Chatham Financial Counterparty Risk and Collateral Protect

7/27/2019 Chatham Financial Counterparty Risk and Collateral Protect

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Overview:

Counterparty risk is the risk that your counter-

party may not be able to make payments due

under a contract. To migate this risk, pares may

oen require the posng of collateral to cover

some or all of the potenal losses in the event of

a default.

The current method of using collateral to migate

counterparty risk in the over-the-counter (OTC)

derivaves market is accomplished through the

negoaon of bilateral credit

support arrangements.

The Dodd-Frank Act promotes central clearing as

the primary method for managing counterparty

risk. In central clearing, a central counterparty

steps in between the pares to a derivaves

contract and becomes the buyer to every seller

and the seller to every buyer.

Various rules and regulaons require central counterpares to manage the potenal risk of customer de -

fault in a number of dierent ways. With regard to protecng customer collateral, two models exist under

the regulaons: (i) the Futures Model, which currently governs futures transacons, and (ii) the LegallySegregated Operaonally Commingled or LSOC) Model, which the CFTC has required for cleared OTC

swaps.

The LSOC Model oers customers greater protecon than the Futures Model against fellow customer risk

because a non-defaulng customers margin cannot be used to cover the losses stemming from another

customers default.

However, under both models, a customer may sll share pro rata in losses due to operaonal

mismanagement or investment risks.

The End-User Guides to Derivaves RegulaonCounterparty Risk and Collateral Protecon

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PROPRIETARY ALL RIGHTS RESERVED


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Overview

When a party enters into a derivave contract, it faces

the risk that its counterparty may not be able to make the

payments due pursuant to the contract. When a party

is uncomfortable with that credit risk, it may require its

counterparty to post collateral to cover some or all of that

risk. This guide explores the treatment of counterparty riskand collateral under:

(i) A bilateral credit support agreement, which is

the current method of using collateral to migate

counterparty risk in the OTC derivaves market; and

(ii) The clearing environment, which is soon to be

mandatory for many OTC derivaves pursuant to the

Dodd-Frank Act.1

This guide will also explore two dierent models for collateral

protecon within the clearing environment: the Futures Model

and the Legally Segregated Operaonally Commingled (or

LSOC) Model.

Credit Support Agreements in the

Tradional Bilateral Environment

Historically, the posng of collateral in OTC derivave

transacons has been accomplished through bilateral credit

support agreements. Under a credit support agreement,

pares to a transacon have two main opons to migate

against dierent risks in the event of a counterparty default.

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Variaon MarginPares may agree to post collateral, somemes as oen as daily

based on the current market value of the trades. The marking

to market process involves calculang the gain or loss on each

contract, using reported market prices if available. Subject to

certain terms, a party will then either post collateral equivalent to

the corresponding loss or receive collateral for the corresponding

gain. This collateral, generally known as a variaon margin,helps protect both pares. If a party defaults and owes money

on the derivave, its counterparty is protected by the variaon

margin the defaulng party has posted. If a party defaults and is

owed money on the derivave transacon, its counterparty can

set-o the amount it owes on the derivave with the variaon

margin held by the defaulng party.

Variaon margin, however, does not eliminate al

counterparty risk. For example, if the market moves between

the me a party defaults and the me its counterparty is

able to terminate (liquidate) the derivaves, the marke

value of the derivaves may no longer match the value

of the posted variaon margin. The dierence in value

between the posted variaon margin and the market value

of the trade could be signicant if the market undergoes a

large movement.

Independent Amount and Inial MarginIf a party is concerned about this potenal risk, it can collec

addional collateral, called an independent amount,

which may cover the ancipated market movement during

any potenal liquidaon process. Under standard credit

support agreement terms, the independent amount overcollateralizes the trades by a certain amount, and wil

remain posted unl the trades have an asset value greate

than the independent amount. Alternavely, pares may

modify the standard terms in a credit support agreement to

require that a specic independent amount remains posted

unl the derivave matures or is terminated, regardless o

the value of the derivave. Collateral that remains posted

even when the trades have an asset value greater than the

value of the collateral, generally is called inial margin.

