Clearing & Collateral

A brief introduction into Clearing and Collateral

Management
October 2013

For internal use only!

Table of Content
1 Executive Summary (JS) ................................................................................................... 7
2 Introduction - Collateral and Clearing under new Regulations (JS)............................... 8
3 ETD Clearing (AF) .............................................................................................................. 9
4 OTC Clearing (SM) ............................................................................................................10
4.1 CCPs (TS) .................................................................................................................. 10
4.1.1 Overview of CCPs (TS) ...................................................................................................... 11
4.1.2 Segregation of collateral at CCPs (TS) ............................................................................... 11
4.1.3 Default waterfall (TS) .......................................................................................................... 12
4.1.4 Connectivity to CCPs (AF) .................................................................................................. 13
4.2 Current OTC derivatives clearing (SM).................................................................... 13
4.3 OTC clearing under new regulations (SM) .............................................................. 13
4.4 Process Changes / Gap Analysis (SM) .................................................................... 14
4.4.1 Process changes (SM) ....................................................................................................... 15
4.4.2 Clearing Obligation (TS) ..................................................................................................... 15
4.4.3 Data requirements (TS) ...................................................................................................... 17
4.4.4 Clearing Exemptions (TS) ................................................................................................... 18
4.5 Clearing Broker (TS) ................................................................................................. 19
4.5.1 FCM (TS) ........................................................................................................................... 19
4.5.2 SCM (TS) ........................................................................................................................... 21
4.6 Margining at CCPs (SM) ........................................................................................... 22
4.6.1 Different margin requirements (SM) .................................................................................... 23
4.6.2 Margining process (SM)...................................................................................................... 24
4.7 Legal documentation (JS) ........................................................................................ 24
4.8 Cost of clearing (JS) ................................................................................................. 26
4.9 Sapient Offerings (SM) ............................................................................................. 26
4.9.1 Client Clearing Portal (SM) ................................................................................................. 26
4.9.2 Expansion of CCP Coverage / Clearing Connectivity Standard (SM) ................................... 28
5 Collateral (SM) ..................................................................................................................30
5.1 Eligible collateral (SM) .............................................................................................. 30
5.2 Collateral process (SM) ............................................................................................ 31
5.2.1 Collateral requirements (SM) .............................................................................................. 31
5.2.2 Processes (SM) .................................................................................................................. 31
5.2.3 Software Provider (SM) ...................................................................................................... 32
5.3 Collateralization via CSAs (AF) ................................................................................ 32
5.4 Margining for non-cleared derivatives under EMIR (TS) ........................................ 33

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 5.4.1 Requirements (TS) ............................................................................................................. 33
5.4.2 Timeline (TS)...................................................................................................................... 35
5.5 Legal documentation (JS) ........................................................................................ 36
5.6 Collateral Mitigation (AF).......................................................................................... 36
5.7 Sapient Offerings (SM) ............................................................................................. 37
5.7.1 Target Operating Model (SM) ............................................................................................. 37

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Table of Figures
Figure 1 Current OTC derivatives clearing (sample) ......................................................... 13
Figure 2 OTC clearing under new regulations (sample) .................................................... 14
Figure 3 Clearing process ................................................................................................. 15
Figure 4 Generic FCM model ............................................................................................ 20
Figure 5 Generic SCM model ............................................................................................ 21
Figure 6 Initial vs. Variation Margin ................................................................................... 22
Figure 7 Portal (Landing Page) ......................................................................................... 27
Figure 8 Portal (Dashboard) .............................................................................................. 28
Figure 9 CCP Coverage .................................................................................................... 29
Figure 10 Target Operating Model .................................................................................... 37

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List of Tables
Table 1 Future OTC derivative obligations .......................................................................... 8
Table 2 Overview of CCPs ................................................................................................ 11
Table 3 Clearing Thresholds under EMIR ......................................................................... 16
Table 4 EMIR Clearing Obligation Matrix .......................................................................... 17
Table 5 Margining in CCPs ............................................................................................... 23
Table 6 Legal Documentation for Clearing Member .......................................................... 25
Table 7 Legal Documentation for Client Clearing .............................................................. 25
Table 8 Collateral Pool per CCP ....................................................................................... 31
Table 9 Standardized Initial Margin Schedule ................................................................... 34
Table 10 Standardized Haircut Schedule .......................................................................... 35

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List of abbreviations
AP Affirmation Platform
BCBS Basel Committee on Banking Supervision
BO Back Office
CB Clearing Broker
CCP Central Counterparty
CFTC Commodity Futures Trading Commission
CM Clearing Member
CRD Credit Rate Derivative (Derivative)
CRD Capital Requirements Directive (Basel)
CRR Capital Requirements Regulation (Basel)
CSA Credit Support Annex
DCM Direct Clearing Member (Eurex)
DCO Derivative Clearing Organization
DFA Dodd-Frank Act
DRV “Deutscher Rahmen Vertrag”
EC European Commission
EMIR European Market Infrastructure Regulation
ESMA European Securities and Markets Authority
ETD Exchange Traded Derivative
FC Financial counterparty
FO Front Office
FX Foreign Exchange
FCM Future Commission Merchant
GCM General Clearing Member (Eurex)
IOSCO International Organization of Securities Commissions
LCH London Clearing House
LCR Liquidity Coverage Ratio
LSOC Legally segregated and operationally commingled
IRD Interest Rate Derivative
ISDA International Swaps and Derivatives Association
MiFID Markets in Financial Instruments Directive
MSP Major Swap Participant
NCM Non-Clearing Member (Eurex)
NFC+ Non-Financial Counterparty above clearing threshold
NFC- Non-Financial Counterparty below clearing threshold
OTC Over-the-counter
SCM SwapClear Clearing Member
SD Swap Dealer
SEC Security and Exchange Commission
SIMM Standard Industry Margin Model
SSI Standard Settlement Instruction
TR Trade Repository
USI Unique Swap Identifier
UTI Unique Trade Identifier
VaR Value at Risk

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 1 Executive Summary (JS)
Collateralization and clearing of derivatives are already now important capital markets business
processes. Both topics will become even more important because of new regulatory requirements
(e.g. EMIR and Dodd-Frank) that will introduce mandatory collateralization and clearing. Market
participants - including corporates - will be affected differently by these new regulatory requirements.
However all market participants will have to adapt to changes in the derivatives trading and
processing environment. Besides market participants will have to re-think and define their clearing
and collateral target operating model and related process effectiveness.

This document is split into two main parts. While the first part deals with clearing the second part
focuses on collateralization. In both parts the current processes are described and gaps are
identified that need to be closed to ensure compliance with the new regulatory requirements. In
addition more detailed information is provided on certain relevant topics, e.g. legal documentation. At
the end of each part the Sapient offerings are described that relate to the topics covered.

This document is intended to provide a thorough overview of the collateralization and clearing
processes as well as new regulatory requirements. Above that it can be a sound foundation to ramp
up knowledge in this space.

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 2 Introduction - Collateral and Clearing
under new Regulations (JS)
Clearing and collateralization are established processes among large OTC derivative market
participants. However for smaller market participants and corporates these processes are new
and need to be established. While currently clearing and collateralization is performed on a voluntary
basis new regulations (e.g. EMIR, Dodd-Frank, CRD IV/CRR) will impose or promote mandatory
clearing and collateralization for certain OTC derivative products and market participants. The
following pillars provide a high-level overview of the future OTC derivative obligations.

