Counterparty Risk Seminar

Counterparty Risk Seminar Presented by: Daniel F.C. Crowley, K&L Gates Chad A. Dale, III, K&L Gates Gordon F. Peery, K&L Gates Marisol Collazo, DTCC Deriv/Serv Brian Gallagher, Deloitte Van Hatziyianis, NYSE Euronext K&L Gates LLP State Street Financial Center One Lincoln Street Boston, MA 02111 March 5, 2009 Contents Panelists………………………..………………………….Tab 1 Daniel F.C. Crowley Charles A. Dale, III Gordon F. Peery Marisol Collazo Brian Gallagher Van Hatziyianis About K&L Gates…………………………..……………Tab 2 Derivatives Practice Public Policy and Law Financial Services K&L Gates Selected Client Alerts………………………...Tab 3 “The Term Asset-Backed Securities Loan Facility in Sharper Focus” “Opening Salve Fired in Financial Market Reform Effort, But Many Battles Lie Ahead” “The Lifecycle of Lehman Trade Fails” “Key Insolvency Issues for Broker-Dealers, Custodial Banks and Counterparties to Repos, Swaps and other Financial Contracts” NYSE Euronext…………….……………………………….Tab 4 “Liffe Credit Default Swaps – some FAQs” “Liffe Credit Default Swaps – a cost-effective solution” “Liffe Credit Default Swaps – more about our high tech approach “A safer, clearer route for OTC” Deloitte………..….………………….……………………….Tab 5 “Integrated Compliance and Risk Management: Rethinking the Approach” “Risk management in the age of structured products: Lessons learned for improving risk intelligence” DTCC DerivSERV………..….……………………………….Tab 6 “Delivering Automated Solutions and Risk Management to OTC Derivatives” 1 Daniel F. C. Crowley AREAS OF PRACTICE Dan Crowley is a partner in the firm’s Washington, D.C. office. He has a broad public policy background, particularly on financial services, capital markets and retirement security issues. PROFESSIONAL BACKGROUND WASHINGTON, D.C. OFFICE 202.778.9447 TEL 202.778.9100 FAX dan.crowley@klgates.com Prior to joining K&L Gates, for five years Mr. Crowley was chief government affairs officer at the Investment Company Institute, the national association of the mutual fund industry. Previously, Mr. Crowley was vice president and managing director, Office of Government Relations, the Nasdaq Stock Market, Inc. (NASDAQ). He joined NASDAQ after managing government relations during the spin-off of NASDAQ from its former parent, the National Association of Securities Dealers, Inc. (NASD). Before joining NASD as vice president, Governmental Affairs, Mr. Crowley served for eight years in the U.S. House of Representatives in increasingly senior staff positions, including: general counsel, Office of the Speaker; general counsel, Committee on House Oversight, and; minority counsel, Committee on House Administration. PROFESSIONAL/CIVIC ACTIVITIES Appointed by President George W. Bush to the President’s Advisory Committee on the Arts (PACA) for the John F. Kennedy Center for the Performing Arts in Washington, D.C., 2002-present Deputy Sergeant-at-Arms, Republican National Convention, 2008 General Counsel, Young Republican National Federation, Inc., 1995-2001 Member of the Bush-Cheney Transition Team (Treasury), 2000 Guest Commentator as a legal expert on elections, MSNBC’s “War Room” during the Florida Presidential election contest, November – December 2000 Alternate Delegate, Republican National Convention, 2000 Advisor on parliamentary procedure to the government of Indonesian (MPR/DPR), during their first presidential election, Jakarta, September – October 1999 (IFES/USAID) Deputy Clerk, U.S. House of Representatives, February – March, 1999 Counsel (restructuring/personnel), House Republican Transition Team, 1994 Alternate Delegate, Republican National Convention, 1992 U.S. Army Reserve, Military Police Corps, Honorable Discharge 1986 BAR MEMBERSHIP District of Columbia Maryland EDUCATION J.D., University of Maryland School of Law, 1990 M.P.M., University of Maryland School of Public Affairs, 1990 B.S., University of Maryland College of Business and Management, 1986 Charles A. Dale III AREAS OF PRACTICE Mr. Dale, a partner in K&L Gates’ Boston office, concentrates his practice on matters of bankruptcy and insolvency. He has extensive experience representing debtors, equity investors, creditor committees, trustees and receivers in connection with out-ofcourt restructurings, bankruptcy proceedings and receiverships. He also frequently represents purchasers of financially distressed businesses both in and out of court. BOSTON OFFICE 617.261.3112 TEL 617.261.3175 