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Best Market Practice in Risk Mitigation
The demise of Lehman Brothers and credit downgrades of certain firms has highlighted the requirement to introduce Collateral Management into some firms, and to upgrade Collateral Management procedures in firms where it has been normal practice for some time.

Collateral Management is a risk mitigation measure designed to reduce current exposures, and is applicable particularly in OTC Derivative trades.  For example, having executed last week a 5-year Interest Rate Swap with your counterparty, the valuation (mark-to-market) process will reveal that the transaction has accumulated value in favour of either you or your counterparty.  If in favour of you, then you are ‘in-the-money’, but you have an exposure as your counterparty may not exist tomorrow (Lehmans!).  To mitigate your exposure, your firm makes a collateral call on the counterparty, resulting in cash or highly-rated bonds being received and held, until the next time valuation is scheduled.

But is your firm adopting best market practice?  Even for those firms that have been practicing Collateral Management for some time, current practices and procedures should be reviewed to ensure that exposures are being mitigated to a level acceptable to management.  Such practices and procedures include:

Frequency of Valuation (mark-to-market); if it’s been considered as adequate to revalue weekly or bi-weekly in the past, should you now be valuing daily?

Accuracy of Internal Record-Keeping; amongst the legal documentation signed with your counterparty is the Credit Support Annex (CSA) containing specific details of all aspects of exposures and collateral.  It is very likely that the CSA for each counterparty will be different from the next.  Are your collateral personnel working according to the agreed details, particularly where the CSA has been renegotiated/amended?

Accuracy of Calculating Collateral Values; where valuation reveals an exposure, are collateral values being calculated accurately?  For example, where your firm gives bonds as collateral, besides the requirement for accuracy in pricing a bond, accrued interest should be included in the calculation as it’s part of the bond’s market value.  Accrued interest can be sizeable monetary amount; for example, a quantity of EUR 50 million of a bond with a 5% annual coupon will result in accrued interest values up to EUR 2.5 million.  So if it’s not included in your calculation you’ll need to find other collateral to give the counterparty, unnecessarily.  
Similarly, ‘haircuts’ are usually applied to securities collateral and are listed within the CSA; this is a percentage to be discounted from the market value of collateral, in order to derive the collateral value.  Unless haircuts are factored-in when receiving collateral, your exposure may not be fully mitigated.

Update of Internal Books & Records; where collateral has been given or taken, whether in the form of cash or securities, it is essential that your internal books & records mirror such collateral movements.  For example, where securities you previously held at your custodian have been given to a counterparty as collateral, continuing to show such securities as still being at your custodian is not a true statement of fact, resulting in further counterparty risk issues, reconciliation ‘breaks’ and potentially incorrect calculation of income and corporate actions.

Segregation of Collateral Received
; where you have received securities collateral from a counterparty, if your intention is not to re-use (‘rehypothecate’) those securities for your own purposes, you would be taking a risk if you co-mingled those securities in the same custodian account as your own (or clients’) securities.  Unless you have very strong internal controls, such securities could accidentally be used for some other purpose (e.g. as collateral in a repo), where you no longer have possession/control of collateral received from the counterparty.  If loss of control is a possibility, you should consider holding received collateral in a segregated account at your custodian.

Recognition of Collateral Now Sold; where you have given securities collateral to a counterparty, but now that security has been sold by your trader, unless such a situation can be recognised quickly there is a risk that settlement of that sale will not occur on its due date (it will ‘fail’) and your firm will suffer a loss of interest through delayed receipt of the sale proceeds. If your internal books & records show that collateral is in the counterparty’s possession, that is a strong starting point.  But another factor is internal communication; are your settlement and collateral personnel working close enough to identify such situations?

Other transaction types creating exposures and the need for collateral include securities lending & borrowing, repo, secured cash borrowing and forward FX trades.

The spotlight has been put on Collateral Management as a primary risk mitigation measure; it’s therefore important that the detailed procedures practiced do not create other exposures for your firm.

Author: Mike Simmons
Mike is part of ICMA Centre’s Operations faculty and runs ICMA’s Collateral Management training course. He has been involved with the capital markets and operations throughout his career and is also the author of two books on operations; "Corporate Actions: A Guide to Securities Event Management” and “Securities Operations: A Guide to Trade & Position Management” both published by Wiley Finance.
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