Wednesday, October 7, 2009

Learning From Lehman Brothers: How to Avoid Collateral Damage, A Year After The Collapse

Posted on FinReg21 by Chris Kentouris:

Do you know where your collateral is on all your trading positions?

And whether, in fact, you are considered the owner of that collateral?

That is some of the collateral damage playing out around the world one year after the collapse of Lehman Brothers.

Hedge funds which pledged collateral with Lehman Brothers International Europe as their counterparty are now realizing that the terms of their prime brokerage agreements with that arm of Lehman Brothers in Europe weren't quite the same as those of Lehman Brothers in the U.S.

Nut nut: They're discovering the collateral they posted got used again as collateral - legally - by Lehman in Europe and there is no clear redress. As a result, what was their collateral no longer is. When it comes to getting anything back, the hedge funds are now considered unsecured creditors, on that continent.

That's just the tip of the iceberg facing Lehman's former trading partners, according to one former Lehman Brothers operations executive in London. "Some of the thousands of counterparties which engaged in over-the-counter derivative deals with Lehman Brothers overcollateralized their transactions," he told Securities Industry News last week. "Either Lehman requested extra or variation margin beyond the initial margin because of the poor creditworthiness of the counterparties involved or the counterparties did not correctly calculate their collateral exposure and took Lehman's analysis at its word. They now have to fight to get back the collateral.''

Collateral, of course, protects sellers of Treasury securities, lenders of securities and traders of over-the-counter derivatives from the potential that the "other" party - the counterparty - ceases to exist or can't otherwise fulfill its end of the bargain. The usual assumption: The party which posted the collateral could go bust. The unexpected result, this time, the holder went bankrupt.

How Lehman's hedge fund customers and other unsecured creditors will fare on both sides of the Atlantic remains to be seen. No payments are expected to be made until next year at the earliest.

Collateral management experts say that buyside firms are beginning to appreciate the importance of accurate collateral management after Lehman's bankruptcy exploded the fallacy that a major securities house could never fail. Heightening their interest is the fact they have become more leveraged as trading explodes in over-the-counter derivative and securities lending programs.

Although only a handful of broker-dealers worldwide control trading in OTC derivatives, asset managers, particularly hedge funds, are becoming increasingly active - -and are discovering that they can no longer do business with bank counterparties unless they put up collateral. Every interest rate swap, equity option and credit default swap is now likely to be controlled by the International Swaps & Derivatives Association's master agreement and its redit support annex that governs the use of collateral.

As a rule of thumb, securities lending and over-the-counter transactions can be collateralized in either cash or securities. Those instruments can include U.S. equities and U.S. Treasury bonds as well as non-U.S. equities and debt instruments. When either U.S. equities or non-U.S. financial instruments are used, a percentage of the market value of the collateral must be deducted to account for the potential decline in value.

In securities lending transactions, only the borrower of the securities posts collateral. In an OTC derivative transaction, both counterparties typically do because they are exchanging payments over the course of the contract's duration.

"Collateral management has gone from a nice-to-have to an absolute requirement. Organizations knew they needed to hold collateral against lending or trading positions but it's far more well understood that sound collateral management is a risk management tool critical to any decision to lend or trade securities," says Kelly Mathieson, global head of clearing and collateral management services for J.P. Morgan Chase.

Fund managers and broker-dealers who relied on spreadsheets to keep track of collateral posted in transactions are now seeking help from software vendors and outside managers such as global custodians, who can act in the role of outsourcing service provider In the OTC market, both buy and sell-side participants have ratcheted up efforts to eliminate discrepancies in records of the number of trades conducted and the size of the trades. Such discrepancies are a common cause of disputes between counterparties over margin calls. That typically is when collateral standing behind a position is either increased or reduced.

In the past, counterparties often did not reconcile their positions until a dispute on the amount of collateral took place. That could be several days or weeks after a trade. At best, counterparties would exchange spreadsheets that might contain tens of thousands of trades and manually read documents line by line to find discrepancies. Because the market often moved before they completed the work, the margin call could be erroneous before the research is completed.

"Post-Lehman, we're seeing more interest from the buyside in validating and calculating margin requirements" says Susan Hinko, director of industry relations for Swedish technology supplier TriOptima. "As broker-dealers are moving from weekly to daily reconciliations, fund managers are following suit."

Now counting 16 of the U.S. largest broker-dealers as its clients, TriOptima replaces the exchange of spreadsheets with a Web service where both parties can view each other's trades side by side.

The system shows trades that match and identifies mismatches. The service also offers search and reporting capabilities so customers can see aggregate exposures to a counterparty or a particular OTC derivative transaction. An electronic messaging capability keeps all communications related to a disputed position in the same place and available to anyone who views the file.