FAX chad.dale@klgates.com PROFESSIONAL BACKGROUND Prior to joining K&L Gates, Mr. Dale was a partner in the Boston office of a Northeast regional law firm. He is also a former student law clerk to then Chief Bankruptcy Judge James N. Gabriel of the United States Bankruptcy Court for the District of Massachusetts. PUBLICATIONS “Tips to Ensure Protection of Directors and Officers,” Boston Business Journal (May 2006) “Restaurant Leases and Liquor Licenses,” Travel, Tourism and Hospitality Law Newsletter (May 2006) “NHL, Union Can’t Count on Miracle on Ice,” Street & Smith’s Sports Business Journal (March 2004) “Call Me Now, Not Later,” American Bankruptcy Institute Law Journal (October 2002) PRESENTATIONS Mr. Dale has written and presented articles on a wide range of matters including the reorganization of professional sports franchises, intellectual property licensing in bankruptcy, executory contracts, director and officer liability insurance, and income and property taxation in bankruptcy. His presentations include: “Asset Sales In or Out of Bankruptcy: How Do You Choose,” Presented to MCLE 10th Annual Bankruptcy Law Conference (October 2008) “Debt Recharacterization,” Presented to MCLE 8th Annual Bankruptcy Law Conference (September 2006) “Access to Business Credit and Capital for Manufacturers,” Presented to Associated Industries of Massachusetts Monthly Meeting (April 2006) “Valuation,” Presented to Association of Insolvency and Restructuring Advisors Annual Meeting (June 2005) “Dealing with Governmental Units,” Presented to American Bankruptcy Institute Annual Northeast Regional Conference (July 2005) PROFESSIONAL/CIVIC ACTIVITIES American Bankruptcy Institute American Bar Association Boston Bar Association Turnaround Management Association Charles A. Dale III COURT ADMISSIONS United States District Court for the District of Massachusetts United States District Court for the Northern District of New York United States Court of Appeals for the First Circuit United States Court of Appeals for the Second Circuit BAR MEMBERSHIP Massachusetts EDUCATION J.D., Northeastern University School of Law, 1991 B.S., University of Dayton, 1988 (with Honors) ACHIEVEMENTS In 1998, Mr. Dale was featured in “Lawyers Weekly” as one of five up and coming lawyers in the Commonwealth. “Chambers USA,” “Best Lawyers in America” and “Super Lawyers” have consistently recognized him as one of the top restructuring and bankruptcy lawyers in the Commonwealth. In 2006, Mr. Dale was named one of the top 100 lawyers in Massachusetts and in 2008 he earned recognition as one of the top 100 lawyers in New England. REPRESENTATIVE EXPERIENCE Restructuring counsel to a Midwestern producer of liquid eggs and related products. Worked closely with senior lender group to provide the client with additional liquidity and time to restructure its operations and balance sheet. Also facilitated the conversion of subordinated debt to equity. Restructuring counsel to several high-end golf course and residential developers in New England. Restructuring counsel to numerous private equity backed businesses in connection with out of court restructurings, including a manufacturer of food and tobacco processing systems, a medical and pharmaceutical education service firm, nationwide package delivery service, a polyethylene pipe manufacturer, a contract manufacturer of medical devices and a manufacturer of specialty transportation equipment. Bankruptcy counsel to Shreve, Crump & Low (and affiliate, Schwarzschild Jewelers), the oldest continuously operating retail jeweler in North America, in connection with the highly successful sale of both chains to separate purchasers. Bankruptcy counsel to Source Precision Medicine, a leading molecular diagnostics firm, in the successful recapitalization of its business through Chapter 11. Bankruptcy counsel to Video Update, one of the largest specialty video retailers in North America, in connection with the successful recapitalization and reorganization of the company through Chapter 11. Bankruptcy counsel to numerous official committees in bankruptcy cases involving the following companies: Merrimac Paper Company, Bay State Paper Co., Cornell Trading, Iron Age Corporation, Coudert Brothers LLP, USM Corporation, Harvard Clinical Technology, Inc., County Seat Stores (special counsel), Essential.com, Charles A. Dale III Number Nine Visual Technology and Auburn