The End-User Guides to Derivatives Regulation

Counterparty Risk and Collateral Protection Version 1.0

Overview:
Counterparty risk is the risk that your counterparty may not be able to make payments due under a contract. To mitigate this risk, parties may often require the posting of collateral to cover some or all of the potential losses in the event of a default. The current method of using collateral to mitigate counterparty risk in the over-the-counter (OTC) derivatives market is accomplished through the negotiation of bilateral credit support arrangements. The Dodd-Frank Act promotes central clearing as the primary method for managing counterparty risk. In central clearing, a central counterparty steps in between the parties to a derivatives contract and becomes the buyer to every seller and the seller to every buyer. Various rules and regulations require central counterparties to manage the potential risk of customer default in a number of different ways. With regard to protecting customer collateral, two models exist under the regulations: (i) the Futures Model, which currently governs futures transactions, and (ii) the Legally Segregated Operationally Commingled or LSOC) Model, which the CFTC has required for cleared OTC swaps. The LSOC Model offers customers greater protection than the Futures Model against fellow customer risk because a non-defaulting customers margin cannot be used to cover the losses stemming from another customers default. However, under both models, a customer may still share pro rata in losses due to operational mismanagement or investment risks.
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Overview
When a party enters into a derivative contract, it faces the risk that its counterparty may not be able to make the payments due pursuant to the contract. When a party is uncomfortable with that credit risk, it may require its counterparty to post collateral to cover some or all of that risk. This guide explores the treatment of counterparty risk and collateral under: (i) A bilateral credit support agreement, which is the current method of using collateral to mitigate counterparty risk in the OTC derivatives market; and (ii) The clearing environment, which is soon to be mandatory for many OTC derivatives pursuant to the Dodd-Frank Act.1

Variation Margin

Parties may agree to post collateral, sometimes as often as daily, based on the current market value of the trades. The marking to market process involves calculating the gain or loss on each contract, using reported market prices if available. Subject to certain terms, a party will then either post collateral equivalent to the corresponding loss or receive collateral for the corresponding gain. This collateral, generally known as a variation margin, helps protect both parties. If a party defaults and owes money on the derivative, its counterparty is protected by the variation margin the defaulting party has posted. If a party defaults and is owed money on the derivative transaction, its counterparty can set-off the amount it owes on the derivative with the variation margin held by the defaulting party. Variation margin, however, does not eliminate all counterparty risk. For example, if the market moves between the time a party defaults and the time its counterparty is able to terminate (liquidate) the derivatives, the market value of the derivatives may no longer match the value of the posted variation margin. The difference in value between the posted variation margin and the market value of the trade could be significant if the market undergoes a large movement.

This guide will also explore two different models for collateral protection within the clearing environment: the Futures Model and the Legally Segregated Operationally Commingled (or LSOC) Model.

Credit Support Agreements in the Traditional Bilateral Environment

Historically, the posting of collateral in OTC derivative transactions has been accomplished through bilateral credit support agreements. Under a credit support agreement, parties to a transaction have two main options to mitigate against different risks in the event of a counterparty default.

Independent Amount and Initial Margin

If a party is concerned about this potential risk, it can collect additional collateral, called an independent amount, which may cover the anticipated market movement during any potential liquidation process. Under standard credit support agreement terms, the independent amount overcollateralizes the trades by a certain amount, and will remain posted until the trades have an asset value greater than the independent amount. Alternatively, parties may modify the standard terms in a credit support agreement to require that a specific independent amount remains posted until the derivative matures or is terminated, regardless of the value of the derivative. Collateral that remains posted, even when the trades have an asset value greater than the value of the collateral, generally is called initial margin. Although both independent amount and initial margin provide protection for the party that receives it, they create risk for the party that posts it. If the party holding the independent amount or initial margin defaults, its counterparty faces the potential loss of any overcollateralization. In fact, if the market moves in favor of the party posting the independent amount or initial margin and its counterparty defaults, the party can end up losing both its variation margin and its independent amount/ initial margin. 2