Table 1 Future OTC derivative obligations

Source Own Illustration

It becomes obvious that the OTC derivative product as well as the counterparty status trigger
different mandatory processes or lead to exemptions. Because of that the interaction between
instrument static data and counterparty static data becomes more important. But not only the
interaction becomes more important but also data maintenance and data accuracy requirements will
increase as well as the timely / immediate availability of such data.

The new regulations will come into effect gradually. However market participants should evaluate
these changes timely and pro-actively not only to ensure compliance but also to look at process
optimization (IT and business). In addition these new regulations will have an impact on the trading
relationships and respective processes. It is fair to assume that these new regulations in sum will
change the way OTC derivatives are traded and processed.

Besides the new regulations market participants will need to review their existing clearing and
collateral processes and come up with a Target Operating Model. Process efficiency and costs
associated with clearing and collateral should be key aspects. Depending on the business model
market participants might also want to explore new growth opportunities and offer clearing and
collateral related services such as client clearing. These market participants will have to
differentiate their offerings from offerings of comparable market participants.

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3 ETD Clearing (AF)

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 4 OTC Clearing (SM)
OTC Clearing means that all ‘standardized’ over-the-counter derivatives are cleared (and settled)
through regulated derivatives clearing organizations (DCOs/CCPs).

OTC Clearing means that a CCP steps into a bilateral OTC derivative transaction. After that
both counterparties have a separate transaction with the CCP and there is no bilateral transaction
between the initial bilateral counterparties anymore. The rationale behind OTC Clearing is to
mitigate credit and default risks as well as a standardization of process.

LCH.Clearnet, the International Derivatives Clearing Group, CME, Eurex and Intercontinental
Exchange (ICE) are among those who provide derivative clearing services in the U.S. and Europe.

4.1 CCPs (TS)

A Central Counterparty (CCP) is an own legal entity that steps into a transaction of their members
as the contractual partner to both counterparties. Therefore, there are two possibilities given:
open offer and novation. By stepping into transaction, credit risk for counterparties is reduced and
trading limits are discharged.

While CCP is often used in Europe, the term Derivative Clearing Organization (DCO) is more
common in the US. Both terms are used equivalent, meaning exactly the same.

Clearing via CCPs shall ensure the following aspects with the CCP serving the following functions:
Reduce transaction costs
Post trade management functions
Financial management of clearing members collateral deposits
Final settlement of outstanding obligations through financial payment or physical delivery
Risk management of market participants
Financial guarantee of performance of its contracts

In order to fulfill all tasks mentioned above, a CCP is usually well capitalized, is highly regulated
and supervised by authorities and demands high financial ratios from financial institutions to
become a clearing member. Moreover, clearing members have to place a contribution to CCPs
default fund. This is usually a mixture of a base contribution (minimum requirement) and a risk-
1
based component, depending on clearing members risk towards CCP .

Condition of clearing membership like financial requirements and creditability is defined by each
CCP. It is common that there are different classes of clearing memberships, e.g. in case of Eurex
Clearing General Clearing Member (GCM) and Direct Clearing Member (DCM), which are
described in more detail in chapter 4.1.4.

Another possibility to access a CCP is via a Clearing Broker (CB) that is clearing member of a
CCP by itself. The different types of CB, like SCM or FCM, are explained in chapter 4.5.

1
For further information visit homepage of Eurex Clearing “http://www.eurexclearing.com/clearing-
en/resources/faqs/” or SwapClear “http://www.swapclear.com/service/becoming-a-member.html”.
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 4.1.1 Overview of CCPs (TS)

In general, CCPs have to be certified by authorities (e.g. ESMA) meeting a bundle of functional
and organizational requirements, which are out of scope of this document.

Both, the new EMIR regime and the Dodd-Frank Act, require a full set of products across all asset
classes for mandatory clearing. Thereby, a bottom-up approach is applied whereby authorities
include derivative types in mandatory clearing list after CCPs ability for clearing is proven.
Nevertheless, a top-down approach is also foreseen where authorities determine independently
from CCPs ability that a specific product requires to be cleared. This could be because of traded
volumes or otherwise identified importance for financial stability.

An overview of currently available CCPs under EMIR regime with its specific offering of clearable
asset classes is given in the following figure.

Table 2 Overview of CCPs

2
Source ESMA, Clearing Obligation under EMIR, Discussion Paper

4.1.2 Segregation of collateral at CCPs (TS)

The bankruptcy of Lehman Brothers in 2008 brought to light that posted collateral was not where
it was supposed to be. Thus, market participants as well as global regulators focused on security
of collateral in case a clearing member fails. Besides stabilization of CCPs default funds,
segregation and portability of collateral has become very important.

Under DFA client collateral is quite simple, as there is only one approach allowed: Legally
separated, operationally commingled (LSOC).

In contrast EMIR requires at least two models that have to be provided by each CCP: omnibus
account and individual segregation. But, EMIR does not specify these approaches further and

2
Discussion Paper is available at http://www.esma.europa.eu/consultation/Discussion-Paper-
Clearing-Obligation-under-EMIR.

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 leaves the market with a range of different interpretations. This leads to a plenty of different
models and hybrids. Currently, more than 15 models are available at major CCPs. Consequently,
clearing members have to decide which model they are offering to their clients.

Nevertheless, each model has to be compliant to local bankruptcy laws and needs to be
approved by local regulators and by ESMA.

The three major models mentioned before will be described briefly in following passages.

The omnibus account provides the lowest level of security. The clearing member can commingle
client’s collateral with collateral from other clients and post margin on a net basis. Obviously, this
riskier approach is cost saving and operationally simpler. The omnibus account is available with
net and with gross approach. The problem with the omnibus account addresses the risk of a
double default in which a defaulting client takes down the clearing member. Thereby, client’s
collateral can be consumed.

The LSOC is a model, where client’s collateral can also be commingled, but besides posting
collateral on a net basis to CCP a detailed report has to be sent to CCP, too. In case of clearing
member defaults, the CCP guarantees that non-defaulting clients will receive mark-to-market
value of their assets. So client’s margin is not used to meet the margin obligation of another
defaulting client. Nevertheless, the client will not receive its posted collateral, what is problematic
for fund managers as they are bearing costs of reinvestment. A further shortage comes from the
restricted possibility of portability in case a clearing member is under stressed conditions. The
“LSOC with excess” is a subtype where client collateral is even more protected as it is hold directly
at CCP.

The highest level of protection is provided by the individual segregation, where collateral of each
client is segregated. With this model client collateral is segregated from both clearing member and
all other clients. Furthermore, the accounts are completely replicated at CCP, making portability
easy. This model is the most cost intensive one, as it has high requirements to account
management at CM and CCP side. Moreover, CM will lose netting effects making this model even
more expensive. This approach has not been tested in a default situation yet. The individual
segregation is the bases for two further models worth to mention: full asset segregation with the
client clearing directly with CCP and quad-party segregation where collateral remains with a
custodian. The last model is in discussion but already preferred option from fund managers. It is not
clear if custodians are allowed for quad-party segregation or if only central securities depositories,
such as Clearstream or Euroclear, can be used.

