Collateral optimization and Risk Management: a buy side perspective - Enrico massignani

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Collateral Management Forum - Vienna, March 29th 2015 Enrico Massignani

Head of Risk Management

Collateral optimization and

Risk Management:a buy side perspective

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IMPORTANT INFORMATION

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CONTENT

The collateral purpose

3

Address the counterparty, market and credit riskchallenge to develop risk management measuresagainst market distress

Assess operational risk throughout the collateralmanagement process

Q&A


THE COLLATERAL PURPOSE

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Starting from the obvious...

...collateral is an asset used to secure an obligation of case by a counterparty

...it’s a guarantee that the counterparty will honour it’s obligation in due time

...it reduces or neutralize losses in case of couterparty default

collateral = counterparty risk mitigation




Post financial crisis .....

...Regulators see collateral as one of the preferred tools to mitigate systemic risk

in the financial system. For this reason they are imposing collateralization either

directly (eg. OTC clearing at CCPs) or indirectly (higher capital charges for

uncollateralized credit exposure).

...Market participants use collateral:

to gain easier access to financing

to obtain much more favorable financing conditions

to reduce capital charges

collateral = money




The financial industry has adapted quickly: collateral optimization, collateral

transformation, collateral management as a profit center.

All these practices have now powerfull incentives to be optimized around the

profitability function.

eventually market participants may be distracted away from the

basic original purpose of collateral: counterparty risk mitigation


CONTENT


7



Q&A


MARKET DISTRESS AND COLLATERAL


Market distress is generally

characterized by fly to quality

behaviour, credit quality

deterioration and defaults on

obligations.

All the above factors have

large impact on the collateral

management process

Market risk

Credit risk

Counterparty risk

Increase in price

volatility

Increase in price

volatility

Change in

correlations

Change in

correlations

Downgrades

Counterparty

downgrade or

default


MARKET DISTRESS AND COLLATERAL:MARKET RISK


Increase in price

volatility

Increase in price

volatility

Change in

correlations

Change in

correlations

• Margin calls

• Substantial increased

need of cash and other

eligible collateral

• Netted collateralized

exposures become

more volatile

(“Netting risk”)

• Market value of the

collateral and of the

collateralized

obligation may

sharply move in the

opposite direction

(“Mismatch risk”)

• Deflation of the asset

book as primary

source of collateral

(“ Availability risk “)


MARKET DISTRESS AND COLLATERAL:CREDIT RISK


• Collateral calls

• Substantial increased

need of eligible collateral

• Generalized reduced

availability of eligible

collateral

• Posted collateral

becomes ineligible

(“Eligibility risk”)

• Quality deteriorarion

of asset book as

primary source of

collateral

(“Availability risk”)

Downgrades


MARKET DISTRESS AND COLLATERAL:COUNTERPARTY RISK


• Increased cost of

novation

• Increase of netted

collateralized exposures

• Increased price pressure

on low grade collateral

• Increased operational

risk

• OTC contracts

novation (“Novation

risk”)

• OTC contracts

unwinding and

collateral liquidation

(“Unwinding risk”)

• Need to reopen

unwinded OTC

contracts

(“Reopening risk”)

Counterparty

downgrade or

default


MARKET DISTRESS AND COLLATERAL:SOME ADDITIONAL OBSERVATIONS (1/2)


Collateralized OTC derivative exposures are particularly impacted by market risk

and counterparty risk.

Hedging and netting is usually optimized on latest correlations and by

counterparty.

A sharp change in asset price volatility and correlations may cause large

unexpected increase of netted collateralized exposures.

Contracts novation or reopening with different counterparties may result in

suboptimal netting and different collateral eligibility standards


MARKET DISTRESS AND COLLATERAL:SOME ADDITIONAL OBSERVATIONS (1/2)


Collateral transformation transactions tend to be particularly affected by market

and credit risk.

Being their purpose to transform lower grade collateral into higher grade, there’s

a structural material mismatch between the secured obligation and the

correspondent collateral

Finally, market distress cause a sudden increase of collateral management

operational activities, wich increase the probability of related operational risk

events.