Although both independent amount and inial margin

provide protecon for the party that receives it, they

create risk for the party that posts it. If the party holding

the independent amount or inial margin defaults

its counterparty faces the potenal loss of any over

collateralizaon. In fact, if the market moves in favor of the

party posng the independent amount or inial margin

and its counterparty defaults, the party can end up losing

both its variaon margin and its independent amount/

inial margin.


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Central Clearing

The Dodd-Frank Act promotes central clearing as the

primary method for managing the counterparty risk

described above in OTC derivave transacons.2 Central

clearing is the process in which transacons are processed,

guaranteed, and seled by a central counterparty (CCP

or clearing house) that steps in between the two pares.3Contracts submied for clearing are novated to the CCP,

meaning that the CCP essenally becomes the buyer to

every seller and the seller to every buyer.4 Central clearing

is already mandatory in the futures market and is currently

oponal in the OTC derivaves market. Dodd-Frank has

made clearing mandatory for certain types of enes for

certain types of swap transacons.

CCPs manage the risk of counterparty default in a number

of ways, including by liming clearing privileges to its

members, who must meet high capital and operaonalstandards. These requirements are a barrier to entry

for most end users (or customers). As a result, the

Commodies and Futures Trading Commission (CFTC)

permits clearing members to clear transacons on their

own behalf (house transacons) and on behalf of

customers (customer transacons). In turn, clearing

members guaranty the performance of their customers

to the clearing house. To work with customers, a clearing

member must be registered with the CFTC as a Futures

Commission Merchant (FCM) and the clearing house

must be registered with the CFTC as a Designated Clearing

Organizaon (DCO).5

DCOs also require that FCMs contribute to the DCOs

guaranty fund, which acts as a capital reserve in the even

of the default of one or two of the DCOs largest members

If a default occurs, the DCO can ulize the guaranty fund

to sasfy the liabilies of its defaulng FCMs.6 Further

the DCO can impose monetary assessments on FCMs i

available margin, guaranty fund deposits, and the DCOs

own capital contribuon are exhausted in a default.7

In addion, DCOs manage counterparty risk by requiring

their FCMs to post inial and variaon margin for the

transacons they clear (separately for customer and

proprietary transacons). DCOs calculate, collect, or return

variaon margin at least daily.8 FCMs correspondingly

calculate, collect, or return margin from their customers

based on each customers porolio of posions, to sasfy

their DCOs customer margin requirements as well as thei

own.9 The DCOs inial margin requirements are designed

to cover potenal losses incurred by market movemen

while liquidang trades in the event of a default. For OTC

derivaves, the DCO must collect enough inial margin to

cover 5 days of market movement with a 99% certainty.10

If an FCM defaults and fails to make a variaon margin

payment to the DCO, the DCO can immediately liquidate the

posions and margin and net out the FCMs obligaons.11

Similarly, if a customer defaults, the FCM may use the

margin that customer has posted to meet that obligaon.

CHATHAMFINANCIAL.COCHATHAM FINANCIAL | 235 Whitehorse Lane Kennett Square, PA 19348 | T 610.925.3120 | F 610.925.3125



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Risks of Central ClearingThere is sll a risk that a customer faces under the central

clearing model. An FCM could default under a couple

scenarios, including: (i) a customers loss that exceeds both the

customers collateral and the FCMs ability to pay (a double

default);12 (ii) shoralls due to losses from the permied

investment of customers collateral or due to operaonal

risks, such as negligence or the of customer funds (not a

usual occurrence), or shoralls when liquidang non-cash

collateral.13

Several models exist to protect customer collateral in the event

of an FCM default, including the model currently used by the

futures market (the Futures Model), and the model the CFTC

has required for the cleared OTC market (the LSOC Model).

Protecon of Customer Collateral

The Futures ModelThe Futures Model requires that FCMs and DCOs segregate

customers collateral funds from the FCMs collateral for its

own house posions; however, an FCM can commingle all

of an FCMs customers collateral in one account. Under the

Futures Model, the DCO does not have informaon about

each of the individual customers posions.

Double DefaultIf there is a double default, the DCO will aempt to idenfy

the customers collateral and facilitate the transfer o

customers posions to a non-defaulng FCM, or they may

transfer the customers in a group with the enre custome

margin account. The transfer of customers accounts may

be dicult, however, because the DCO will have to obtain

informaon from the defaulng FCM as to which customers

are in default and which posions belonged to defaulng

customers (which would not be transferred).14 The DCO

will not immediately know if a shorall will occur and, if so

how much it will be.

