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Importance of Valuations – and All Other Inputs - in OTC Derivatives Collateral Management

Importance of Valuations – and All Other Inputs - in OTC Derivatives Collateral Management. Scott Linden Derivatives Collateral Management Services . Agenda. Derivatives Collateral Management Overview Data Inputs and Management Identification of Valuation Issues Global Trends Conclusion.

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Importance of Valuations – and All Other Inputs - in OTC Derivatives Collateral Management

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  1. Importance of Valuations – and All Other Inputs - in OTC Derivatives Collateral Management Scott Linden Derivatives Collateral Management Services

  2. Agenda • Derivatives Collateral Management Overview • Data Inputs and Management • Identification of Valuation Issues • Global Trends • Conclusion

  3. Overview of Derivatives Collateral Management Process • Collateral - a Rapidly Growing Credit Risk Mitigation Tool • Consistent with overall growth in OTC derivatives trading • Collateral in use – increased from $719 billion year end 2002 to $1.3 trillion at year end 2005 • Growth in collateral agreements – increased from 38,500 in 2002 to 110,000 at year-end 2005 • Growth in collateralized exposure – increased from 30% in 2002 to 60% in 2005 • Reasons beyond trading growth – • Corporate credit shocks have lead to increased collateralization • Increased derivatives trading by asset managers and other new entrants • Results have led to an expansion well beyond the historic dealer to dealer and dealer to hedge fund collateral relationships Source: ISDA Margin Survey 2006

  4. Overview of Derivatives Collateral Management Process • Legal Framework • ISDA Master Agreement – netting agreement in event of default across OTC products • Credit Support Annex (New York or English law) – contains negotiated margin and collateral terms • Bilateral or Unilateral • Credit Threshold • Minimum Transfer Amount • Eligible Collateral, Haircuts, Interest Rates on Cash • Initial Margin Requirements • Valuation and Settlement Timing

  5. Overview of Derivatives Collateral Management Process Illustration of the Derivatives Margin Call Process Portfolio Valuation Communication Collateral Valuation Verification Collateral Requirement Calculation Movement of Collateral T T + 1 T + 2 T T + 1 T + 1 Source: ISDA Margin Survey 2006

  6. Data and Information Inputs • Missing, incorrect, or mishandled data from the many inputs can lead to missed or incorrect margin calls. • Areas Information • Legal ISDA agreements and CSAs • Credit Ratings and margin terms • Trade Support Trades and valuations • Custodian Services Security positions and pricing • Treasury Services Interest rates

  7. Management of Data and Margin Process Minimum In-House Support Requirements • Derivatives trade valuations • Derivatives trade warehouse • Collateral holdings and pricing • CSA term warehouse • Collateral calculation engine and • Operational resources

  8. Identification of Valuation Differences • Margin Dispute – But where is the problem? • Market Practice – calling party reconciles, disputing party provides trade report • Reconciliation Tools – all require manual formatting/manipulation over numerous iterations • Problems with reconciliations – “many to many”, trade types, novations, resets, unwinds, terminations • End Result - highlight population differences for further investigation or valuation differences for discussion with counterparty • Periodic Reconciliations – ISDA recommends at least annually • Monthly MTM Validation – Adopted byHedge funds and asset managers

  9. Global Trends Impacting Collateral Process • Market Utilities – Deriv/serv electronic confirmation, ISDA Novation Protocol, DTCC Trade Information Warehouse • Independent Service Providers – Many provide easy links to DTCC for buyside firms • Prime Brokerage-like Services – Improved reporting of derivatives valuations – web based, customized, etc. - allows for more frequent reconciliation/validation • The Next Big Thing - Market Innovation – LLCDs, CDS on MBS/ABS… ?

  10. Conclusions ? • Positive trends in market should lead to cleaner populations between counterparties. Valuation differences will be easier to identify – and resolve. • But - • Will lofty goals of DTCC Trade Information Warehouse – “golden” copy of trade with standard valuation across products with link to settlements and collateral - be realized? • Will funding of post trade process improvements remain high? • Will ISDA Collateral Clearing House ever materialize? • Will market innovation and growth outpace processing related utilities and innovation?

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