4.1.3 Default waterfall (TS)

One central question with regards to CCPs market participant and clearing members are interested
in is what happens in case of a default of a clearing member. Although all clearing houses have
their own specific rules, a more or less similar default waterfall method in order to fund the debts of
defaulting clearing member applies as best practice at all major CCPs.
3
In general, the default waterfall presents mostly as follows :
1. Initial Margin of the Defaulter
2. Default fund contribution of the defaulter
3. Capital Reserves of CCP
4. Default fund contribution of other clearing members

3
More information can be found at relevant under Eurex Clearing
“http://www.eurexclearing.com/clearing-en/resources/faqs/”; LCH.Clearnet
“http://www.lchclearnet.com/Images/2a%20Default%20Waterfal-l%20Ltd%200.1_tcm6-63514.pdf”.
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 5. Insurance, if any
6. Additional payment of other clearing members
7. Assets remaining within CCP
8. Closure of CCP

Deviations in the generic waterfall model described above are possible in the area usage of paid
Initial Margin of other clearing members (ICE Clear Europe) or an additional payment liability
(SwapClear) for other clearing member.

Please note that Dodd-Frank Act requires a separate default procedure for each company, leading
in case of LCH.Clearnet to four different default waterfalls with different and separated default
funds. This is because LCH.Clearnet operates with a subsidiary structure – one company for each
asset class.

Before a potential closure of CCP as a final solution is performed, the realistic opportunity of a
public bail-out exists by socializing costs with public. This solution might attract more interest in
the future as authorities are currently shifting risk from market participant to CCPs by clearing
obligation of OTC derivatives. Thereby, they create enormous systematic risks.

4.1.4 Connectivity to CCPs (AF)

4.2 Current OTC derivatives clearing (SM)

Traditionally OTC derivatives have been bilateral and operationally intensive, with non-
standard and manual processes and technologies throughout the trade life cycle.

Currently to enter into an OTC contract (meaning a derivative contract not traded on a derivatives
exchange) a dealer (counterparty) needs to be selected and before trading a legal framework such
as an ISDA Master Agreement, AFB/FBF or Deutscher Rahmenvertrag für Finanztermingeschäfte
with that counterparty needs to be negotiated and signed. In addition, the parties may include a
Credit Support Annex or other collateral agreement to collateralize positions, depending on their
perception of credit risk against each other. Transactions executed between the parties are then
governed by those arrangements. The key proposition is that these transactions are private
contracts between two parties, as follows:

Figure 1 Current OTC derivatives clearing (sample)

Source Own Illustration

4.3 OTC clearing under new regulations (SM)

The European Market Infrastructure Regulation (EMIR), the Dodd-Frank Wall Street Reform and
Consumer Protection Act (Dodd-Frank) and other new regulatory initiatives require that certain
derivatives are mandatorily centrally cleared via central counterparties.

This legal requirement poses various challenges to the industry operationally, technically and
legally. Central clearing of standardized OTC derivatives is an important aspect of these changes

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and will necessitate end-users establishing new contractual agreements with each clearing
member. Additional new legal documentation will also be required between each clearing
member and CCP. It is prudent for clients to have relationships to multiple clearing members, and
each clearing member will need relationships with multiple CCPs to ensure that different products
can be cleared. Therefore the operational risks and costs of creating and maintaining the
multiple layers of legal documentation will be substantial.

The clearing obligation applies to all OTC derivatives contracts once the applicable thresholds
above are reached. For further information see chapter 4.4.2.

Key features of the Client Cleared OTC Derivatives Addendum

Netting Sets
Valuation of transactions following a client default
Disapplication of client’s termination rights
Pre-default porting
Collateral

The relationship between the end-user and the dealer will continue, but the dealer, in its capacity as
a clearing member of the clearinghouse, will act as a clearing agent for the end-user. The
relationship between the end-user and the clearing member will continue under a new customer
agreement, e.g. modified ISDA Master Agreement, and the clearing member will be subject to the
clearinghouse rules:

Figure 2 OTC clearing under new regulations (sample)

Source Own Illustration

Key elements of the regulatory technical standards:

For OTC derivatives not cleared by a CCP: indirect clearing arrangements, clearing
obligation procedure, public register, access to a trading venue, non-financial
counterparties and risk mitigation techniques.
For CCPs: Capital requirements, retained earnings and reserves as well as the format of
the records to be maintained.

4.4 Process Changes / Gap Analysis (SM)

With the regulations of the OTC business following areas are impacted:
Central Clearing
Exchange Trading
Trade Reporting
Margin and Capital
Exceptions

The market participants are anticipating significant resource, infrastructure and cost
implications due to the OTC client clearing regulations.

Regulatory and business drivers and the resulting issues and considerations:
Central clearing / new capital, margin and segregation rules / exchange and clearing
memberships / cross-jurisdictional and border considerations => Target Operating Model
(TOM)
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 Multiple CCP and exchange connectivity / trade reporting requirements => Infrastructure
changes
Trade and portfolio reconciliations / policies and strategies for margining / policies and
models for credit risk management => Risk Management
Client infrastructure requirements => Client onboarding

4.4.1 Process changes (SM)

The clearing process places the clearinghouses in the middle of the trade, by a transfer
(commonly referred to as a “give up” or “novation”) of each cleared trade to the clearinghouse.

Figure 3 Clearing process

Source Sidley, “Preparing for OTC derivative clearing”

In the clearing process now the clearinghouse becomes the counterparty to both party’s (buyer and
seller), effectively guaranteeing performance of each party’s obligations under the transaction. The
clearinghouse reduces the credit risk (settlement netting, valuation, margining and the capital
requirement for clearing members), operational risk (by standardizing), systemic risk and the legal
risk. In the end, the centralized clearing of OTC derivative leads to more transparency, liquidity
and lower counterparty risk.

4.4.2 Clearing Obligation (TS)

This chapter deals with the clearing obligations under DFA and EMIR. In order to define if a specific
transaction is subject to the relevant regulation, two perspectives are necessary: counterparty
attributes and product attributes.

The Dodd-Frank Act demands mandatory clearing obligation in case at least one of the
counterparties is a US person. Thereby, US person as per definition of DFA is any legal entity that
is incorporated in the US, not incorporated in the US but with its primary place of business in the
US or that is guaranteed by another US person. Moreover, there is an extension for funds in
place: a fund (legal entity) managed by a US fund manager is also a US person. Please note that
the status of a market participant (Swap Dealer, Major Swap Participant or Other) is subject to
entity requirements by DFA but irrelevant for clearing obligation as only compliance dates are
different for different subjects.

The product perspective is pretty more complex. The Dodd-Frank Act applies for all OTC traded
“swaps”, whereas the term “swap” can be interpreted as every derivative that is not a future.
Nevertheless, the regulative bodies, CFTC for swaps and SEC for security-based swaps, excluded

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 4
some product types from scope, such as :
FX swaps and forwards
Physically settled commodities
Energy and agricultural commodities
Embedded option in cash product

The attitude that a specific product type is in scope of DFA does not qualify automatically for the
clearing obligation. The clearing opportunity by CCPs has to be given as well (upstream
regulation). Besides, regulative bodies have also the possibility to force CCPs for clearing ability
(downstream regulation), e.g. when transaction volumes are high or the specific product type is
considered as systemic relevant for other reason. An overview about product types that are
currently subject to clearing obligation is provided on the CFTC homepage.5

In contrast to DFA EMIR clearing obligation is slightly different at least on a counterparty level:
besides the country of incorporation an EMIR classification becomes relevant too. In general,
EMIR is applicable to each legal entity within the EU, also if the other counterparty is located
outside the EU. Moreover, EMIR classifies legal entities in financial counterparties (FC), non-
financial counterparties above a clearing threshold (NFC+) and the ones below threshold (NFC-).
Clearing obligation is only subject to FCs and NFCs+ incorporated in the EU. The thresholds are
based on notional value and are as follows:

Table 3 Clearing Thresholds under EMIR

6
Source ESMA, “What does EMIR mean for non-financial institutions?”

Please note that only speculative OTC derivatives count towards the clearing threshold. In case a
clearing threshold is exceeded the non-financial counterparties has to start clearing all eligible OTC
derivative products in all asset classes on a group-wide basis.
The product perspective is similar to the DFA approach. All products that have to be cleared
mandatorily will be published in a register that is maintained and made public by ESMA.
Additionally, EC has to approve all product types added on this list. In total this can last up to 18
month. Therefore, ESMA is able to follow two approaches too: bottom-up and top-down, forcing
CCPs to develop clearing ability for certain products. Differences between DFA and EMIR are
significant in product scope as EMIR also includes ETD business. In order to define product
scope EMIR references to MiFID, Annex 1 Section C. Embedded options are also excluded like
covered bonds and FX asset class (still under discussion).
Although the clearing obligation has not become effective at time of writing (October 2013), a
proposal for products qualifying for clearing has been published by ESMA and is currently under

4
Please note that the provided list is not exhaustive.
5
More detailed information can be found at:
“http://www.cftc.gov/PressRoom/PressReleases/pr6607-13”
6
Article is available for download at “http://www.esma.europa.eu/system/files/emir_for_non-
financials.pdf”
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 7
discussion. Please note that intragroup transactions can be excluded from clearing obligation
too, what is described more detailed in chapter 4.4.4.

The combination of country of incorporation and EMIR classification on the one hand and the list
of qualified product types results in the following matrix describing clearing obligation under EMIR:

Table 4 EMIR Clearing Obligation Matrix

Source Own Illustration

Counterparty Counterparty OTC derivative stated in ESMA register Mandatory

1 2 (EMIR Article 6) Clearing

FC FC Y Y

FC NFC+ Y Y

NFC+ NFC+ Y Y

NFC+ NFC- Y N

FC NFC- Y N

NFC- NFC- Y N

4.4.3 Data requirements (TS)

Based on the before mentioned clearing obligations several new data is required in deal capture
systems in order to determine if a transaction has to be cleared or not:
Static data of counterparty
Flag, if product is subject for mandatory clearing
Accessible clearing houses

Whenever a financial institution registered as Swap Dealer or Major Swap Participant at CFTC or
SEC is entering into a transaction with a US person Dodd-Frank Act becomes applicable and
transaction has possible clearing obligation. Thereby, a legal entity is a US person either by
country of incorporation, by principal place of business, by guarantee of other US person or
by US fund manager in case of funds.

Along with the US person feature information about possible end-user exception (described in
next chapter) is needed. This information can only be provided by counterparty itself.

Similar information about EMIR classification is needed for clearing obligation under EMIR, as
only NFC- and intragroup transactions (conditions briefly described in next chapter) are exempted.

Additionally, Front Office has to know if counterparty signed in all relevant contracts in order to be
compliant and not infringing national laws. Usually, counterparties have to sign an ISDA or DRV
Annex for each regulation as well as other contracts which are described in chapter 4.7 more
detailed.

Static counterparty data in combination with product statics, i.e. officially subject to mandatory

7
ESMA, Clearing Obligation under EMIR, available at
http://www.esma.europa.eu/consultation/Discussion-Paper-Clearing-Obligation-under-EMIR.

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clearing, finally determines clearing obligation of specific transaction. This in turn also influences
prices and spreads.

Another data needed in Front Office is information about access to different clearing houses,
either as membership or via a Clearing Broker. As a transaction can only be cleared at one clearing
house contractual partners has to agree on a specific one. Thus, information about access is
needed. An established approach in financial market is that buy-side suggests a specific clearing
house and sell-side agrees.

The new regulations also introduced new transaction identifiers - Unique Swap Identifier (USI) for
Dodd-Frank Act and Unique Trade Identifier (UTI) for EMIR. In future, transactions are identified by
these identifiers only. Moreover, they are part of the confirmation. Thus, best practice would be to
agree on USI or UTI between traders or sales persons like all other trade details such as SSIs,
fixing dates or calendar.

Not only Front Office systems are affected by new regulations in terms of new data necessary, but
so are Back Office systems. In order to achieve timely confirmation and perform risk mitigation
techniques all data mentioned above have to be fed by Front Office systems to BO systems or
implemented in BO systems directly, e.g. counterparty statics, clearing data, transaction identifiers
or information about legal contracts.

4.4.4 Clearing Exemptions (TS)

In general, internal (e.g. back-to-back trades) and intragroup transactions are excluded from
clearing obligation in both regulations. While internal transactions are legally no transactions as
counterparties are the same, intragroup transactions are treated differently. They are out of scope
for Dodd-Frank Act by definition, but within EMIR preliminary registration at and agreement from
ESMA is required. Please note that there is still the reporting obligation for intragroup transactions
under EMIR.

Dodd-Frank Act contains an End-User Exception from mandatory clearing requirement,

companies can qualify for. In order to do so, companies have three requirements to meet for each
transaction:
Not a financial entity
Swap used to hedge or mitigate commercial risk
Notification of CFTC or SEC about how to meet financial obligations of non-cleared
transactions

In case one of the counterparties qualifies for end-user exception the transaction can be cleared
bilaterally as before. Nevertheless, higher capital and margin requirements make the transaction
drastically more costly.

In contrast EMIR doesn’t know any clearing exceptions. Whenever a transaction or more precisely
a product type is qualified for mandatory clearing this product has to be cleared even if the
counterparty is incorporated outside the EU. This has to be managed by a bilateral contract or an
ISDA agreement.

Besides some few supranational or national organizations like IMF or KfW, which are explicitly
mentioned in regulations, only Non-financial Counterparties below the clearing thresholds (NFC-)
are exempted from EMIR’s clearing obligation. In case of intragroup transactions the clearing
obligation is also not applicable. This covers the “Sparkassenverbund” and “Genossenschafts-
verbund” too, meaning that clearing or collateral obligation between “Sparkassen” or “Volks- und
Raiffeisenbanken” is not a topic.

In summary, new OTC derivatives regulations do not allow many exceptions from clearing

© COPYRIGHT 2013 SAPIENT CORPORATION | CONFIDENTIAL 18

obligation. Mainly only smaller or medium-sized companies aiming hedging activities for their
commercial activity can benefit from clearing exceptions. Coexistent, bilaterally cleared tranactions
are becoming more costly with financial institutions passing additional costs to their clients, either
by worse prices or by wider spreads.

4.5 Clearing Broker (TS)

Besides a direct membership with a CCP using a Clearing Broker (CB) is another option in order
to get transactions cleared. The CB itself has to be a clearing member at CCP. This option is quite
interesting for medium-sized or smaller banks (tier-II and lower) with lower volumes of transactions
that have to be cleared at specific CCP as costs could be saved. In contrast clearing brokerage
could be a good business case for larger banks (tier-I).

Several legal agreements between clearing broker and client have to be made, what is described
more detailed in chapter 4.7.

Two essential clearing models are established in global financial markets: SwapClear Clearing
Member (SCM) and Futures Commission Merchant (FCM). Whereas the SCM model is the
preferred model in Europe, the FCM model is dominating the US market. All available clearing
models are derivative from these two models. Which model a CB can use, depends on regulation
and membership types of CCP. Both models are described in next chapters.

Using a clearing broker doesn’t guarantee that a transaction is really cleared at a CCP. It’s more
that both, the CCP and the CB can refuse to clear a specific transaction with a specific
counterparty. In case the specific transaction is subject to mandatory clearing it will be cancelled,
otherwise the transaction remains in place and has to be cleared bilaterally. This means that three
limit checks are needed in Front Office:
Limit with CCP
Limit with CB
Limit with Counterparty

4.5.1 FCM (TS)

The FCM model could be also described as an agent model, whereby CCP becomes contractual
partner of both, the buyer and the seller. Thereby counterparty credit risk is reduced.

