2013 SIFMA Collateral Conference | May 2013

THE IMPACT OF REGULATION ON

THE COLLATERAL MARKETS

OVERVIEW

2

Quick Comments on Collateral & Collateral Markets

Collateral is the topic of the hour. . . And is not going

anywhere soon.

There is a great deal of activity currently going on around the

topics of collateral, collateral management and collateral

availability, including:

The initiation of Category 2 Clearing

Bloomberg LP v. Commodity Futures Trading Commission, 13-cv-

00523, U.S. District Court, District of Columbia

It is not over until its over. . .

The central clearing carrot and stick

3

Mandate Regulator Jurisdiction Requirement

Dodd FrankTitle VII;

Rule 731

EMIRRule 103

BASEL III

CFTC

SEC

ESMA

BASEL Committee on

Banking Supervision

USA (w/global

implicaitons)

Europe (w/global

implications)

Global

o Clearing of swaps through CCP’s (w/ available)

o Collateral Requirements for both OTC & Bilateral swaps

o 5 & 10 IM for cleared & un-cleared swaps; w/daily mark

to market VM requirements

o Similar in nature to Dodd Frank

o Cover’s OTC clearing, collateral, segregation, CCP’s,

interoperability, etc.

o Strengthens banking capital requirements for

counterparty credit exposure arising from derivatives,

repo’s & securities financial transactions

o Incentives movement of OTCD contracts to CCP’s

Source: TABB Group

Source: LCH.Clearnet

How is margin calculated?

Initial Margin – PAIRS

Designed to cover worse-case

losses based on historical

scenarios from the past five years

(1250 scenarios)

Represents the amount required to

close out a full portfolio without loss

Based on 5 day holding period for

members and 7-day holding period

for clients (the period required for

transfer or close-out in the event of

a default)

Calculated on a Portfolio basis,

using a filtered historical value at

risk (VAR) method

Back tested against a 99.7%

confidence interval

Variation Margin

Represents the current value of the

portfolio

Net Present Value derived intraday;

based on market standard

valuation techniques

Currency portfolios revalued

according to the LCH.Clearnet yield

curve

Margin charged/paid out in the

currency of obligation

Price Alignment Interest (PAI)

applied/charged to Variation Margin

Balance

Portfolio valuations using OIS

discounting for 6 major currencies

Please note that the above description is being provided to you for informational purposes only and is intended only as a broad overview of

certain aspects of SwapClear, a service of LCH.Clearnet Limited. The above does not, and does not purport to, contain a detailed description

of any of the topics discussed and has not been prepared for any specific audience. Accordingly, you may not rely upon the above

description and should seek your own independent legal advice.

Cash78.8%

Bonds (Sovereign)

11.6%

Bonds (Corporate)

3.1%

Other6.5%

Current Collateral Usage By Breakdown

How is the collateral universe expanding?

Source: TABB Group

6

Acceptable Forms of Collateral for CCP’s.

Product CME ICELCH

Clearnet

Cash X X X

Government Securities X X X

Government Sponsored Enterprise / Government

Agency Securities (i.e. FNMA, GNMA, FHLMC) X X

Corporate Bonds X

Equities X

Performance Bonds / Letter of Credit X X

Money Market Fund Shares X

Precious Metals (Bold Bullion * X X X

7

In the end, collateral is about risk, and the tail risk

of some of these products can be long lasting

Source: TABB Group, DTCC

665 668 1,063

1,979 1,576 1,476 1,340

1,235 1,368

2,193

2,576

1,944 2,004 2,572

2005 2006 2007 2008 2009 2010 2011

US

$ B

illio

ns

OTCD Margin RequirementCurrent Req. ($ BB) + Collateral ($ BB)

Current Margin (Single Counted) Additional Margin Requirement

3,256

1,900 2,036

4,555

3,520

2,572

3,4803,912

Source: BIS, ISDA ,WFE, TABB Group

Targeting OTCD Collateral

RequirementsComparison of the ETD

and GCE Margin Benchmarks

Our initial ’11 estimate of $1.6 trillion is now ~$2.6 trillion How big is the collateral shortfall?

