Michael Buttner June 1007

Derivatives, Notional Value Exposure, Policing Collateral and Safety Issues for Financial Systems GIC Conference Dublin, Ireland 11 June, 2007

AGENDA • Define the size of the Derivative Market.

• Examine the Credit, Market and Operational Risks associated with the Derivative market.

• Explore Collateralisation as a Risk Mitigate.

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Derivative Market • Data from the BIS Statistical Report Q4 2006 • OTC Notional Amount of Derivatives is over $415 Trillion • 70% of Notional are Interest Rate Contracts • Credit Default Swaps are the fastest growing product – Over $28 Trillion – 65% Single Name Instruments – 35% Multi – Name Instruments

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Is The Derivative Market Too Large?

• “Derivatives are compounding aggregate risk, and are doing so at a geometric rate.”

Source: M. Ramsey King

• “There is a theoretically optimal number of ‘derivative’ contracts that ‘should’ exist: It is a number millions of times larger than today’s value.”

Source: H. “Woody” Brock SED Inc.

• Positive: Derivatives help to manage risks of all kinds.

• Negative: Derivatives can increase endogenous risks of many kinds.

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What Does Notional Value Mean?

• •

Purely a Reflection of Business Activity Does Not provide a useful measure of – Credit Risk – Market Risk – Operational Risk • The Relevant Statistic to measure the Size and Impact of the Derivative Market is Gross Market Value (GMV). GMV is defined as the sum of the total gross positive market value of contracts and the absolute value of the gross negative market value of contracts with non – reporting counterparties. (BIS Dec 2006 report) – June 2004 $6.4 Trillion – Dec 2004 $9.4 Trillion – June 2005 $10.5 Trillion – Dec 2005 $9.7 Trillion – June 2006 $10.1 Trillion 03/02/13

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Global Financial Asset $229.9 Trillion as of April 30, 2007 Global Cash Financial Market

Size ($ Billion)

Lehman Brothers Global Real Assets

Size ($ Billion)

Fixed Income

36,866.27

Real Estate/Land

133,662.48

Multiverse Index U.S. Aggregate Eurodollar (ex-Agg) 144A (ex-Agg) Pan-European Aggregate

24,282.45 8,501.94 270.90 292.11 9,082.95

Non-U.S. Real Estate4 United States Total

96,551.98 37,110.50 133,662.48

Asian-Pacific Aggregate Euroyen Canadians Other Currencies Global High Yield Global Inflation-Linked Securities Index Global Capital Securities U.S. Municipal Bond Index Global FRNs China Aggregate Index

4,435.68 47.91 519.55 127.88 1,003.53 1,011.43 773.37 1,029.44 3,192.18 539.27

Short-Term Indices Non-Agency U.S. MBS, U.S. Hybrid ARMS, Danish Mortgages U.S. Commercial & Industrial Loans Equity

1,832.32 2,985.51 1,220.30 49,663.87

Global Common Equity1

48,544.58

NYSE-listed Preferred Stock2 Private Equity Funds3 North America Europe Asian-Pacific Middle East & Africa Central and South America Total

81.50 1,037.79 691.52 253.98 68.84 12.95 10.50 86,530.14

1. DJ Wilshire Full Cap 2. September 2006. 3. Dec. 2005.

4. Non-U.S. real estate estimated from GDP scaled stock value of U.S. real-estate.

5. June 2006 6. Market value roughly approximated as par Source: BIS; DJ Wilshire; NYSE; PwC; Federal Reserve; Lehman Brothers Fixed-Income Research

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What is Credit Risk in a Derivative?

•

It is function of: – Whether counterparties exchange notional; – The volatility of the underlying instrument; – The maturity and liquidity of the contract and – The credit – worthiness of the counterparty.

• Additionally the credit risk of a derivative is bilateral where the credit risk of a loan is unilateral.

• There is volatility of the credit exposure that must be factored into the allowable exposure to any given counterparty.

• Systems, Procedures and Policies are put together to measure the possible credit exposure, determine the acceptable threshold to a counterparty and determine if a counterparty must post upfront collateral to cover the potential exposure.