The main vehicle for clearing is the novation process, meaning that the counterparties are
substituted by CCP. Technically, two new transactions are created (β and γ), whereas the original
transaction (α) is terminated.

Within the FCM model the CB is responsible for settlement, margining and above all, guarantees
client’s obligation of the transaction to CCP. The complete performance of end-user’s obligation
has to be guaranteed.

© COPYRIGHT 2013 SAPIENT CORPORATION | CONFIDENTIAL 19

 Figure 4 Generic FCM model
Source Own illustration

Concrete processing of a common FCM model:

1. Agreement between counterparties
2. The transaction is entered in Affirmation Platform (AP) and the CB is assigned
3. The AP propagates the transaction to the CB
4. The CB accept the transaction and confirms acceptance to the AP
5. The AP sends the accepted transaction to the CCP
6. The CCP accept the transaction and novates counterparty to CCP
7. The CCP sends affirmation notice to AP
8. The AP propagates novated transaction to the counterparties FO system

The FCM model becomes more popular as Dodd-Frank Act requires client domiciled in the US to
clear with CB registered with the CFTC as FCMs. This is the reason why SwapClear, an entity of
LCH.Clearnet responsible for clearing IRD, introduced FCM model along with already existing SCM
8
model .

Moreover, FCM model allows client to clear directly at CCP, substituting counterparty risk with risk
of CCP.

8
Further information can be found at “http://www.swapclear.com/service/becoming-a-member.html”
© COPYRIGHT 2013 SAPIENT CORPORATION | CONFIDENTIAL 20
4.5.2 SCM (TS)

The SCM model, mainly used in Europe, is a principal model. The CB becomes a real
counterparty towards its client. Thus, CB has no longer the function of a guarantor, but is directly
involved into the transaction.

Although novation process to CCP remains almost the same, three transactions are created now:
Client and CB (β1), CB and CCP (β2) and finally, CCP and other counterparty (γ).

Figure 5 Generic SCM model

Source Own Illustration

Generically the process flow is:

1. Agreement between counterparties
2. The transactions is entered in Affirmation Platform (AP) and the CB is assigned
3. The AP propagates the transaction to the CB
4. The CB accept the transaction and confirms acceptance to the AP
5. The AP sends the accepted transaction to the CCP
6. The CCP accept the transaction and novates counterparty to CCP
7. The CCP sends affirmation notice to AP
8. The AP propagates novated transaction to the counterparties FO system

As demonstrated there is no difference in novation process compared to FCM model. The only
change is the contractual partner – CB instead of CCP from client’s perspective.

The SCM model is easier to handle as no connectivity or legal agreements are needed with
CCP. Moreover, the model is more flexible as one CB (β1) can provide access to several CCPs
(β2) with one standardized process and connection. Only free limit for CB is necessary (besides
limit for contractual partner as CB still has right to refuse clearing).

© COPYRIGHT 2013 SAPIENT CORPORATION | CONFIDENTIAL 21

Besides the advantages of the SCM model there are also weighty disadvantages. First of all, client
remains with credit risk of CB instead of CCP. Secondly, limits with CB are strongly charged,
avoiding other desirable business. Finally, Basel III regime charges CB for each transaction, i.e.
trasaction with client and with CCP. Also for clients capital requirements are higher as credit risk of
CB is applied rather than CCP’s credit risk. Higher costs will be passed to clients. Furthermore,
leverage ratio of CB deteriorates.

Due to the disadvantages of SCM model as well as the requirement for FCM model by DFA, it is
expected that SCM model will be abolished in medium-term, forcing clients and CB to change their
clearing offerings and legal documentation. All notable CCPs are offering FCM model to their
members in the meantime.

4.6 Margining at CCPs (SM)

Margin is defined as the cash or securities which must be deposited by CCPs or Clearing
Members as collateral for a given position. The aim of margin is to minimize the risk of default
by counterparty clearing member. The payment of margin ensures that the risk is limited to the
previous day’s price movement on each outstanding position. Margin is like a security deposit or
insurance against a possible loss of value. There can be different types of margin like initial
margin, variation margin, maintenance margin, additional margin and premium margin

The initial margin is the amount required to open a position, the losses during the day must be
met by depositing of future collateral – known as variation margin (also known as MTM), which is
required by the close of business on the following day. Any profits on the contract are credited to
the client’s variation margin account. The variation margin needs to be paid in cash. The
maintenance margin is required in order to keep an open position. This is the minimum required
amount for a margin account. The additional margin covers all possible additional costs of closing
a position and the premium margin is used for all options where the premium must already be
paid by the seller when the option transaction takes place.

The following figure illustrates changes in value between transaction date and the date of the
margin call:

Figure 6 Initial vs. Variation Margin

Source David Murphy, “The Systemic Risk of OTC Derivatives Central Clearing”

An effective CCP will clear many OTC derivatives. Typically this will result in significant net
positions and hence calls for large amounts of margin. Thus for instance in 2010 LCH had cleared
$248 trillion notional of interest rate swaps, and had taken € 58.5 billion of margin.

There are two different initial margin calculation methods, which are usually VaR based (can use

© COPYRIGHT 2013 SAPIENT CORPORATION | CONFIDENTIAL 22

any number of scenarios, typically 1.250 or 2.500 scenarios) or SPAN (use 16 scenarios) based.

The VaR (Value-at-risk) margin is a margin intended to cover the largest loss that can be
encountered. The SPAN (Standard Portfolio Analysis of Risk) margin system was developed to
replace the so-called strategy-based margin system. SPAN calculates the maximum loss for a
position and references the margin rate to calculate the gain or loss in the position. A further
system of margin requirements called portfolio margining, whereby combined positions of stock
and options on that stock can be offset each other, and is only available for large customers. With
the cross margining agreements the allocated margin can be more efficient used on different
exchanges/clearinghouse, the collateral savings can be as high as 50-75% with the effect of lower
costs and greater financial flexibility. Eurex is planning to use the portfolio based margin approach
called Prisma, which will cover all products and permits cross margining between products.

CCP Recalculation:
Basic: Manually intensive process using ad-hoc calculators and excel driven. Calculations are
overnight or T+1.
Maturing: Semi-automated process with periodic feeds from CCPs and calculators provided to
some clients in a non-sustainable manner.
Best-in-class: Fully automated process with predictive modeling to project next day’s margin calls.
Offered through portals or integrated within client applications.

Scale-Up/Down:
Basic: Scale-Up/Down calculated on a per-CCP/per legal entity basis.
Maturing: Scale-Up/Down calculated across some CCPs and some legal entities taking into
account netting opportunities.
Best-in-class: Single Scale-Up/Down margin calculated across all CCPs and legal entities taking
into account netting opportunities.

Overview – Margining in CCPs:

Table 5 Margining in CCPs

Source Own Illustration
Clearing House Calculation Further information
LCH Clearnet SPAN Margining methodology for derivatives
SwapClear Global PAIRS Margining SwapClear
CME SPAN CME CORE: Clearing Online Risk Engine
Eurex Margin Process
ICE Futures US SPAN SPAN Margin System
Margin Requirements
Margin Rates
ICE Futures Europe SPAN Margin Rates
ICE Futures Canada SPAN Margin Rates

4.6.1 Different margin requirements (SM)

The margin requirements will change significantly for products that become centrally cleared.
Variation margin is typically required to account for changes in the prices of the contract in bilateral
trades but initial margin, which protects against counterparty or credit risk, is used with much
variation where it is used at all. This use has, in part, depended on the nature of the counterparty; a
long-only buy-side fund does not carry the same risks as a hedge fund engaging in speculation.

