Part 2 – Comparing the ISDA bilateral exposure management model with a CCP
The current bilateral exposure mitigation tools used by ISDA members provide protection in the OTC market, now is the time to learn from the CCP approach and consider what the future is for these techniques, Bill Hodgson explains.
Within the OTC derivatives world is the International Swaps and Derivatives Association (ISDA), the trade association to which all users of OTC products belong. ISDA has provided a comprehensive legal framework enabling the OTC market to grow as it has. One part of this framework is a tool to mitigate credit risk between firms called a Credit Support Annex (CSA). When this was created it drew ideas from existing Central Counter Party (CCP) services in providing ways for firms to measure and manage risk in the same layered way.
CCP credit risk management relates to the membership criteria for trading on the exchange. The membership criteria is broad, allowing many different participants from one man ‘locals’ to the major dealers. The CCP reduces credit risk to zero allowing wide access to the trading environment, but at the cost of posting higher amounts of margin than in the OTC environment.
The OTC derivatives market has a much tighter entry criteria, usually set by local regulators such as the UK FSA. A participant wanting to execute an ISDA Master agreement (and therefore begin trading) must provide considerable formal documentation (such as the articles of association, a board mandate, investment strategy and others) that they are a ‘professional counterparty’ which in most cases excludes any private individual, so restricts the market participants and the credit exposure profile of counterparties.
How do CCPs work?
Most CCPs use three layers of protection on a members portfolio, a) Variation Margin, the change in the mark-to-market of the portfolio b) Initial Margin, a measure of potential losses in the portfolio and c) a Default Fund, a stress test based pool of funds. These three layers are used to compensate members when a default occurs, for any losses or costs involved in the close out of the defaulting member. In a ‘doomsday’ scenario there are two final layers of protection, an insurance policy, and the capital of the CCP. These would only be drawn upon should the first three layers be exhausted.
How does a CSA work?
An ISDA CSA enables firms to mitigate credit exposure between themselves directly, using their own valuations of the trade portfolio usually on a daily basis. The basic calculation of exposure is the net mark-to-market of the contracts in scope of the CSA.
Most (if not all) ISDA CSAs are as shown above, with the exchange of the net mark-to-market as protection from losses. In some cases the CSA includes an Independent Amount (IA), an additional amount of margin equivalent to the Initial Margin at the CCP. The method by which the IA is calculated is usually based on a simple calculation such as a fixed amount, sometimes driven by credit rating, or a percentage of notional. In rare cases the IA will be based on a VaR calculation intended to give the parties the benefit of cross-product margin calculations. In some cases VaR based methods have been offered to hedge funds who have refused to accept such a method, partly as it is hard to replicate or verify, and partly as it is a one way call from the dealer only.
Comparing the operational processes between a CCP and an ISDA CSA, the CCP has tight time requirements for the call and delivery of collateral, plus no room for disputes on portfolio population or valuation. Any firm who fails to meet the time deadlines or wants to dispute the CCP calculations will soon find itself out of the market – the primacy of the CCP preserves stability rather than allowing for open ended dispute.
An ISDA CSA on the other hand, relies upon significant automation to gather the required trade data and valuations and correctly apply the rules of the agreement. The process then drops into what some practitioners call a “world of pain”, as the ISDA rules to govern disputes lead to issues in making the process effective. It is quite simple for a firm facing losses to dispute each and every OTC margin call to delay delivering margin to cover exposure, quite frustrating for the firm making the call.
Within an OTC portfolio of a large bank or hedge fund can be a wide range of products covering rates, equities, FX, credit and commodities asset classes, and include both vanilla and non-vanilla trades. The key to a successful margin call is that both parties have the same trade population, and similar valuations for each contract. Once either of these is out of line it is almost certain that one party will dispute the margin call, the result of which is to kick off a portfolio reconciliation to work out on a trade by trade basis any differences in population or valuation.
Given daily margin calls, the firms (in some cases) may agree to exchange collateral at the lowest agreed exposure amount, minimising protection but short circuiting the dispute process. The reconciliation using Excel or automated tools can often take much longer than one day to complete, given that some dealers will have a portfolio of a million or more open OTC trades. This means the underlying reasons for a dispute can have an effect for days at a time.
Given the urgency of this problem there are now multiple providers of portfolio reconciliation solutions including TriOptima, Markit, Euroclear, Omgeo / Allustra, and Lombard Risk. Whether the market will support multiple providers, or like trade confirmation, coalesce around one remains to be seen.