International. Appointed Special Assistant Attorney General for the Commonwealth of Massachusetts in bankruptcy proceedings for Modern Continental Construction Co., one of the largest prime contractors on Boston’s Central Artery/Third Harbor Tunnel project (i.e. the “Big Dig”). Bankruptcy counsel to numerous project owners, including State Street Bank, Blue Cross Blue Shield and Mellon Bank in connection with the Chapter 11 proceedings for Payton Construction Co. Bankruptcy counsel for a major US lender in connection with the collapse of The Education Resources Institute, a guarantor of more than $20 billion of private student loans. Bankruptcy counsel for the Managing General Partner of the Pittsburgh Penguins during the National Hockey League franchise’s Chapter 11 proceedings in 1998 and 1999. Counsel to purchasers of numerous distressed businesses both in and out of court, including a national chain of restaurant and entertainment centers, a computer aided design software firm, a fault tolerance and disaster recovery software maker and the Dutch subsidiary of a multi-national manufacturer of particle accelerator systems. Counsel to numerous officers and directors in connection with bankruptcy proceedings and subsequent director and officer liability actions. Gordon F. Peery AREAS OF PRACTICE Mr. Peery is Of Counsel at K&L Gates and works exclusively as a derivatives lawyer. He represents a wide range of clients in the firm’s Investment Management, Derivatives and Structured Products practice groups and is a leader of the firm’s Derivatives Task Force. PROFESSIONAL BACKGROUND BOSTON OFFICE 617.261.3269 TEL 617.261.3175 FAX Mr. Peery regularly handles these matters: Derivatives Counterparty Risk and Counterparty Insolvency Representation. Mr. Peery provides practical legal advice to minimize counterparty risk and has represented end-users in bringing about the termination of derivative and cash trades and release of collateral. Prime Brokerage, Securities Lending, Repos and Related Derivatives Documentation. Mr. Peery negotiates prime brokerage documentation, including Margin Agreements, Master Securities Loan Agreements, Global and Overseas Lending Agreements; ISDA Master Agreements and accompanying Schedules and Credit Support Annexes; tri-party/Control Agreements; futures, commodities and options documentation; Bridge Agreements and ERISA amendments to margin account agreements. Mr. Peery has structured numerous repurchase and warehouse facilities and brought about several dozen repo financings and related transfers of assets, ranging from commercial real estate whole loans, subordinated real estate debt (e.g., mezzanine loans, B-pieces, etc.) to various complex securities. Mr. Peery is experienced in handling 130/30 strategy, margin lending and other prime brokerage matters. Fund Crisis Management and Valuation Issues. Mr. Peery has recently represented both hedge funds and registered funds in a wide range of disputes involving collateral valuation, ISDA Events of Default and Early Terminations; transfers of ISDAs from off-balance sheet swap providers, novations and fund wind-downs. Washington D.C. Derivatives and Structured Finance Representation. Mr. Peery assisted with several investigations by Congress in connection with a series of Congressional hearings involving structured finance products and derivatives provided by major international investment banks to Enron Corp. Total Return Swaps. Mr. Peery worked as the lead attorney in the structuring, negotiation and documentation of numerous TRSs, including a complex bespoke TRS for a major international bank. Interest Rate Swaps. Mr. Peery has structured and negotiated fixed-to-floating interest rate swaps in numerous transactions, and, most recently, sets of interest rate swaps and back-to-back swaps in connection with securitizations involving automobile loans. As outside rating agency counsel, Mr. Peery has reviewed over 20 interest rate swaps accompanying rated structured finance transactions. gordon.peery@klgates.com Gordon F. Peery Caps, Floors and Collars. Mr. Peery has handled derivatives documentation for numerous caps accompanying large commercial real estate transactions as well as floors and collars. Cost of Funds Swap. Mr. Peery structured an interest transformer swap for a commercial paper conduit sponsored by a French investment bank. Credit Default Swaps. Mr. Peery was the lead attorney in