Under the central clearing process, both counterparties will be required to post both initial margin

© COPYRIGHT 2013 SAPIENT CORPORATION | CONFIDENTIAL 23

and variation margin with the central counterparty or clearing member. Calculation of the
margin, getting hold of, and then posting the assets required for collateral, will be a new and
complex process for some firms.

In the area of margin management there have been two different workflows until now. For
exchange-traded derivatives, there is a well-established procedure with the exchange making
the margin calls overnight. Due to the long-standing nature of these arrangements, they are
processed using relatively old technology in many firms, with a report produced once a day. On the
other side, bilateral OTC derivatives trade, requiring more up-to-date technology used for
collateral management and with a function to dispute margin calls where needed.

Under the new rules, both initial and variation margin are applicable to all centrally cleared trades.
The way that margin calls need to be handled for cleared derivatives is a hybrid between the two
existing models.

4.6.2 Margining process (SM)

The clearing member must deposit margin before commencing dealing on exchange. Each day
a further amount must be deposited or will be returned, depending on the results of the day’s
trading activity.

The margin account is updated on a daily basis and the maximum loss that must be made up on
any morning is the maximum price movement that occurred the previous day.

If a clearing member is unable to meet the margin call the exchange will order it to cease
further trading and will close open positions in the account; any losses will be met out of the
firm’s margin account. If the levels of funds in the margin account are insufficient, the losses will
be made good from funds paid out of a general fund run by the clearing house, which is maintained
by all members of the exchange. Client positions will be transferred to a back-up clearing
member.
The payment of margin is made by electronic funds transfer between the trading party’s bank
account and the clearing house. Initial margin is often paid in cash, although clearing houses will
also accept highly quality securities, to the value of the margin required. The realized variation
margin is only paid in cash.

4.7 Legal documentation (JS)

The legal documentation is a crucial aspect of the clearing process since the legal documentation
defines the rights and obligations of the parties during the whole clearing life-cycle. Although
agreements can be negotiated bilaterally standard agreements are commonly used. These
standard agreements are based on established ISDA agreements (please note that respective
agreements are also available based on German Master Agreements - “Deutscher
Rahmenvertrag”) and agreements provided by the respective CCP.

The following table shows the legal documentation that is required from a Clearing Member
perspective to clear own transactions.

© COPYRIGHT 2013 SAPIENT CORPORATION | CONFIDENTIAL 24

Table 6 Legal Documentation for Clearing Member
Source Own Illustration
Agreement Purpose Signing Parties

Clearing Counter-
CCP
Member party

ISDA Master Establishes the basic legal framework for

Agreement derivative transactions between two X x
counterparties.

Cleared Derivatives Supports the existing ISDA Master

Execution Agreement with clearing specific aspects
Agreement (ISDA) which are required since the ISDA Master X x
Agreement was intended to be the legal
framework for non-cleared derivatives.

Clearing Establishes the relationship between the

Membership Clearing Member and the CCP. The Clearing
Agreement Membership Agreement is the final
agreement at the end of the “on-boarding”
X x
process. The Clearing Membership
Agreement references to the Rules of the
respective CCP which become legally
binding.

The following table shows the legal documentation that is required to set up a Client Clearing
relationship. The setup involves the following parties: Client (of a Clearing Member), Execution
Broker (Counterparty of the Client), Clearing Member as well as CCP (e.g. LCH).

Table 7 Legal Documentation for Client Clearing

Source Own Illustration
Agreement Purpose Signing Parties

Execution Clearing
Client CCP
Broker Member

ISDA Master Establishes the basic legal framework for

Agreement derivative transactions between two X X
counterparties.
The Clearing Agreement creates a
(Client) Clearing
modified ISDA Master Agreement which
Agreement
governs the swap transactions between
the Client and the Clearing Member that
are registered for clearing. The intention is
to supplement the standard ISDA Master X X
Agreement with regards to clearing
specific aspects. It is assumed that an
ISDA Master Agreement is already in
place between the Clearing Member and
the Client.
The give-up agreement authorizes the
Give-up
Client to enter into transactions on behalf X x
Agreement
of the Clearing Member and to agree that

© COPYRIGHT 2013 SAPIENT CORPORATION | CONFIDENTIAL 25

 transactions between the Client and the
Execution Broker may be novated to
become transactions between the Clearing
Member and the Execution Broker.
The Deed of Assignment is a trilateral
Deed of
agreement between the Clearing Member,
Assignment
Client and CCP. The Clearing Member
grants security interest to the Client over X x x
the receivable due to it from CCP which
relates to the Client’s transactions and
collateral posted by the Clearing Member.
The Compensation Agreement provides
Clearing
that if the Clearing Member does not
Compensation
accept a transaction executed between the
Agreement
Client and the Execution Broker, the
Execution Broker can require that X X
compensation be paid for any cost or
expense that is incurred upon the close-
out of a position resulting from the
executed transaction.

4.8 Cost of clearing (JS)

Clearing involves different types of costs. While some costs are flexible others are fixed. A
thorough cost assessment should be part of a CCP selection process. In case of client clearing
the clearing broker will likely pass some of the costs to the client. Please find below a list of typical
costs:
Membership Fee
Technical Fees (connectivity to CCP)
Clearing Fee (per cleared transaction)
Maintenance Fee (reflecting the maintenance of cleared transactions)
Collateral Fee (per collateral transaction)
Price Alignment Interest (interest on variation margin received)
Contribution to CCP default fund

Above that market participants should assess how clearing will affect them from a cost perspective.
To assess the “cost of clearing” different scenarios should be applied (e.g. ratio of clearable
products in comparison to un-cleared products, use of a clearing member (as clearing broker)
against direct CCP membership) and measured against the current costs (un-cleared
environment).

4.9 Sapient Offerings (SM)

4.9.1 Client Clearing Portal (SM)

Using observation-based techniques, Sapient developed a database-backed web application with
intuitive interfaces that connect to clearinghouses and enable client’s end users to make more
informed trading decisions. By layering reporting capabilities on top of a user-centric portfolio view,
the portal design unlocks analysis capabilities for value added services, such as margin
optimization, trade lifecycle management, risk mitigation and what-if scenario analysis.

© COPYRIGHT 2013 SAPIENT CORPORATION | CONFIDENTIAL 26

 The landing page gives an overview of the margin calls, a graphical overview of the daily margin
(Margin Monitor), the portfolio mark to market, the collateral value, the what-if scenarios and the
reporting.

Figure 7 Portal (Landing Page)

Source Sapient

The user can navigate via the Dashboard to further detailed pages with more information about the
client reporting, margin calls, reconciliations (internal or external), valuations and portfolio analytics
(Initial margin scenarios).

© COPYRIGHT 2013 SAPIENT CORPORATION | CONFIDENTIAL 27

Figure 8 Portal (Dashboard)
Source Sapient

4.9.2 Expansion of CCP Coverage / Clearing Connectivity Standard (SM)

Sapient has helped various clients to become a clearing member of a CCP. In addition Sapient has
supported clients defining a client clearing strategy as well as the related implementation.