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Central Clearing
The Dodd-Frank Act promotes central clearing as the primary method for managing the counterparty risk described above in OTC derivative transactions.2 Central clearing is the process in which transactions are processed, guaranteed, and settled by a central counterparty (CCP or clearing house) that steps in between the two parties.3 Contracts submitted for clearing are novated to the CCP, meaning that the CCP essentially becomes the buyer to every seller and the seller to every buyer.4 Central clearing is already mandatory in the futures market and is currently optional in the OTC derivatives market. Dodd-Frank has made clearing mandatory for certain types of entities for certain types of swap transactions. CCPs manage the risk of counterparty default in a number of ways, including by limiting clearing privileges to its members, who must meet high capital and operational standards. These requirements are a barrier to entry for most end users (or customers). As a result, the Commodities and Futures Trading Commission (CFTC) permits clearing members to clear transactions on their own behalf (house transactions) and on behalf of customers (customer transactions). In turn, clearing members guaranty the performance of their customers to the clearing house. To work with customers, a clearing member must be registered with the CFTC as a Futures Commission Merchant (FCM) and the clearing house must be registered with the CFTC as a Designated Clearing Organization (DCO).5

DCOs also require that FCMs contribute to the DCOs guaranty fund, which acts as a capital reserve in the event of the default of one or two of the DCOs largest members. If a default occurs, the DCO can utilize the guaranty fund to satisfy the liabilities of its defaulting FCMs.6 Further, the DCO can impose monetary assessments on FCMs if available margin, guaranty fund deposits, and the DCOs own capital contribution are exhausted in a default.7 In addition, DCOs manage counterparty risk by requiring their FCMs to post initial and variation margin for the transactions they clear (separately for customer and proprietary transactions). DCOs calculate, collect, or return variation margin at least daily.8 FCMs correspondingly calculate, collect, or return margin from their customers, based on each customers portfolio of positions, to satisfy their DCOs customer margin requirements as well as their own.9 The DCOs initial margin requirements are designed to cover potential losses incurred by market movement while liquidating trades in the event of a default. For OTC derivatives, the DCO must collect enough initial margin to cover 5 days of market movement with a 99% certainty.10 If an FCM defaults and fails to make a variation margin payment to the DCO, the DCO can immediately liquidate the positions and margin and net out the FCMs obligations.11 Similarly, if a customer defaults, the FCM may use the margin that customer has posted to meet that obligation.

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Risks of Central Clearing

Double Default

There is still a risk that a customer faces under the central clearing model. An FCM could default under a couple scenarios, including: (i) a customers loss that exceeds both the customers collateral and the FCMs ability to pay (a double default);12 (ii) shortfalls due to losses from the permitted investment of customers collateral or due to operational risks, such as negligence or theft of customer funds (not a usual occurrence), or shortfalls when liquidating non-cash collateral.13 Several models exist to protect customer collateral in the event of an FCM default, including the model currently used by the futures market (the Futures Model), and the model the CFTC has required for the cleared OTC market (the LSOC Model).

If there is a double default, the DCO will attempt to identify the customers collateral and facilitate the transfer of customers positions to a non-defaulting FCM, or they may transfer the customers in a group with the entire customer margin account. The transfer of customers accounts may be difficult, however, because the DCO will have to obtain information from the defaulting FCM as to which customers are in default and which positions belonged to defaulting customers (which would not be transferred).14 The DCO will not immediately know if a shortfall will occur and, if so, how much it will be. How one customers margin may be used to cover a defaulting customers positions is determined by the DCOs default resources package or waterfall.15 This waterfall governs the order in which the DCO utilizes various funds in order to satisfy debts arising from a double default, as follows:

Protection of Customer Collateral The Futures Model

The Futures Model requires that FCMs and DCOs segregate customers collateral funds from the FCMs collateral for its own house positions; however, an FCM can commingle all of an FCMs customers collateral in one account. Under the Futures Model, the DCO does not have information about each of the individual customers positions.