Timing is everything
With a CCP, you don’t have discretion over the timing, you must meet the margin call or face being placed into default. With an ISDA CSA there are multiple ways the call for margin and the arrival of sufficient assets can be delayed, including disputes, but also the settlement cycle of securities being two or three days. This is why nearly 80% of collateral assets are in cash, and of those 50% in USD. Cash can be delivered same day so immediately gives comfort on the financial stability of the other party.
Quality of protection
The CCP model for exchange traded products, and for OTC Interest Rate Swaps (at SwapClear) has been demonstrated to provide sufficient protection to the CCP and its members to pay out any losses from the margin collected.
For example, the default of Lehman Brothers was processed smoothly by LCH.Clearnet (in SwapClear) purely within the design parameters of the VM & IM, with a full reassignment of the Lehman trades, within 3 weeks of the default.
An ISDA CSA is not generally intended to reduce credit risk to zero, but to reflect the underlying quality of your counterparty and therefore be proportionate to their perceived risk. Some CSAs include an Independent Amount (equivalent to the IM portion at a CCP), which will cover volatile market conditions.
With this in mind, the operational differences between a CCP and an ISDA CSA reflect the willingness of the parties to accept a certain amount of risk, and therefore losses in a default.
The ultimate collapse and recapitalisation of LTCM was triggered by the inability of LTCM to meet its margin calls – but of course the margin held by its counterparties didn’t cover their losses.
Time for CSA 2.0?
As with software maybe the time has come to upgrade the ISDA CSA? There have been some dramatic suggestions to ‘fix’ the OTC market, including moving all trading onto an Exchange, putting all trades through a CCP, and a central registration system for all trades.
Each of these is so fundamental they may either eliminate the OTC market as we know it, or be unachievable from many aspects. The major worry for governments and regulators, is how to ensure a meaningful link between risk exposure and risk protection. Maybe there are some more easily implemented ideas to improve the link between risk and protection:
– If your OTC portfolio is net out of the money, you lose the right to dispute, and must accept the other parties call
– Both parties must acquire and publish a reference price for each trade, and include this in the reconciliation data if requested
– Both parties must publish the date on which the last valuation was calculated for a trade. It isn’t unknown for more structured trades to be valued manually – keeping these up to date is crucial
– The OTC industry to agree on a data format for publishing reconciliation data, enabling quick transfer and processing of such data either bilaterally or by a service provider
– Firms to achieve and maintain 99% trade reconciliation by Trade Date + 1. Despite industry efforts, current market infrastructure doesn’t solve this problem (yet)
– The industry to include an add-on margin requirement above net mark-to-market calculated using stress test scenarios in a VaR model on their OTC portfolios. Applying this requirement to the major sell-side and buy-side participants alone would be equivalent to putting the majority of the world’s OTC trades within a virtual global CCP, although without an independent arbiter of the risk measurements
Warning: VaR has been widely criticised as being unable to predict the ‘fat tail’ events such as the drop in CDO asset values. If you share this view, any add-on amount of margin is by definition never going to be enough. Readers can now debate whether we have built a house of cards on the foundations of a model which is never going to protect us from disaster. For those who want a supporting view, watch Nassim Nicolas Taleb on BBC Newsnight tell an economist and the viewers exactly what he thinks of VaR, follow this link: http://bit.ly/wGQO
The current crisis is often mentioned in the same breath as illiquid assets where they are difficult or impossible to value. The CCP model will (probably) never allow such products into their space, as there is no way to offer protection on such complex products. The ISDA CSA is the only line of defence between firms in the OTC markets, and is a framework on which further protection could be built.
The ISDA CSA provides a foundation for a wide range of OTC contracts and isn’t strictly comparable to the way a CCP processes standardised exchange traded products. Firms always have the choice of avoiding volatile products, making the margin call less prone to disputes. ISDA and its Collateral Committee work continuously to review the use of the CSA in the market and already have a programme in place to tighten the dispute process.
Isn’t it time to blend the experience of both markets and upgrade the financial technology to give firms a higher level of protection and a positive feedback loop to associate higher margin levels with illiquid products and to balance banks enthusiasm for such risky trading?
Follow up points for practitioners
Firms must maximise the effectiveness of their exposure management techniques. Adsatis can provide advice and help on a range of points including:
– Achieving effective portfolio reconciliations
– Your mix of collateral assets and their effects on exposure reduction timing gaps
– Using an Independent Amount to collect some equivalent of Initial Margin, providing better protection against market volatility
– Monitoring the timeliness of valuations, especially for complex products or trades supported on spreadsheets
– The latest thinking on cross-asset and cross-process exposure management within your ISDA Master, or across asset classes
Part 3 – Coming Soon!
Part 3 of this series takes a more global view of risk management and proposes a plan to build a research tool for the benefit of the world capital markets.