© COPYRIGHT 2013 SAPIENT CORPORATION | CONFIDENTIAL 28

Figure 9 CCP Coverage
Source Sapient

The Clearing Connectivity Standard (CCS)

Working with ISDA, the Standard covers cleared IRS and CDS trade, position, margin, and
collateral data for LCH and CME products.
The scope is currently being expanded to include NDFs and engagement with ICE and
Eurex is ongoing.
Custodian Service Providers, led by State Street, BNY Mellon & Northern Trust, approached
Sapient in October 2011 to gather information on data formats and reach a consensus that
would become the industry standard.
Derivatives customers, notably large asset managers, have approached their Clearing Firms
to request compliance with CCS.
Clearing Firms are cooperating with the Standard both because of client interest and to
streamline their operations.
The account level Summary Report of CCS has been finalized as of 3/15/13, and constituent
banks have committed to an implementation schedule culminating in a go-live date of
6/10/13.
Further information can be found at https://www2.isda.org/functional-areas/technology-
infrastructure/clearing-connectivity-standard-ccs/

© COPYRIGHT 2013 SAPIENT CORPORATION | CONFIDENTIAL 29

5 Collateral (SM)
Collateral refers to assets (cash or securities) that are posted by the counterparties to secure
their transactions. Collateral management is the process used to control counterparty or client
assets against the exposure calculated as part of the risk management process. Most importantly,
collateral management ensures that margin requirements are covered by available collateral. If
there is a collateral shortfall, a collateral call is generated. If there is a collateral excess, a
collateral release is generated (automated or upon member request). The evaluation of collateral
can be complex. Collateral needs to be evaluated on an ongoing basis to ensure adequate
coverage of risk exposure. Note that collateral is deposited as initial margin payment.

5.1 Eligible collateral (SM)

The eligible collateral is one of the important aspects in the collateral management.

The clearing houses have rules regarding collateral eligibility apply depending on whether the
collateral is posted as initial or variation margin. For initial margin they accept generally cash or
other highly liquid collaterals (U.S. treasuries or GSE securities) and for variation margin they
only accept cash. The investor must transfer eligible collateral with the value at least equal to the
delivery amount. The collateral must meet the eligibility criteria (currency, type of bond, haircut).

Basic requirements:
Liquidity (The securities must be highly liquid.)
Easy to settle (Treasury bonds, AAA corporate bonds, large-cap equities, mortgage-
backed bonds)
High quality (The collateral should not have a significant embedded risk itself)
Approval from the credit department (Guidance from the CSA)

Types of collateral:
Cash
Fixed income securities
Bank guarantees
Equities (stock)
Mortgage-backed securities
Convertible Bonds
Exchange Traded Funds (ETFs)
Mutual Fund Shares

The following list shows the acceptable collaterals for the clearinghouses:

© COPYRIGHT 2013 SAPIENT CORPORATION | CONFIDENTIAL 30

Table 8 Collateral Pool per CCP
Source Own Illustration

Clearinghouse Acceptable Collateral Haircuts

LCH Clearnet Ltd Acceptable Collateral Acceptable haircuts (16.08.2013)

LCH Clearnet US Acceptable Collateral Acceptable haircuts ((16.08.2013)

CME OTC IRS Acceptable Collateral IRS Information regarding haircuts can be
found on the same page (Acceptable
Collateral)

Eurex Securities Collateral

5.2 Collateral process (SM)

This chapter describes the collateral management requirements and processes.

5.2.1 Collateral requirements (SM)

The requirements to collaterals are the use of cash, securities or precious metals to cover
margin requirements at the clearing house. Note that the variation margin can only covered in
cash. To facilitate the delivery, the counterparties may lodge securities either directly or
using a tri-party mechanism.

A centralized collateral management system is optimizing collateral among the business and have
following benefits:
Efficiency: Duplicated functionalities across business silos are removed.
Risk modeling: Enhanced risk modeling techniques can be used in credit exposure
calculations
Single view of capital utilization and liquidly risk and enable a single counterparty view
and provides the view of the collateral pool, balance sheet and collateral obligations.
Real time platform with the funding margin for securities based on real risk, creation of
mutually beneficial funding options for clients and the transformation of collateral
management to a revenue center.

Straight Through Processing (STP): A STP workflow engine will enable the advanced
processing of the margin calls, more efficient reconciliations and the reduction of operational risk
and to offer clients collateral options which have been turned to their overall business
requirements.

5.2.2 Processes (SM)

The key components of a process of a collateral management system are the

Collation: A collateral management begins with the Collateral documentation. A collateral
agreement will specify all pre-requisites of the Collateral Agreement, like the collateral that
is acceptable by the counterparty, frequency of margin calls, haircuts to be applied to the
collateral, valuation based on MTM, conditions for re-hypothecation, and close-out and
termination clauses

© COPYRIGHT 2013 SAPIENT CORPORATION | CONFIDENTIAL 31

 Allocation: The next step is the allocation of the collateral. This is a complex process that
involves validations to evaluate Collateral on the basis of the documentation. The
Allocation is done keeping in mind the following characteristics of the Collateral:
o Eligibility of Collateral to the Lender
o Barrower Ratings
o Rating from Rating Agencies
o Maturity and Record Date and other Corporate Actions for the Collateral
o Required Value to be Collateralized
o Lender preference (in case of more than one lender)
o Hair-cut to be applied for collaterals other than cash.
o Concentration Limits to be applied.
Calculation: A system performs complex calculation for allocating collateral to the lender
account, in exchange or funds. The system calculates the portfolio value of the collateral
(MTM).
Evaluation
Communication: The ability to communicate effectively between the counterparties also
like reporting (report for decrease in collateral value and request for margin calls)
Reconciliation: Check if the collateral cycle has been successfully completed.
Mitigation

5.2.3 Software Provider (SM)

9 10 11
Historical OTC vendor systems, such as IBM (Algorithmics) , Omgeo and Lombard Risk are
introducing repo collateral management and/or collateral optimization functionalities as additions
12
to their existing offerings. Trading platforms such as Calypso are utilizing their expertise to
bridge the traditional gap between trading and collateral by introducing a collateral solution. Other
13
vendors, such as 4Sight which has strong repo and collateral optimization functionality are
broadening their product capabilities to include central counterparty (CCP) clearing and OTC
collateral management in one comprehensive product.

Furthermore software vendors like Acadiasoft14 providing a platform called Marginsphere which is
focused on automated communication for collateral and for margin calls.

5.3 Collateralization via CSAs (AF)

9
http://www-01.ibm.com/software/analytics/algorithmics/
10
http://www.omgeo.com
11
http://www.lombardrisk.com/products/risk-management/colline
12
http://www.calypso.com/solutions/collateral-securities-finance.php
13
http://www.4sight.com/products/4sight-collateral-management
14
http://www.acadiasoft.com/
© COPYRIGHT 2013 SAPIENT CORPORATION | CONFIDENTIAL 32
 5.4 Margining for non-cleared derivatives under EMIR (TS)
In response to the financial crisis, the Group of Twenty (G20) initiated a program to reduce
systematic risk in OTC derivatives markets. Thereby, the Basel Committee on Banking
Supervision (BCBS) and the International Organization of Securities Commissions (IOSCO) were
assigned to develop a framework that establishes global minimum standards for margin
requirements for non-centrally cleared derivatives. This final policy was published in
15
September 2013 .

The overall goal on margining is to globally reduce systematic risk and to promote central
clearing.

Moreover, the standards have to be implemented globally. Otherwise financial institution would
gain possibility for regulatory arbitrage and the one operating in a low-margin location would
benefit from a competitive advantage.