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1. Margins of Defaulting Customer and Defaulting FCM

The DCO will attempt to identify the various customers positions, liquidate the defaulting customers positions, and apply the defaulting customers collateral to settle the defaulting customer positions. The DCO also liquidates the defaulting FCMs house positions and applies the FCMs house collateral to settle the FCMs house positions.

2. Defaulting FCMs Remaining Collateral, Equity, and Guaranty Fund Contribution

If more funds are needed, the DCO applies the defaulting FCMs: (i) house collateral (if any is left after the defaulting FCMs house positions are settled); (ii) equity in the clearing house (if any); (iii) the defaulting FCMs contribution to the guaranty fund; and (iv) any other property the DCO has from the defaulting FCM.

3. Non-Defaulting Customer Margin

If there is still a shortfall, then non-defaulting customers of the defaulting FCM will have their collateral applied rst against their own positions and then against the defaulting customers positions. Each customer will provide a pro-rata share until the defaulting customers positions are closed or there is no more customer collateral remaining.

4. The DCOs Capital and Guaranty Fund Contribution

5. The Non-Defaulting FCMs Guaranty Contributions

The DCO utilizes various funds in order to satisfy debts arising from a double default

6. Assessment to Non-Defaulting FCMs

While this default resources package exists, to date, no customer has actually lost any collateral due to another customers default under the Futures Model.

Shortfalls Due to Operational or Investment Risks

To the extent that an FCM holds a customers margin within its customer account, the customer faces the risk that operational errors or investment risks could result in losses to the customer in the event of a bankruptcy. For example, the collateral lost at MF Global was not collateral held by the DCO, but was collateral held by MF Global, which MF Global appears to have mismanaged.16
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In these circumstances, the DCO will attempt to transfer or liquidate the FCMs customer positions or collateral. However, to the extent there is a shortfall in the customer funds, each customer ultimately shares equally in the pro rata shares of the losses. Hence, customers do face a risk of losing the value of their collateral if an FCM bankruptcy results from operational or investment mismanagement. This is an unlikely occurrence and the rules should prevent it, however MF Global shows that these events can occur.

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Finally, if the DCO needs to liquidate non-cash collateral as a result of any of the above events, there is a risk that the customer would not receive the full value of their collateral if they or other customers have posted non-cash collateral. While non-cash collateral is valued at a hair-cut, it is possible that the market may move in such a way that the collateral becomes insufficient to satisfy a loss. As a result, any final shortfall would be shared on a prorated basis with all customers.

Double Default

If a double default occurs, the LSOC Model utilizes the same waterfall as the Futures Model, with one key distinction: a DCO may not use the collateral of any non-defaulting customers to satisfy the payment obligations arising from the default.20 As a result, the LSOC Model offers customers greater protection against fellow customer risk for cleared swaps then for futures.

Protection of Customer Collateral The LSOC Model

Shortfalls Due to Operational or Investment Risks

Effective November 8, 2012, the CFTC will require that FCMs and DCOs utilize the LSOC Model for cleared swaps.17 The LSOC Model does not apply to futures transactions. Broadly speaking, the LSOC Model provides greater protection to customer collateral than the Futures Model. The LSOC Model still allows for the FCM and DCO to commingle all of a FCMs customers collateral in one account. Unlike the Futures Model, however, the FCM is required to provide the DCO with information about the identity of each of its customers and the amount of cleared swap collateral held at the DCO and attributable to each customer daily.18 In addition, the DCO will have to hold the gross margin of each customer, rather than just the net margin of all the customers of an FCM.19 Accordingly, if an FCM defaults, it may be easier for the DCO to transfer customer positions than under the Futures Model. Note, however, that some commentators have claimed that the LSOC Model would cause increased delays in the transfer of customer positions.