How one customers margin may be used to cover a

defaulng customers posions is determined by the DCO

default resources package or waterfall.15 This waterfal

governs the order in which the DCO ulizes various funds

in order to sasfy debts arising from a double default, as

follows:




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While this default resources package exists, to date, no

customer has actually lost any collateral due to anothercustomers default under the Futures Model.

Shoralls Due to Operaonal or Investment RisksTo the extent that an FCM holds a customers margin within

its customer account, the customer faces the risk that

operaonal errors or investment risks could result in losses

to the customer in the event of a bankruptcy. For example,

the collateral lost at MF Global was not collateral held by

the DCO, but was collateral held by MF Global, which MF

Global appears to have mismanaged.16

1. Margins of Defaulng Customer and Defaulng FCM

2. Defaulng FCMs Remaining Collateral, Equity, and

Guaranty Fund Contribuon

3. Non-Defaulng Customer Margin

4. The DCOs Capital and Guaranty Fund Contribuon

5. The Non-Defaulng FCMs Guaranty Contribuons

6. Assessment to Non-Defaulng FCMs

The DCO ulizes various funds in order to

sasfy debts arising from a double default

The DCO will aempt to idenfy the various customers posions, liquidate the

defaulng customers posions, and apply the defaulng customers collateral to

sele the defaulng customer posions. The DCO also liquidates the defaulng

FCMs house posions and applies the FCMs house collateral to sele the FCMs

house posions.

If more funds are needed, the DCO applies the defaulng FCMs: (i) house collateral

(if any is le aer the defaulng FCMs house posions are seled); (ii) equity in

the clearing house (if any); (iii) the defaulng FCMs contribuon to the guaranty

fund; and (iv) any other property the DCO has from the defaulng FCM.

If there is sll a shorall, then non-defaulng customers of the defaulng FCM willhave their collateral applied first against their own posions and then against the

defaulng customers posions. Each customer will provide a pro-rata share unl

the defaulng customers posions are closed or there is no more customer

collateral remaining.

In these circumstances, the DCO will aempt to transfe

or liquidate the FCMs customer posions or collateralHowever, to the extent there is a shorall in the custome

funds, each customer ulmately shares equally in the pro

rata shares of the losses. Hence, customers do face a risk

of losing the value of their collateral if an FCM bankruptcy

results from operaonal or investment mismanagement

This is an unlikely occurrence and the rules should preven

it, however MF Global shows that these events can occur.



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Finally, if the DCO needs to liquidate non-cash collateral as

a result of any of the above events, there is a risk that the

customer would not receive the full value of their collateral

if they or other customers have posted non-cash collateral.

While non-cash collateral is valued at a hair-cut, it is

possible that the market may move in such a way that the

collateral becomes insucient to sasfy a loss. As a result,

any nal shorall would be shared on a prorated basis withall customers.

Protecon of Customer Collateral

The LSOC ModelEecve November 8, 2012, the CFTC will require that FCMs

and DCOs ulize the LSOC Model for cleared swaps.17 The

LSOC Model does not apply to futures transacons. Broadly

speaking, the LSOC Model provides greater protecon to

customer collateral than the Futures Model.

The LSOC Model sll allows for the FCM and DCO tocommingle all of a FCMs customers collateral in one

account. Unlike the Futures Model, however, the FCM is

required to provide the DCO with informaon about the

identy of each of its customers and the amount of cleared

swap collateral held at the DCO and aributable to each

customer daily.18 In addion, the DCO will have to hold

the gross margin of each customer, rather than just the

net margin of all the customers of an FCM.19 Accordingly,

if an FCM defaults, it may be easier for the DCO to transfer

customer posions than under the Futures Model. Note,

however, that some commentators have claimed that the

LSOC Model would cause increased delays in the transferof customer posions.

Double DefaultIf a double default occurs, the LSOC Model ulizes the same

waterfall as the Futures Model, with one key disncon

a DCO may not use the collateral of any non-defaulng

customers to sasfy the payment obligaons arising from

the default.20 As a result, the LSOC Model oers customer

greater protecon against fellow customer risk for cleared

swaps then for futures.