The advantages of a margin system over capital requirements are obvious: targeted to a specific
portfolio/transaction, dynamic in dealing with actual market situation and the feature that margin is
“defaulter-pay” where the surviving party is not charged for counterparty’s default.

5.4.1 Requirements (TS)

The policy framework published by BCBS and IOSCO is organized in principles which are more
specified in requirements. Key elements are described in this chapter.

The margining requirements apply in general to all derivative transactions that are not cleared
by a CCP. Exceptions are only made for physically settled FX forwards and swaps.
Nevertheless, IOSCO recognized that variation margining of this derivatives is a common practice
among certain market participants.

Covered entities by margin requirements are financial institutions (FC) and important non-
financial entities (NFC+). All margin transfers may be subject to minimum transfer amount which
is capped at € 500,000, in order to reduction transfers.

Eligible collateral should be defined in detail by national supervisors, but BCBS and IOSCO still
provide a guide of collateral that appear adequate, including:
Cash
High-quality government securities
High-quality corporate bonds
High-quality covered bonds
Equities included in major stock indices
Gold

Furthermore, national supervisors should avoid duplicative regulatory margin requirement. Thus,
cross-border guidance, such as substitute compliance, has to be developed by each regulator.

The variation margin should be calculated on a daily mark-to-market valuation and full amount
should be transferred, i.e. zero threshold. As variation margin will be paid in cash, there is no
major difference in handling compared to central cleared derivatives.

15
The document is available for download: “https://www.bis.org/publ/bcbs261.htm”.

© COPYRIGHT 2013 SAPIENT CORPORATION | CONFIDENTIAL 33

New to market participants is the introduction of initial margin requirements. Subject to these
requirements are all participants, which are exceeding € 8 billion of gross notional outstanding
amount and that are trading with another participant meeting this requirement as well. A
maximum threshold of € 50 million at a level of the consolidated group is foreseen, in order to
reduce collateral transactions. But, exchange of initial margin should be performed on a gross
basis. This is because net basis between two significant market participants could be insufficient,
not covering all replacement costs in case of a failure.

Re-hypothecation of collateral (the re-utilization of received collateral) is limited to a level that it is

basically no longer allowed (with some few contingent exceptions for providing collateral to buy-
side firms). BCBS and IOSCO demands that collateral has to be protected in case of bankruptcy.
Also cash collateral has to be segregated, e.g. posting cash collateral to a custodian at a pledge
account for received collateral.

For calculation of initial margin two approaches are outlines: a statistical risk-based approach
(including stress scenarios defined by regulators) that has to be accepted by national authorities
(proposed calibration of model: 99% confidence level, 10 days holding period, 5 year time horizon)
and a standardized approach based on schedule.

The standardized approach is calculated for each asset class separately and uses the following
schedule:

Table 9 Standardized Initial Margin Schedule

Source BCBS/IOSCO, Margin requirements for non-centrally cleared derivatives

Obviously, the standardized approach undermines the advantage of margining as it is neither

dynamic nor risk-based. So volatility and correlation effects are suppressed completely.
Nevertheless, the approach is easy to implement and allows market participants to reconcile
collateral payments. IT requirements for computation are low.

ISDA has established a working group in order to provide a market-wide accepted, risk-based
approach that fulfills all requirements set by BCBS and IOSCO. Thereby, ISDA focuses on a
single, risk-sensitive metric. This model is called “standard industry margin model (SIMM)” and
would join the advantages of both proposed models. A final solution is outstanding.

Also haircuts, that have to be used when securities are used for collateral, are recommended, but
need to be proven by national authorities:

© COPYRIGHT 2013 SAPIENT CORPORATION | CONFIDENTIAL 34

Table 10 Standardized Haircut Schedule
Source BCBS/IOSCO, Margin requirements for non-centrally clear

5.4.2 Timeline (TS)

Initial margin in the area of OTC markets is fairly new to market participants. BCBS and IOSCO
propose a stepwise introduction, beginning with biggest and thus most systematic relevant
participants. Collateral obligation depends on gross outstanding notional amount:
st
By 1 Dec 2015, any firm with a portfolio over € 3 trillion to exchange IM
st
By 1 Dec 2016, inclusion threshold down to € 2.25 trillion
st
By 1 Dec 2017, inclusion threshold down to € 1.5 trillion
By 1st Dec 2018, inclusion threshold down to € 750 billion
st
By 1 Dec 2019, inclusion threshold down to € 8 billion

Calculation bases on a group aggregated month-end average for June, July and August. Subject
to initial margin are only new transactions done from December of the year the firm hits the
threshold until November of following year and only if the firm trades with another firm meeting this
condition. Please note that FX forwards and swaps (initially out of scope of margin requirements)
are included in threshold calculation.
st
In contrast the variation margin becomes mandatory for all market participants by 1 of
December, 2015. All transactions done after the compliance date are subject to variation margin,
whereas old transactions are not affected.

© COPYRIGHT 2013 SAPIENT CORPORATION | CONFIDENTIAL 35

5.5 Legal documentation (JS)
The legal documentation is a crucial aspect of the collateral process since the legal documentation
defines the rights and obligations of the parties during the collateral life-cycle. Although
agreements can be negotiated bilaterally standard agreements are commonly used. These
standard agreements are based on established ISDA agreements.

Most of OTC derivative transactions are executed under an ISDA master agreement. The
collateral agreement is defined by a Credit Support Annex (CSA) which supplements the ISDA
master agreement (per counterparty) and covers the same product scope except when otherwise
agreed. Although standard CSAs exist most CSAs are negotiated bilaterally defining key
collateral terms and conditions (e.g. eligible collateral, haircuts, independent amounts). Please
note that similar documentation is available for German Master Agreements (Deutscher
Rahmenvertrag + Besicherungsanhang).

The following key aspects summarize the usual CSA content:

independent amount,
exposure amount and calculation methodology,
margin thresholds,
minimum transferable amount,
how collateral calls and collateral returns are to be calculated,
interest on collateral,
the mechanics and timing of transfers,
the method and timing of valuations made by the collateral Valuation Agent,
substitutions or exchanges of collateral,
resolution of disputes regarding valuation of collateral or exposure,
enforcement on default,
representations and warranties,
allocation of expenses relating to the collateral arrangement,
default interest,
re-hypothecation.

Although not identical to the margining of CCP cleared transactions similarities exist. The total
credit support amount consists of the exposure amount and the independent amount. While the
independent amount is similar to the initial margin, the exposure amount is similar the
variation margin - threshold.

The new collateralization requirements under EMIR will have a significant impact on CSAs.
According to the final policy framework published by BCBS and IOSCO regarding margin
requirements for non-centrally cleared derivatives certain aspects of established CSAs will have
to be amended, e.g. initial margin (independent amount) will have to be posted by both
counterparties and held separately.

5.6 Collateral Mitigation (AF)

© COPYRIGHT 2013 SAPIENT CORPORATION | CONFIDENTIAL 36

5.7 Sapient Offerings (SM)

5.7.1 Target Operating Model (SM)

Firms must comply with global regulations that will require them to re-engineer business processes
and infrastructure for OTC trade and relationship documentation.

Sapient has a proven track record, and robust methodologies, in defining powerful operating
models for its clients. Our track record for “on-time and to-plan” delivery success derives from our
ability to couple deep business expertise with innovative technology studies.

Firms have to select and align with the solutions that have the best fit and ROI as well as align
to the evolving Target Operating Model.

Figure 10 Target Operating Model

Source Sapient

© COPYRIGHT 2013 SAPIENT CORPORATION | CONFIDENTIAL 37