1,9002,036

3,256

4,555

3,520

3,480

3,912

1,545

2,014

3,508

4,699

3,776

2005 2006 2007 2008 2009 2010 2011

US

$ B

illio

ns

2011201020092008200720062005

2011201020092008200720062005

GCE Margin Benchmark1

ETD Margin Benchmark2

Note 1: GCE – gross credit exposure

Note 2: ETD – exchange traded derivatives

Cross-product netting and margin offsets could

reduce collateral requirements from 15% to 65%

Source: TABB Group

99.5% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0%

Dealers (w/ CCP) 244,912 62% 1.50% 3,674 3,655 18 18 18

Other Dealer

Exposures52,420 13% 1.50% 786 550 472 393 236 315 393

Financial

Insitutions74,850 19% 1.50% 1,123 449 337 225 674 786 898

Non-Financial End

Users25,565 6% 0.00% - - - -

Total 397,747 100% 5,583 910 1,119 1,310

1,909 1,909 1,909

910 1,100 1,291

1,000 809 618

52% 42% 32%

Gross Notional (US $B)Gross Notional

(%)

Avg. Margin

(%)

Gross Margin

($) Mid OffsetsLow

Offsets

August '12 Demographic EstimatesEstimated Average Benefit from Netting

Estimated Margin Posted ($B)

Estimated Impact on Initial Margin ($B)High

Offsets

Not yet

cleared

Gross Margin Required

w/Portfolio Margining

Additional Margin Savings

Percentage Savings

10

Asset Class Initial Margin Requirement (% of

notional exposure)

Credit: 0-2 year duration 2

Credit: 2-5 year duration 5

Credit 5+ year duration 10

Commodity 15

Equity 15

Foreign Exchange\Currency 6

Interest Rate: 0-2 year duration 1

Interest Rate: 2-5 year duration 2

Interest Rate: 5+ year duration 4

Other 15

Source: BCBS/IOSCO

What will be the margin requirements for

uncleared trades?

Cleared (Multi-Asset)

Swaps*

Overnight Index Swap (OIS)*

Basis Swaps*

Forward Rate Agreements

(FRAs)*

* certain currencies / tenors

Credit Default Indices**

** certain baskets of CDS

Energy Related Swaps

Est. Notional Value (2011):

$261 trillion (40%)

Potentially Clearable (Rates Only)***

Swaps:

Zero Coupon Swap

Quanto Swap

Vanilla Inflation Swap

X-Currency Swap

Swaptions:

European / American Swaption

Forward Swaption

Straddle

Strangle

Spread

Caps/Floors:

Vanilla Cap / Floor

Straddle, Collar, Strangle, Spread

*** certain currencies / tenors

Est. Notional Value (2011):

$254 trillion (39%)

Clearly Unclearable (Rates Only)

Swaps:

Amortizing

Rollercoasters

Exotic Swaps

BMA, UF, UDI, IMM, LPI

Caps / Floors

Quantos

Digital / Digital Range

Knock-in / Knock-out

Constant Maturity Swaps (CMS)

Structured Products

Cancelable / Callable

Range Accrual

Inverse Floaters

Snowballs / Reverse Snowballs

Est. Notional Value (2011):

$133 trillion (21%)

What will be the impact of clearing and

collateral costs on product selection/extinction?

Source: TABB Group

Do you already hold enough collateral to post?

Yes63%

No37%

Acquire38%

Transform62%

What will you do to meet

collateral requirements?

Source: TABB Group, State Street

Based on interviews

with 34 Buy-side Firms

circa June 2012

Collateral Attitudes – Continued. . .

What is the difference between collateral

transformation and optimization? But . . .

