SOURCE: Derivatives Special Report

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S O C I E T E G E N E R A L E, NOW INCLUDING NEWEDGE: FULLY-INTEGRATED, FRONT-TO-BACK GLOBAL MARKETS SOLUTIONS SOCIETE GENERALE’S TOP TIER RESEARCH, INVESTMENT, RISK MANAGEMENT & FINANCING CAPABILITIES. NEWEDGE’S BENCHMARK PRIME SERVICES CROSS-ASSET. LISTED OR OTC. AGENCY OR PRINCIPAL ACCESS TO 125+ MARKETS AND EXECUTION VENUES SELECT HOW YOU CONNECT SGCIB.COM THIS COMMUNICATION IS FOR PROFESSIONAL CLIENTS ONLY AND IS NOT DIRECTED AT RETAIL CLIENTS. Societe Generale is a French credit institution (bank) and an investment services provider (entitled to perform any banking activity and/or to provide any investment service under MiFID except the operation of Multilateral Trading Facilities) authorised and regulated by the French Autorité de Contrôle Prudentiel et de Résolution (“ACPR”) (the French Prudential and Resolution Control Authority) and the Autorité des Marchés Financiers («AMF»). This document is issued in the U.K. by the London Branch of Societe Generale, authorized in the U.K. by the Prudential Regulation Authority and subject to limited regulation by the Financial Conduct Authority and Prudential Regulation Authority. Details about the extent of our authorisation and regulation by the Prudential Regulation Authority, and regulation by the Financial Conduct Authority are available from us on request. 2014 Societe Generale Group and its affiliates. © David Despau – FRED & FARID Back Cover.indd 2 21/10/2014 19:37 CIB_MARK_NEW_210X276_EARTH.indd 1 21/10/2014 19:10
RISK MANAGEMENT such as hedge funds, with which they were not prepared to take unsecured exposure. Such CSAs were unilateral, meaning that the counterparty would need to post collateral to the bank but the bank would never post collateral to the counterparty. There has been a progressive march towards collateralising a much higher proportion of OTC business. Today, most derivative and forward FX transactions between interbank counterparties are on a collateralised basis. Business with non-banking financial institutions (asset managers, insurance companies and pension funds) is increasingly collateralised, as is some business with large corporates. In addition to an expansion in scope of the types of counterparties that are being collateralised the terms of CSAs have also become increasingly tighter. Most CSAs are now bilateral (i.e. both parties post to one another if transactions are out of the money to them), provide for daily collateral calls and have zero thresholds (the minimum mark to market before collateral is called). The move towards increasing collateralisation is driven both by momentum within the industry to reduce counterparty risk and by regulatory capital calculations which give a benefit for collateralised business. Central clearing One of the biggest regulatory changes to come out of the 2008 crisis was the move to central counterparty clearing. The precise regulations and timetables differ according to regulator but the thrust is the same – a large proportion of OTC derivative transactions will need to be cleared through a CCP. Financial end-users have the option of transacting and clearing either through a clearing broker or to become a direct member of a CCP subject to qualification criteria. Whichever route is taken, any counterparty risk which The traditional approach to counterparty risk is still an important discipline in an institution’s toolkit for managing risk would have existed bilaterally between the two counterparties is eliminated and shifted to the CCP. This change will significantly reduce the amount of counterparty risk in the system, although counterparties now have the task of quantifying their exposure to CCPs. Many institutions see their exposure to CCPs as a cost of doing business and therefore quantify their exposure to CCPs without necessarily limiting it. In many respects CCPs have become the new institutions that are “too big to fail”. CCPs have a multi-layered system of controls to mitigate counterparty risk. A default waterfall specifies how credit losses of a defaulting member will