MARKET DISTRESS AND COLLATERAL:SOME EXAMPLES MITIGATION MEASURES (1/6)


Risk type Mitigation

Market

Netting Risk

Mismatch Risk �

Availability Risk

CreditEligibility Risk �

Counterparty

Novation risk �

Unwinding Risk �

Re-opening Risk �

Some obvious ones:

• Collateral diversification requirements• Counterparty diversification limits





Market

Netting Risk �

Mismatch Risk

Availability Risk

CreditEligibility Risk

Counterparty

Novation risk �

Unwinding Risk

Re-opening Risk

Establish maximum levels of OTC contract exposures under stressed

market risk scenarios Asses OTC contract exposures with tail risk mode correlations, as well as on a

pure gross (un-netted) basis, in order to quantify potential need of collateral.

Establish preset limits to be monitored and escalated.

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Establish minimum levels of unpledged eligible assets under stressed

market risk scenariosStress test the asset book free for hypothecation, to simulate eligible collateral

availability under severe market risk scenarios. Combine with OTC contract

exposures under stressed scenarios results. Establish preset minimum limits to

be monitored and escalated.


Market

Netting Risk �

Mismatch Risk �

Availability Risk �


Counterparty

Novation risk

Unwinding Risk

Re-opening Risk



Apply migration risk stress tests to posted/received collateral

Such tests help to understand how much of the current collateral may become

ineligible and would have to be replaced .


Market

Netting Risk

Mismatch Risk

Availability Risk

CreditEligibility Risk �

Counterparty

Novation risk

Unwinding Risk

Re-opening Risk



Establish minimum levels of unpledged eligible assets under migration risk

scenarios Stress test the asset book with migration risk. Identify the assets that would be

free for hypothecation. Quantify how much would be eligible for collateralization.

Establish preset minimum limits to be monitored and escalated.


Market

Netting Risk

Mismatch Risk



Counterparty

Novation risk

Unwinding Risk

Re-opening Risk



Stress test counterparties credit risk

Credit deterioration of a counterparty triggers the need of contracts novation to

other counterparties in order to reduce specific ctp exposure.

Netting risk limits (slide 12) need to be reassessed. Eligibility may change due to

different CSA agreements


Market

Netting Risk �

Mismatch Risk



Counterparty

Novation risk �

Unwinding Risk

Re-opening Risk



CONTENT


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Q&A


OPERATIONAL RISK AND COLLATERAL MANAGEMENT


On buy side organizations collateral management has transformed...

...from

An activity «remotely» performed in

the mid-backoffice

With weekly or even monthly

frequency

Related to very few transactions

to

An integrated front-to-back process

With daily frequency

Concerning a material and

increasing portion of assets and

transactions




Complexity and scale has dramatically increased and operational risk as a consequence.

How to address it? A few questions that need an answer:

• Are the involved departments and decision makers (Top Management, Front,

Risk Manag., Middle-BackOffice, Legal, Compliance) properly engaged and

trained?

• Is your infrastructure (systems, procedures, contracts) properly designed to

support the collateral management process lifecicle?

Finding an answer to these question is just the starting point.




Implementation risk rises the stake.

Level of integration is a critical feature:

• Similarly to any transaction processing process, low level of system and

information integration rise exponentially the probability of painfull operational

risk events.

• On the other side, integration implies considerable investment and

implementation time.

Fundamental to make sure that the organization is aware of the

trade offs to make proper design decisions


THE OPERATIONAL RISKS, UNDER TAIL CONDITIONS


Collateral management is tool to protect in case of counterparty default.

To accoplish such purpose it should work very well during defaults occurrences

and in general credit crises.

Fortunately they are infrequent events! For the CM process though means that

there are very few occasions to properly test if it works as expected during such

occurrences

Ex ante approach should be applied here. In particular:

Verify wether the organization is ready :

• to secure collateral ownership and disposal on counterparty default.

• to roll OTC derivative exposure to another ctp

Some regular tests may be one of the best options to perform such assessment


CONTENT


25



Q&A

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THANK YOU

Q&A

Collateral optimization and Risk Management: a buy side perspective - Enrico massignani

Economy & Finance

Transcript of Collateral optimization and Risk Management: a buy side perspective - Enrico massignani