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Derivative Credit Approval Process • Pre – Settlement Risk (PSR) must be approved before a transaction is executed.

– PSR is a statistical estimation of market value change of the derivative transaction.

– The approval is of the peak or Maximum Potential Exposure.

• The maximum tenor for a particular counterparty must be established.

• The appropriateness of the transaction for the counterparty must be addressed.

• All credit aspects of the documentation must be approved.

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Market Risk Issues • Findings of the Counterparty Risk Management Policy Group II (27 July 2005): – Difficult for the market to anticipate shocks.

– Today’s Financial Markets are: • Very Complex; • There are tighter linkages between financial markets and participants in them; • The enormous speed with which market developments are transmitted throughout the global markets.

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Perfect Storm Part I • “Experience shows that the fact or the fear of large credit problems is often the key variable through which financial disturbances become financial shocks.”

• Two factors determine the speed and severity of market deterioration: – Credit Risk – in particular counterparty credit risk – is the most important determinate and; – Evaporation of market liquidity is the second most important determinant.

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Perfect Storm Part II • Perfect Financial Storms result from a witches brew of four ingredients: – Pricing Model Uncertainty; – Leverage; – ‘Missing’ Hedging Markets and – The extent of Correlation in Forecasting errors across market participants.

Source: Strategic Economic Decisions, Inc

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Better Risk Assessment • Understand that Market Volatility has two types of risk: – Exogenous – news driven; – Endogenous – belief structure driven.

• More Advanced Risk Models that: – Determine the joint probability distribution of the underlying trigger events and – Determine the unconditional probability distribution of payoffs generated by these risks.

Source: Strategic Economic Decisions, Inc. 03/02/13

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Operational Risk Issues • BIS report on Clearing and Settlement for OTC Derivatives (March ’07) identified 6 issues: – The Risks created by Delays in Documenting and Confirming transactions; – Implications of expanding use of Collateral to mitigate Counterparty Credit Risk; – Potential for Central Counterparty Clearing System; – OTC Derivative Prime Brokers; – Unauthorized Novations of Contracts; – Implications of a Default of a Large Market Participant.

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Policing Collateral • BIS and ISDA report.

• Collateralisation has been adopted by major jurisdictions worldwide.

• At the end of 2005 $1.3 Trillion of Collateral had been posted.

• From 1998 to 2005 number of Collateral agreements increased from 12,000 to 110,000.

• Roughly 60% of Trade Volume and Exposures are Collateralised.

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Collateralisation Issues • Type of Collateral used.

• Legal footing of Collateralisation Arrangements.

• Operational problems related to the calculations of Collateral Requirements.

• The Funding Liquidity Risk of Counterparties.

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Credit Support Annex (CSA) of ISDA Master Agreement • The CSA specifies initial pledge amounts (if any) and supplemental pledge amounts which are based on: – The value of all derivative exposures to counterparty and; – The credit rating or position of the counterparty.

• Collateralisation can be full or permit some level of unsecured exposure.

• Collateral Managements Groups monitor and manage the collateral exposure.

• Important issue is to assess the counterparty’s funding liquidity and capital market access.

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Type of Collateral • 1998 Government Bonds – Today Cash • According to ISDA Margin Survey 2006 – 75% was Cash Collateral

• Why Cash?

– – – –

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Operational Convenience Balance Sheet Management Low Opportunity Cost of Cash v Securities Two-Way Collateral Agreements more prevalent

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Back Office Reforms, Enhanced Disclosure and Transparency • Back Offices need to: – Margin Daily and – Mark to Market Daily.

• Differences in Collateral Requirements must be disclosed and reconciled.

• Pricing of Derivative Instruments must be theoretically sound and Transparent to both parties of a transaction 03/02/13

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Conclusions • The Derivative Market has had tremendous growth and will and should continue to grow in size and complexity.

• Credit events are usually the cause of market shocks.

Thus, a strong credit culture is necessary to support the Derivative Market.

• The Financial Markets need to continually examine its Risk Assessment tools. New models must be built to include endogenous and exogenous risks.

• The Derivative Market needs to ensure that the Operational processes connect to the risk models and that Collateralisation is focus of risk mitigation.

• The Collateral of choice is Cash.

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