be dealt with. Losses are initially borne by the initial and variation margin deposits taken from clearing members and their clients. Individual CCPs have their own way of calculating IM requirements but global regulations stipulate a confidence level of 99% over a 5 day close-out period. In the event that margin deposits are insufficient to absorb the losses of a defaulting member, the losses will subsequently be allocated against the member’s default fund contribution, followed by a tranche of the CCP’s equity and then the surviving members’ default fund contributions. If this is still insufficient, the CCP may make additional calls on its surviving members. Initial Margin Coupled with Variation Margin (VM), the payment of an Initial Margin IM is an effective mitigant against counterparty risk. IM is paid upfront and VM is exchanged between the counterparties as a transaction moves into or out of the money. If a counterparty defaults the VM should cover the counterparty’s current market to market and the IM should provide sufficient cover against adverse market moves whilst the counterparty’s positions are closed out. IM has long been a feature of the financial markets. It was originally best known in the context of exchange traded derivatives where exchange members must make an upfront payment of IM to the exchange and also settle daily variation margin. In the OTC world the concept of IM has historically been less well developed, although is economically similar to the independent amount (IA) under a CSA. In financing transactions such as securities lending and repo the margin ratio is also economically similar to IM. For OTC derivatives it was market practice to call IM/IA only when a bank was dealing with a less creditworthy and non-prudentially regulated institution such as a hedge fund. Most collateralised OTC business has historically been conducted without an IA. Many 37 DR_Counterparty Risk.indd 37 20/10/2014 21:18
Page 1 and 2: SOURCE DERIVATIVES SPECIAL REPORT S
Page 3 and 4: CONTENTS 6 Market Review Interest r
Page 5 and 6: CONTENTS 51 Technology Mastering da
Page 7 and 8: DTCC is proud to be recognized by R
Page 9 and 10: MARKET REVIEW The size of the deriv
Page 11 and 12: MARKET REVIEW derivatives had decli
Page 13 and 14: MARKET ANALYSIS statistics from the
Page 15 and 16: MARKET ANALYSIS est rate and inflat
Page 17 and 18: SPONSORED FEATURE Who remembers Pit
Page 19 and 20: SPONSORED FEATURE asset, the need f
Page 21 and 22: COVER STORY 19 DR_Cover Story.indd
Page 23 and 24: COVER STORY ing risk; smaller, regi
Page 25 and 26: COVER STORY WWW.SHUTTERSTOCK.COM 23
Page 27 and 28: SPONSORED FEATURE to shrink or even
Page 29 and 30: Q&A AM: Non-cleared OTC is still se
Page 31 and 32: CCPs to whether the existing provis
Page 33 and 34: CCPs Resolution planning for CCP co
Page 35 and 36: RISK MANAGEMENT A revolution in cou
Page 37: RISK MANAGEMENT ty risk is still an
Page 41 and 42: RISK MANAGEMENT risk sensitive meth
Page 43 and 44: SPONSORED FEATURE Collateral has al
Page 45 and 46: Trade beyond borders That’s what
Page 47 and 48: OTC CLEARING ESMA proposes a phased
Page 49 and 50: OTC CLEARING atives without clearin
Page 51 and 52: COST OF CLEARING buy-side firm, com
Page 53 and 54: TECHNOLOGY Mastering data and techn
Page 55 and 56: TECHNOLOGY sources of collateral fo
Page 57 and 58: TECHNOLOGY SOURCE: 4SIGHT FINANCIAL
Page 59 and 60: TECHNOLOGY custodians and tripartie
Page 61 and 62: MACRO VIEW in the domestic property
Page 63 and 64: EQUITY REVIEW clinical trials and r
Page 65 and 66: Corporates & Markets What I need is
Page 67 and 68: NEW RULES SAME LEADER TRADE CDS NOW
Page 69 and 70: Q&A Q & A Survival of the fittest P
Page 71 and 72: REGULATIONS US divergence could pos
Page 73 and 74: REGULATIONS counterparties. US cons
Page 75 and 76: Q&A Q & A A trading revolution Gary
Page 77 and 78: SPONSORED FEATURE ETFs: A Growing A
Page 79 and 80: SPONSORED FEATURE ABOUT THE AUTHORS
Page 81 and 82: STRUCTURED PRODUCTS Structured cost
Page 83 and 84: Print? Digital? Editorial? Design?

SOURCE: Derivatives Special Report

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