the preparation and negotiation of numerous credit default swaps, including the negotiation of formapproved synthetic documentation governed by applicable rating agency criteria. He has negotiated a credit default swap involving 737 aircraft leases, as the reference obligations, for a major international fund. Mr. Peery has also assisted with the representation of swap insurers and credit enhancers in connection with structured finance transactions and negative basis credit default swaps. Equity Derivatives. Mr. Peery has negotiated numerous equity swaps and dealerspecific confirmation documentation, including, for example, the Morgan Stanley Automated Transaction Supplement and the Credit Suisse Portfolio Swaps Annex. Mr. Peery negotiated a share forward purchase with a major French investment bank. ISDA Documentation. Mr. Peery has prepared and finalized other derivatives documentation for numerous registered funds and hedge funds ranging from plain vanilla derivatives to exotic derivatives provided by Barclays, Bear Stearns, Goldman Sachs, Morgan Stanley, HSBC, Bank of America, Jefferies & Company, Merrill Lynch and other dealers. PROFESSIONAL/CIVIC ACTIVITIES Mr. Peery is a current member of International Swaps and Derivatives Association, Inc. (“ISDA”) committees and working groups, including the Potential Industry Improvements working group and various other ISDA bodies directly involved with post-Lehman and central counterparty matters, the Energy, Commodities and Developing Products Committee; Japan Committee; ISDA Definitions Working Group; the Covered Bonds Working Group and the ABS Hedging Documentation Project Working Group. Mr. Peery is a former member of the following ISDA committees: Collateral Framework Working Group; Collateral Committee; and the Credit Derivatives – ABS Committee. BAR MEMBERSHIP California District of Columbia (Inactive) New Jersey Pennsylvania EDUCATION J.D., Vanderbilt School of Law, 1995 (recipient, Bennett Douglas Bell Memorial Honor) B.A., University of Southern California, 1991 (magna cum laude; Phi Beta Kappa) LANGUAGES Japanese Marisol Collazo, Vice President, Business Development DTCC DerivSERV 212.855.2670 mcollazo@dtcc.com Marisol Collazo joined DTCC Deriv/Serv in April 2007 as Vice President, Business Development, responsible for leading various initiatives related to DTCC/DerivSERV's Trade Information Warehouse, such as buy-side inclusion of the central settlement service, enabling connectivity for central clearinghouses, public data reporting, and other service enhancements. Marisol brings to the business more than 15 years of experience in the OTC derivatives market from her previous positions at Bank of America, Deutsche Bank and Mizuho Capital Markets. Marisol held various roles managing documentation and operations processing, new product development, and was involved in several key market initiatives, including the creation of the FpML standard for derivatives which is now widely used by the industry. Brian J. Gallagher, Audit Partner EXPERIENCE DELOITTE & TOUCHE 617.437.2398 bgallagher@deloitte.com Brian has more than 30 years of public accounting experience with Deloitte & Touche, has expertise in the audits of mutual funds. As the firm's National Audit Partner for investment companies, Brian is responsible for the development of the firm’s audit approach as it relates to investment management clients, formation of the firm’s position on investment management accounting and reporting issues, and the overall quality of audit services provided to the firm’s investment management clients. A member of Deloitte’s National Investment Management Services Group, he has extensive experience dealing with mutual funds, offshore funds, investment advisers, broker/dealers, custodians, trust, and transfer agents. A certified public accountant, Brian is currently a member and the former chairperson of the AICPA Investment Company Expert Panel and has been involved in the development of several accounting standards related to investment companies. Brian received his M.B.A. from Suffolk University and B.B.A. from the University of Notre Dame. COMMUNITY INVOLVEMENT Director- Catholic Schools Foundation Member- Suffolk University Accounting Advisory Board Member- Finance Committee of the Pine Street Inn REPRESENTATIVE CLIENTS SERVED BlackRock Family of Funds Brown Bothers Harriman Eaton Vance Investment Companies Fidelity