In the case of shortfalls due to operational or investment risks, the LSOC Model is the same as the Futures Model. If the FCM loses collateral due to mismanagement, as in the case of MF Global, the loss would still be taken by customers on a pro rata basis. Lastly, although the amount of each customers collateral is tracked at the DCO, the DCO does not know what specific collateral (i.e., a specific bond or agency) belongs to which customer. Therefore, if the DCO needs to liquidate noncash collateral as a result of any of the above events, there is a risk, as mentioned above, that there could be a shortfall after liquidation which would be shared on a prorated basis with all customers. Due to these remaining risks, some market parties are pushing for additional protections above and beyond the LSOC Model. Many large funds would like full physical segregation of collateral. The CFTC is considering allowing this choice and evaluating its permissibility in light of existing bankruptcy laws.

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End Notes
1

See Protection of Cleared Swaps Customer Contracts and Collateral; Conforming Amendments to the Commodity Broker Bankruptcy Provisions, 77 Fed. Reg. 6336 (Feb. 7, 2012). 2 Id. at 6336. 3 Id. at 6337. 4 Id. 5 Id. 6 Id. at 6338. 7 Id. 8 Id. at 6337. 9 Id. 10 Id. at 6338. 11 Id. at 6337. While a CCP can use house margin to meet obligations in either the clearing members house account or customer account, a CCP cannot use customer margin to meet a default in the clearing members house account. Id. at 6338. 12 Id. 13 Id. at 6340. A customer does not face risk that their collateral will be impacted by: (i) the default of a fellow customer of their FCM, without triggering a default by the FCM, or (ii) the default of another FCM of the DCO. With regard to the former, the FCM will satisfy any outstanding debts of the customer without accessing any other customer funds. With regard to the later, the DCO will satisfy any outstanding debts of the defaulting FCM without accessing any non-defaulting FCMs customers collateral. 14 Id. 15 Id. at 6338. 16 A FCM may hold customer collateral without passing it to the DCO for a few reasons: Under the Futures Model, the FCMs only need to provide the net margin of all its customers to the DCO. As a result, the FCM may hold excess collateral that it did not have to post to the DCO; An FCM may require a customer to post additional collateral beyond that required by the DCO, and the FCM would hold onto these additional funds; and Some customers would over-collateralize or leave excess collateral with the FCM to reduce the operational burden of constantly posting and calling collateral. 17 Id. at 6336. 18 Id. at 6339. 19 As referenced in endnote 4, under the Futures Model, customer margin is posted by an FCM to a DCO on a net basis based on the total exposure across all the of FCMs customers collective portfolios. For example, if the FCMs customers collectively enter into an equivalent number of long and short positions, the FCM would post zero margin. Under the LSOC Model, customer margin is posted by an FCM to a DOC on a gross basis, meaning that each customers margin is posted to the DCO. 20 Id. at 6337.

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About Chatham

Chatham Financial is the largest independent interest rate and currency risk advisory, and a recognized leader in accounting, valuations and debt advisory. Founded in 1991, Chatham has built its business bringing transparency, fairness and responsiveness to more than 1,000 firms globally. Through our work on tens of thousands of complex financial transactions, Chatham has married deep capital markets expertise with best-in-class technology. For the past two years Chatham has been actively engaged in the policy debate over effective regulation of the over-the-counter (OTC) derivatives market, playing a lead role in the legislative and regulatory rulemaking process for Title VII of the Dodd-Frank Act.

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Version 1.0 Disclaimer

August 2012: First version of this online guide. All Rights Reserved. The information in this document is for informational purposes only and should not be used as legal, accounting, financial or regulatory advice. The information in this document is not intended as a substitute for appropriate professional advice. The impact of the DoddFrank Act and related laws will vary for any particular situation based upon numerous factors; therefore, you should not act upon any information in this document without seeking an appropriate professional legal, accounting or financial advisor. No responsibility is assumed for the accuracy or timeliness of any information in this document.

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