13Source: TABB Group

High

Low

14

Clearinghouse differentiators ranked highest to lowest

Source: TABB Group

Based on

interviews with 50

Firms circa May

2012

FCMs and Banks Buy-side

Collateral Attitudes

If swaps become more expensive to trade, what other products will you use instead?

17%

8%

8%

33%

58%

TBAs/Repo/ETFs/Bond Options

New Products

No Change

Cash

Futures

Based on interviews

with 31 Buy-side Firms

circa March 2012

The future of swaps

15Source: TABB Group

Will the market move to futures?

16

Issue Advantage Goes to… Because…

Current Liquidity SwapsVanilla US IR Swaps have an annual notional turnover of $175 Trillion;

swap futures have nearly zero turnover

Future Liquidity Swap Futures

- Even if the swaps market remains vibrant, swap futures have the

potential to reach a much broader swath of the market

- Swaps liquidity will likely fragment across multiple SEFs

- Recent trends favor highly liquid, standardized instruments

Customization SwapsEven cleared swaps will allow for greater customization than swap

futures. There is limited customization available on Eris contracts

Margin Efficiency Swap FuturesThe minimum VaR calculation for futures contracts is 1 day, compared to

5 days for cleared swaps

Regulatory Status Swap FuturesTrading swap futures is a known regulatory and reporting framework that

will not require additional registration

Status Quo SwapsIf regulations prove less onerous than expected, then the swaps market

will likely continue largely as it is today

Source: CME, LCH, TABB Group

Conclusions / Takeaways

Things are never as bad, or as good, as you think they will

be – the cost of collateral will be high but no where near top

line estimates

Both DCOs and FCMs/clearing brokers are working on a

range of solutions to help investors find the least expensive

collateral to trade swaps

But there are unforseen consequences from OTC regulatory

reform

Bilateral margin requirements are an unknown

Independent amounts and potential collateral disputes

Variation margin under LSOC

The futurization trend could hurt swaps liquidity

17

Q & A

18

When the clearing mandate goes live in March, Derivatives Clearing Organizations (DCOs), Futures Commission

Merchants (FCMs) and clearing brokers must be able to accept trades for clearing within just one minute of

submission. The goal is to create a market in which clicking “execute” completes the trade entirely. A more

automated and real-time clearing workflow will allow the market to more accurately manage risk and, by doing

so, better deploy capital. But the path to this environment will require a technology investment by swaps

dealers, FCMs and the clearinghouses themselves

Real Time Clearing: The New Race to Zero

Author: Will Rhode

Relevant Recent Research from TABB Fixed Income

Death of a SEF – The Coroner’s Report

Author: Adam SussmanSwap Execution Facilities (SEFs) have a problem: They have the same amount of regulatory burdens as

exchanges but control a narrower slice of the derivatives market, and they largely will depend on the survival of

the status quo. There are multiple scenarios in which the SEF is made obsolete. In contrast, Designated

Contract Markets (DCMs) benefit if the markets move to an exchange-like model and, at the same time, a DCM

can allow many of the existing swaps processes to survive under a futures model. This is the confidence trick of

Dodd-Frank..

This report builds on TABB’s initial Global Risk Transfer Market report, published in November 2010, exploring

the ongoing battle between the status quo and the transformation of the global derivatives market as well as

where various components of the market ecosystem are in their development and implementation cycles. The

report focuses on the primary issues in swaps today -- including clearing, margin, collateral, automated trading

solutions, trading costs, trade reporting and repositories, and extraterritoriality -- with an eye toward juxtaposing

them with exchange-traded derivatives markets.

The New Global Risk Transfer Model – Transformation and the Status Quo

Author: Paul Rowady

US Buy-Side Swaps Trading 2012: I Can See Clearing Now

Author: Will RhodeThis study is based on conversations with 31 buy-side firms, including asset managers, hedge funds, regional

banks and insurance companies. It looks at clearing behavior, dealer relationships, fees, accessing Swap

Execution Facilities (SEFs), central counterparty clearinghouse selection, alternative products, basis risk, and

changes in market structure resulting from regulation