Investments Massachusetts Financial Services Investment Companies MassMutual Family of Funds Merrill Lynch Family of Funds Morgan Stanley Family of Funds SSgA Family of Funds . Van Hatziyianis, Head of US Wholesale Services NYSE Euronext 212.656.5122 vhatziyianis@nyx.com Van Hatziyianis heads the team in the US responsible for Liffe’s OTC products and services. OTC services are delivered through Bclear and Cscreen platforms. Bclear is Liffe’s award winning OTC trade administration and processing platform for Equity Derivatives and Credit Default Swaps. Van joined NYSE Euronex in 2008 from Merrill Lynch where he was a Director of the Global Markets Division for the past four years. Based in New York, he was responsible for Global Fixed Income Prime Brokerage Client Services and Product Development. Prior to joining Merrill Lynch, Van spent ten years at Lehman Brothers where he managed Global Derivative Operations. Van holds a BA from Adelphi University. 2 K&L Gates Prime Brokerage, Derivatives, Repo, and Securities Lending Practices There are approximately 30 lawyers at K&L Gates with substantial prime brokerage, derivatives, repurchase facility and securities lending experience in New York, Boston, Washington, D.C., Dallas, Seattle, and London. These lawyers complement K&L Gates’ Investment Management practice group, which consists of nearly 100 lawyers in 15 offices in the United States, Europe, and Asia. This practice is one of the largest and most sophisticated global investment management practices, with a presence on three continents. We capitalize on our institutional knowledge and achieve efficiencies for the benefit of clients by establishing multidisciplinary teams of practitioners in all areas of the financial services industry. The National Law Journal has identified K&L Gates as a “go-to” law firm for financial America. A recent “Chambers” publication ranked K&L Gates as having “one of the leading financial service practices.” Our Services Prime Brokerage and Securities Lending Experience Our lawyers are experienced in representing a wide range of market participants in the prime brokerage and securities lending space, including investment banks, brokers, traditional fund customers (domestic and offshore hedge funds and mutual funds), custodians, and traders in a wide range of prime brokerage, clearing, and securities lending arrangements. As the recent credit and liquidity crises have changed the prime brokerage industry, we have been in front of its continuous evolution. We have assisted in the development of new and innovative terms in agency and lending relationships that facilitate securities lending at a time when borrowers have become scarce. We regularly negotiate traditional prime brokerage documentation that includes documentation for bridged products incorporating ISDA documentation as well as Margin Agreements, Master Securities Loan Agreements, Global and Overseas Lending Agreements, ERISA amendments, and other ancillary agreements that accompany prime brokerage documentation. Our lawyers are experienced in handling 130/30 and other strategies as well new prime brokerage substitute arrangements. We capitalize on our Documentation Experience Our lawyers represent financial institutions and others in a variety of contexts involving structured products, derivatives, and securities lending. We are experienced in negotiating a wide range of derivative and brokerage documentation, including dealer-specific master equity confirmations as well as the entire suite of prime brokerage, securities lending, and repurchase facility documentation. We work regularly with the forms of master agreements and security documents under New York and English law, as well as with most complex confirmation templates for equity, credit, energy, and other derivative transactions. We are also very familiar with applicable securities regulations and rules governing security interests under U.S. and English law. Crisis Management in 2008 and Beyond We have represented both hedge funds and registered funds in a wide range of financial crises involving leading brokers and dealers as well as in disputes involving collateral valuation, ISDA Events of Default and Early Terminations, transfers of ISDAs from offbalance sheet swap providers, novations, and fund wind-downs. Our multi-disciplinary team includes liquidation professionals throughout the world. We are