"After ensuring that trade positions are reconciled, valuing the collateral and transactions involved is also critical - and doing so in as close to real-time as possible is essential," says Tim Lind, managing director of strategic planning for Omgeo, a New York-based provider of post-trade communication services. "Speed as well as accuracy have now become critical components in collateral management."

Also targeting the buy-side, Omgeo's derivatives reconciliation and collateral management services match details of over-the-counter derivative transactions between counterparties such as buy-side firms and their broker-dealers and then determines the appropriate collateral that needs to be posted.

Unfortunately, not all the collateral management process has been automated. Margin calls are still often conducted either over the phone or by fax - which can take days to resolve.

Even email communications are far from ideal. "Sending margin calls by email still requires someone on the recipient firm to interpret the message before any action is taken," says David Wechter, senior director of collateral product management at Toronto-based Algorithmics, a risk management software vendor.

Mistakes in communicating and interpreting margin calls by operations executives can result in either undercollateralization or over-collateralization of transactions as well as over or underpayment of interest on reinvested cash collateral.

Algorithmics is developing Collateral Connectivity, an open message exchange service for fund managers and broker-dealers, which will allow them to electronically communicate information on margin calls, interest payments and collateral substitution. It will rely on structured message formats based on standards being defined by the Collateral Infrastructure Working Group (CIWG). a subgroup of the Collateral Committee. The CIWG, first created in 2005 as the Collateral Framework Group, consisted of the London-offices of Credit Suisse, Goldman Sachs, JP Morgan and Morgan Stanley, among other broker dealers. Its objective was to improve communications between group members. Its subsequent affiliation with the ISDA expanded its reach to the buy-side as well as North America and Asia-Pacific. The CIWG has also expanded its goal to ensuring the interoperability of messaging on margin calls and other collateral management functions between users of different service providers. Hence, the group has opted not to endorse a specific vendor.

For users of Collateral Connectivity which also use Algorithmics' own collateral management platform Algo Collateral, Algorithmics will automatically generate a margin call message. Customers of other collateral management services must either generate their own margin call messages or log onto a website operated by Algorithmics to forward margin call messages to counterparties. Either way, users of Collateral Connectivity, will receive a confirmation that the margin call was received. Firms using Collateral Connectivity can also program workflow so that the appropriate person can monitor the state of a margin call and handle any disagreements with counterparties electronically.

Even the most automated buy- and sell-side firms may not have the best handle on their collateral management functions. Because they often rely on multiple applications in multiple units which in turn may depend on different data inputs, they lack a timely and consistent view and valuation of the collateral they are either using or receiving. That means firms cannot ensure that the correct amount of collateral is being delivered or received and that accurate margin calls are being made.

In July 2007, J.P.Morgan began a three-year multimillion dollar initiative to create a global and close-to-real time view of collateral management for clients of its securities services unit as well as customers of its investment bank and asset management unit.

"As J.P. Morgan's collateral management business has grown rapidly, disparate platforms have been developed in different parts of the world," explains Mathieson, its head of collateral management services. "We are working to consolidate these platforms with a common data infrastructure, common risk controls, and common reporting tools in the repurchase agreement, securities lending, and over-the-counter derivative arenas."

Such a global platform will allow J.P. Morgan's customers to have a consistent and complete view of all collateral in all transactions in any time zone with any entity involved. Because the transactions and collateral will also be valued correctly using the same price inputs and models, firms will be able to either minimize the amount of collateral used or maximize the amount received. "It goes way beyond risk mitigation," says Mathieson. "Collateral optimization can't be accomplished if we don't have all of the pieces of the puzzle correct."

Avoiding Collateral Damage

Take these steps to ensure accurate and timely collateralization of any type of transaction.

* Get signoff. Make sure terms of the transaction and identities of the counterparties involved are agreed upon by all parties.

* Act quickly. Update terms and reconcile any discrepancies in positions or valuations daily, rather than weekly or monthly.

* Stay proactive. Reconcile before there is a complaint about an inconsistency.

* Recalculate. Give the appropriate haircut to a piece of collateral, as values change.

* Double-check. Be sure that the data used to value the collateral is accurate and consistently applied.

* Open the mail. Read it. Evaluate it. "Post-Lehman, my fund manager client in a triparty repo deal actually opens the file and checks that the individual pieces of collateral match its requirements," says Jane Stabile, a principal at IMP Consulting in Boston.

* Communicate clearly. Send notices of any margin calls or discrepancies by email.

* Create an audit trail. Resolve any disputes electronically. Keep track of all exchanges of messages.

* Centralize. If possible, put management of all collateral in all transactions in a single operating unit.

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