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The Wall Street Reform and Consumer Protection Act—known as the Dodd-Frank Act—is set to change the rules of collateral management for over the-counter (OTC) derivative transactions in the financial services industry.
While the definition of the applicable rules have not yet been finalized, adoption of the Dodd-Frank Act will lead to significant growth of the amount of collateral held against OTC trades and a sharp increase in the operational complexity of managing collateral.
Title VII of the Dodd-Frank Act introduces new margin requirements that affect the margining of over-the-counter (OTC) swap transactions for swap dealers and major swap participants (collectively called “Covered Swap Entities”). Dodd-Frank mandates the posting of what is termed “independent amounts” for all OTC swap transactions that are not cleared by a central clearinghouse (CCP).
Similar to initial margin, independent amount only applies to collateral posting for uncleared OTC swaps while initial margin applies to derivatives of all types that are centrally cleared. Dodd-Frank also requires the independent amount to be segregated at an independent, third-party custodian and prohibited from re- hypothecation. The legislation also imposes restrictions on the type and quality of collateral that can be pledged.
Although the final version of the regulation is still being discussed, the Prudential Regulators—the Federal Reserve Board, the Office of the Comptroller of Currency, the Federal Deposit Insurance Corporation, the Farm Credit Administration and the Federal Housing Finance Authority as well as the Commodity Futures Trading Commission (CFTC)—have established most rules and issued compliance timelines with respect to many obligations under such rules. The changes being introduced by the proposed regulations can be categorized within five areas of the banks’ collateral management process:
Product and counterparty coverage—instruments based on “rates” and “yields” are being included in the definition of swaps. The proposed IA requirements depend on whether the swap entity enters into a swap with another swap dealer (SD) or major swap participant (MSP), a financial entity, or a non-financial entity.
Documentation of IA terms in agreements—would outline the calculation of IA, type of assets eligible to be posted as IA, margin thresholds, and where the IA would be held along with transfer of rights and obligations, valuation and dispute resolution procedures.
Collateral eligibility and restrictions—the prime requirement for the assets is that there should be a deep and liquid market for them so that they can be readily valued and easily liquidated in the event of a default.
Timing of posting IA—propose the posting on or before execution date.
IA margin calculation methodology—two methods for calculating IA are proposed: A “lookup” table, based upon notional value that does not consider portfolio offsets, and an approved internal IA calculation model that needs to meet specified requirements.
Banks’ operating models will have to change in order to adapt to the new rules of Independent Amount (IA). While the final details of Dodd-Frank are being determined, we believe that now is the time for banks to engage in the transformation of their IA collateral management process and position themselves to answer the new collateral management paradigm.
In our experience, most banks have elements in place to begin a successful transformation of their collateral process in response to the IA challenge. They will need to link these elements together to create a comprehensive approach to IA collateral management, and should consider an approach based upon the following four steps:
Perform a portfolio analysis of trades and counterparties in scope for Dodd-Frank, and strategically set the direction of the OTC swap business after the implementation of the new margin rules.
Begin the re-papering of credit support agreements to include appropriate IA terms and conditions and enhance internal resource and staff according to the level of effort required.
Develop risk-based IA calculation models and prepare for regulatory approval.
Develop a collateral optimization program that will proactively identify and select the right and most cost efficient asset to pledge as collateral.
A. Gupta is a managing director—Capital Markets—Risk Management. Based in New York, Gupta has over 15 years of risk consulting and capital markets industry experience delivering strategic solutions in a wide variety of client situations.
R. Inoussa is a manager—Risk Management. Inoussa is based in New York and has over 10 years of broad-based consulting and industry experience within the capital markets and resources sectors.
April 3, 2013
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