actively engaged in countries where administrations and other liquidation proceedings of derivative dealers are underway. Our crisis management representation also includes extensive work in connection with Congressional inquiries and formal investigations of providers of derivatives and various structured products. institutional knowledge and achieve efficiencies for the benefit of clients... Structuring Derivatives to Achieve Client Goals Our counseling covers derivatives structuring, negotiation and trading, regulatory compliance, and other issues. Our interdisciplinary team structures derivatives with an eye toward helping our clients achieve a broad range of tax and investment objectives. For example, our tax lawyers often work in tandem with our derivatives documentation professionals to achieve client objectives. Identifying and Minimizing Counterparty and Other Risks We have also been retained by leading fund managers and other clients throughout the world to identify the risk that their operations may not be: (i) requiring the posting of collateral by dealers where bi-lateral CSAs are in place; (ii) scrutinizing dealer requests to post collateral when trades are “out of the money”; and (iii) marking-to-market derivative trades to ensure that the foregoing activities are properly taking place (i.e., requiring dealers to post collateral and marking-to-market the derivatives). We work on behalf of our clients with the leading custodians in recommending a wide range of measures to minimize derivativerelated risk. Our lawyers are invited to speak at industry roundtables and regularly counsel market participants with respect to compliance with industry mandates relating to electronic processing of trades and novations. Repo Transaction Experience Our lawyers have regularly negotiated and structured numerous repurchase and warehouse facilities and related custody arrangements for many asset classes including commercial real estate whole loans, subordinated real estate debt (e.g., mezzanine loans, B-pieces, etc.) to various complex securities. We have analyzed repurchase facility documentation for investment management arms of major investment banks to determine whether the documentation is consistent with current market practice and our team has provided repurchase facility counsel to investment banks and custodians on a wide range of liquidation issues following the filing of a Chapter 11 bankruptcy petition by Lehman Brothers Holdings Inc. K&L Gates is ranked as having one of the leading financial services practices in the United States. (Chambers USA, 2007) The laws governing financial institutions and the capital markets are undergoing the Public Policy and Law: most significant revision in generations. K&L Gates combines one of the largest and most Financial Services with the policy and regulatory know-how of the 6th largest law firm public policy practice experienced financial services and investment management practice groups in the U.S., (Legal Times, March 2008). Our attorneys and public policy professionals have significant experience in senior government positions and a broad network of bipartisan relationships. Often clients’ needs go beyond traditional An effective government affairs strategy integrates Our Services: legal advice and require government solutions. both legislative and regulatory components. Indeed, in an increasingly competitive and We regularly work with the key Congressional • Legislative Monitoring and Lobbying dynamic marketplace in which the rules are committees and leadership, as well as the changing, a government affairs component SEC, FINRA, CFTC, HUD/FHA, OCC, OTS, is an integral part of many strategic business FDIC, White House, Departments of Treasury plans. Working with Congress, government and Labor, and the FRB. Whether clients simply agencies and industry groups, we solve clients’ require insight and understanding, or seek to most difficult problems by understanding policy proactively influence proposed legislation, issues from every direction – substantively and regulatory changes or agency interpretations, politically – and navigating the corridors of K&L Gates has the know-how to ensure our clients Washington to ensure that the interests of our achieve their objectives. clients are effectively represented where and • Regulatory Advocacy and Implementation • Strategic Planning Advice • Compliance Strategies • