisation
In September 2009, the G20 committed to introducing the following changes to OTC derivative markets:
1. All OTC derivatives should be traded on electronic platforms
2. All derivative contracts should be reported to Trade Repositories
3. Where possible, derivatives should be cleared through Central Counterparties (CCP)
4. Non-centrally cleared derivatives should be subject to higher capital requirements
EMIR is part of a globally co-ordinated effort to reduce risk in derivative markets:
Europe US
Electronic Execution MIFID Dodd-Frank Act
Clearing EMIR Dodd-Frank Act
Derivatives Reporting EMIR Dodd-Frank Act
Capital Requirements for CPP Exposures Basel / CRD Basel
Bilateral Margin for Non-Cleared Swaps Basel / IOSCO Basel / IOSCO
Source: Morgan Stanley
4. Teach-in Central Clearing: Implications for Collateral Management 4th September 2013
EMIR: Key Dates
Without an exemption in place, the impact of clearing could be as soon as Dec 2013 (front-loading date)
4
Source: European Securities and Markets Authority (ESMA)
Q1 2013 Q2 2013 Q3 2013 Q4 2013 Q1 2014 Q2 2014 Q3 2014 Q4 2014
CCP application closes
Earliest that the front-
loading period could start
(6m pre Go-Live) Clearing obligation starts for IRS
Front-loading date: Swaps entered into after this
point must be cleared following the go live date.
5. Teach-in Central Clearing: Implications for Collateral Management 4th September 2013
Liquidity Policy: an Overview
5
6. Teach-in Central Clearing: Implications for Collateral Management 4th September 2013 6
The key challenge for pension schemes is to establish a liquidity policy which allows for enough
collateral in the world of Central Clearing while maintaining portfolio efficiency
Liquidity
Policy
Backloading
Exemption
Collateral
Management
Product Mix
/ Portfolio
Effects
Monitoring
and
Rebalancing
8. Teach-in Central Clearing: Implications for Collateral Management 4th September 2013 8
Backloading: Voluntarily deciding to novate legacy IRS into Clearing
Backloading involves a tradeoff between credit risks and Clearing costs
• Risk transfer to Clearing House (e.g. LCH) reduces credit exposure vs swap counterparties
• Moving swaps into Clearing will carry cost implications with it (i.e. initial margin)
-200
-100
-
100
200
300
400
500
600
700
800
A B C D
Counterparty
IRS
(pv01)
Inflation swap
(ie01)
TRS
(pv01)
Repo
(pv01)
-400
-200
-
200
400
600
800
1,000
1,200
1,400
1,600
A B C D LCH
Counterparty
IRS
(pv01)
Inflation swap
(ie01)
TRS
(pv01)
Repo
(pv01)
Sample Portfolio: Impact of Backloading IRS on RiskSample Portfolio: Risk per Counterparty
9. Teach-in Central Clearing: Implications for Collateral Management 4th September 2013 9
Variation Margin can be a source of cash, particularly where a scheme has a large number of
counterparties or significant in-the-money swaps
• Backloading in the money swaps can release cash (before initial margin impact in gilts)
• Alternative: remain bilateral and re-coupon IRS to release cash, although this incurs frictional costs
-60
-40
-20
0
20
40
60
80
100
120
140
A B C D
Counterparty
IRS Inflation TRS Repo
-60
-40
-20
-
20
40
60
80
100
120
140
A B C D LCH
Counterparty
IRS Inflation TRS Repo
Sample Portfolio: Mark to Market Impact of Backloading IRSSample Portfolio: Mark to Market (£m) per Counterparty
11. Teach-in Central Clearing: Implications for Collateral Management 4th September 2013
EMIR implementation timeline:
When does the Exemption window really start?
11
Source: European Securities and Markets Authority (ESMA)
Q1 2013 Q2 2013 Q3 2013 Q4 2013 Q1 2014 Q2 2014 Q3 2014 Q4 2014
15 Sep 2013
Portfolio Reconciliation
Dispute Resolution
Portfolio Compression
EMIR protocol
CCP application closes
15 Mar 2013
RTS now in force
CCP application window
opens
15 Mar 2014
National Competent Authority (NCA)
decision to authorise CCPs
Q4 2013
First CCPs authorised:
Clearing Member
obligations
Front loading period starts
(6m pre Go-Live)
Jan 2014 (estimated)
Trade reporting obligation to
trade repositories
Summer 2014
Clearing obligation starts
(subject to CCP authorisation)
12. Teach-in Central Clearing: Implications for Collateral Management 4th September 2013 12
Exemption Timeline:
Importance of the exemption window is relative to the amount of hedging planned for that period
Legacy ClearedExempt
Start of Pension
Scheme Exemption
Front-Loading Window
prior to Go Live Date
End of Pension
Scheme Exemption
August 2015
(if not extended)
Size of
Hedge:
50% 10% 40%
Timing:
• Most likely date for mandatory Clearing is Summer 2014
• Likelihood is that pension scheme exemption will be extended beyond August 2015
• Backloading decision is important where legacy swaps make up a high proportion of the overall hedge
• Exemption window serves to extend legacy status for hedges enacted in exemption period
13. Teach-in Central Clearing: Implications for Collateral Management 4th September 2013
Collateral Management
13
14. Teach-in Central Clearing: Implications for Collateral Management 4th September 2013
What is changing?
In a Cleared world, collateral requirements involve both non-Cleared & Cleared portfolios
Collateral amount is changing as initial margin now required
14
Cleared
%
Non-Cleared
%
Portfolio
Initial Margin
Variation Margin
Initial Margin
Variation Margin
Total Collateral Requirements
Required
Collateral
15. Teach-in Central Clearing: Implications for Collateral Management 4th September 2013
In a Cleared world, more collateral will be required due to initial margin requirements
Also, variation margin on cleared swaps must be met in cash. Hence the ability to source
cash is important.
15
Other Assets
(LDI & non-LDI)
Collateral
Non-Cleared
%
Cleared
%
Investment
Portfolio
LDI Portfolio
VM VM
IM
Collateral
Requirement
Other Assets
(LDI & non-LDI)
Collateral
Investment
Portfolio
16. Teach-in Central Clearing: Implications for Collateral Management 4th September 2013 16
Gilts
Gilts
Top Up fund
Cash for VM
Initial Margin
(LCH)
Other assets
Other assets
MTM gains
Before After Clearing
Key Points:
• Mark to Market (MTM) gains: These will sit in a
cash account unless swept into other assets
• Other assets: Using other assets to replenish the
Cash VM and Top Up Fund will pull the portfolio out
of balance. Periodic review needed
• Initial Margin: Sourced from other assets and
posted in gilts
• Cash for VM: Initial margin is often used as proxy.
Used to cover MTM moves
• Top Up Fund: this is required to replenish the Cash
VM fund. When exhausted it must be replaced by
transforming other assets.
The mix of collateral required will also change as a result of Central Clearing
The diagram below shows the impact of initial margin on an overall investment portfolio
17. Teach-in Central Clearing: Implications for Collateral Management 4th September 2013
Product Mix and Portfolio Effects
17
18. Teach-in Central Clearing: Implications for Collateral Management 4th September 2013
Product Mix: Under Central Clearing, there are several choices available to an LDI portfolio
manager when sourcing risk. The different options have different initial margin (and hence
collateral) treatment on a standalone basis.
18
Best Initial
Margin
Treatment
Worst Initial
Margin
Treatment
Gilts
Legacy swaps
Bilateral swaps (under
EUR 8bn)
Gilt repo
Cleared ‘real portfolios’ (see following
two slides)
Cleared interest rate swaps, Cleared inflation
swaps
Bilateral swaps (over EUR 8bn in 2019), TRS etc
19. Teach-in Central Clearing: Implications for Collateral Management 4th September 2013 19
Bloomberg now has an initial margin calculation tool
(using an approximate LCH methodology).
• The graph, left, shows the initial margin
requirement for IRS at various tenors (5-50 years)
[red line]
• LCH has yet to release the calculation methodology
for inflation swaps
-
10.0
20.0
30.0
40.0
50.0
60.0
70.0
5 10 15 20 30 40 50
BpsxRisk
Tenor (yrs)
Initial Margin multiples (of pv01) by tenor
for single trade only
IRS per Bberg
Product Mix: Estimating initial margin requirements is not a trivial task
Trades with different tenors will be treated differently. This is also true at portfolio level
Key points:
The pv01 multiples vary with tenor, so applying a
simple multiple is at best an approximation
It is necessary to know the mix of rates / inflation in
the liabilities and the duration for the scheme
20. Teach-in Central Clearing: Implications for Collateral Management 4th September 2013 20
-200,000
-100,000
-
100,000
200,000
300,000
400,000
500,000
600,000
700,000
800,000
0-10 yrs 11-20 yrs 21-30 yrs 31-40 yrs 41+ yrs
Riskinpv01andie01
Tenor buckets
pv01 ie01
Sample portfolio of 94 ZC Interest Rate Swaps (IRS) and 76 ZC Inflation Swaps (total liability hedge c. £4bn):
PV01 and IE01 across tenor buckets
Portfolio Effects:
Effect of combining rates and inflation in a ‘real’ portfolio
21. Teach-in Central Clearing: Implications for Collateral Management 4th September 2013 21
Scenarios
1. Rates (IRS) only (2.0m total
pv01 net*)
2. Inflation only (1.3m total ie01
net*)
3. Real portfolio (1.3m pv01 and
1.3m ie01 net*)
4. Both rates (2.0m pv01 net*)
and inflation (1.3m ie01 net*)
* Curve risk is a factor .0 mio
10.0 mio
20.0 mio
30.0 mio
40.0 mio
50.0 mio
60.0 mio
70.0 mio
80.0 mio
IRS only Inflation only Real All IRS and ILS
IMrequirement
1
IM requirement under 4 different scenarios:
2 3 4
Portfolio Effects: IM requirement constitutes a sea change in portfolio construction
Best execution will become a portfolio decision rather than being solely based on best price
Observations (initial margin required)
•Inflation is a driving factor (#2).
•Real portfolio (#3) is risk reducing
•The whole portfolio (#4) is below inflation only (#2) – due to
the real portfolio effect
Impact on Product Mix (cleared and non cleared)
Real effect: Better to source both inflation and rates through
swaps, rather than inflation swaps combined with (non
cleared) gilt repo
22. Teach-in Central Clearing: Implications for Collateral Management 4th September 2013
Monitoring and Rebalancing
22
23. Teach-in Central Clearing: Implications for Collateral Management 4th September 2013 23
Given the implications of Central Clearing, it is vital for schemes to develop a clear system for
monitoring portfolio efficiency and ensuring enough collateral is available when needed
Inputs into Decision-Making
Process:
• Backloading and exemption
choices
• Capability: are the various
legal documents (e.g. GMRA)
in place to allow flexibility?
• Product Mix (use of cleared
and non-cleared sources of
risk)
• Portfolio Effects
Outputs:
• Monitoring framework & liquidity
triggers
• Collateral waterfall (order in
which assets transformed into
collateral)
• Re-investment order for MTM
gains
• Portfolio review: periodic
rebalancing of assets back to
“ideal portfolio”
Trustee
Investment
Manager
Advisor
Set Monitoring and
Rebalancing Policy
25. Teach-in Central Clearing: Implications for Collateral Management 4th September 2013 25
Several options exist for pension schemes in a Centrally-Cleared world concerning what to clear
and when. These have credit risk, collateral and portfolio implications. Putting a solid
framework in place is an important step in retaining control of the transition process
Liquidity
Policy
Backloading
Exemption
Collateral
Management
Product Mix
/ Portfolio
Effects
Monitoring
and
Rebalancing
27. Teach-in Central Clearing: Implications for Collateral Management 4th September 2013
Appendix:
Summary of EMIR Protocol
27
28. Teach-in Central Clearing: Implications for Collateral Management 4th September 2013 28
Regulatory Technical Standards come into effect on 15 September 2013
They concern risk management of non-cleared OTC derivatives
ISDA: EMIR Portfolio reconciliation, dispute resolution and disclosure protocol (the “EMIR Protocol”)
Amends ISDA (and non-ISDA) to comply with EMIR requirements (19th July 2013)
Breach of Protocol does not give a right to terminate or constitute an event of default
Portfolio reconciliation:
All non cleared OTC derivatives outstanding as at 15 Sept 2013 to be reconciled
Reconciliation of key terms including valuation
Frequency determined by number outstanding: 500+ daily; 51+ weekly; 1-50 quarterly
Dispute resolution: Applies to all non cleared OTC derivatives.
FCs and NFCs: procedures in place to identify, record and monitor disputes.
Disputes not resolved in 5 business days to be dealt with by specific process
FCs required to report to regulator any disputes in excess of 15 days or €15m
Portfolio compression: (not part of EMIR Protocol) unilateral requirement
Applies to all non cleared OTC derivatives.
FCs (and NFCs) with more than 500 OTC non cleared with a counterparty
Procedure to regularly (at least twice per year) conduct a portfolio compression exercise.