Shoralls Due to Operaonal or Investment RisksIn the case of shoralls due to operaonal or investmen

risks, the LSOC Model is the same as the Futures Model

If the FCM loses collateral due to mismanagement, as in

the case of MF Global, the loss would sll be taken by

customers on a pro rata basis.

Lastly, although the amount of each customers collateral is

tracked at the DCO, the DCO does not know what specic

collateral (i.e., a specic bond or agency) belongs to which

customer. Therefore, if the DCO needs to liquidate non

cash collateral as a result of any of the above events, there

is a risk, as menoned above, that there could be a shora

aer liquidaon which would be shared on a prorated basi

with all customers.

Due to these remaining risks, some market pares are

pushing for addional protecons above and beyond the

LSOC Model. Many large funds would like full physica

segregaon of collateral. The CFTC is considering allowing

this choice and evaluang its permissibility in light of

exisng bankruptcy laws.


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End Notes1 See Protecon of Cleared Swaps Customer Contracts and Collateral; Conforming Amendments to the Commodity Broker Bankruptcy Provi-

sions, 77 Fed. Reg. 6336 (Feb. 7, 2012).2 Id. at 6336.3 Id. at 6337.4 Id.5 Id.6 Id. at 6338.7 Id.8 Id. at 6337.9 Id.10 Id. at 6338.11 Id. at 6337. While a CCP can use house margin to meet obligaons in either the clearing members house account or customer account, a CCP

cannot use customer margin to meet a default in the clearing members house account. Id. at 6338.12 Id.13 Id. at 6340. A customer does not face risk that their collateral will be impacted by: (i) the default of a fellow customer of their FCM, without

triggering a default by the FCM, or (ii) the default of another FCM of the DCO. With regard to the former, the FCM will sasfy any outstanding

debts of the customer without accessing any other customer funds. With regard to the later, the DCO will sasfy any outstanding debts of the

defaulng FCM without accessing any non-defaulng FCMs customers collateral.14 Id.15 Id. at 6338.16 A FCM may hold customer collateral without passing it to the DCO for a few reasons:

Under the Futures Model, the FCMs only need to provide the net margin of all its customers to the DCO. As a result, the FCM

may hold excess collateral that it did not have to post to the DCO;

An FCM may require a customer to post addional collateral beyond that required by the DCO, and the FCM would hold onto these

addional funds; and

Some customers would over-collateralize or leave excess collateral with the FCM to reduce the operaonal burden of constantly

posng and calling collateral.17 Id. at 6336.18 Id. at 6339.19 As referenced in endnote 4, under the Futures Model, customer margin is posted by an FCM to a DCO on a net basis based on the total expo-

sure across all the of FCMs customers collecve porolios. For example, if the FCMs customers collecvely enter into an equivalent number

of long and short posions, the FCM would post zero margin. Under the LSOC Model, customer margin is posted by an FCM to a DOC on a

gross basis, meaning that each customers margin is posted to the DCO.20 Id. at 6337.



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Contact Informaon

Version 1.0

August 2012: First version of this online guide. All Rights Reserved.

DisclaimerThe informaon in this document is for informaonal purposes only and should not be used as legal, accounng, nancial or regulatory

advice. The informaon in this document is not intended as a substute for appropriate professional advice. The impact of the Dodd-

Frank Act and related laws will vary for any parcular situaon based upon numerous factors; therefore, you should not act upon any

informaon in this document without seeking an appropriate professional legal, accounng or nancial advisor. No responsibility is

assumed for the accuracy or meliness of any informaon in this document.

About ChathamChatham Financial is the largest independent interest rate and currency risk advisory, and a recognized leader in accounng

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responsiveness to more than 1,000 rms globally. Through our work on tens of thousands of complex nancial transacons

Chatham has married deep capital markets experse with best-in-class technology. For the past two years Chatham ha

been acvely engaged in the policy debate over eecve regulaon of the over-the-counter (OTC) derivaves market

playing a lead role in the legislave and regulatory rulemaking process for Title VII of the Dodd-Frank Act.

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Structured Finance Advisory Services

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Advisory Services

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Chatham Financial Counterparty Risk and Collateral Protect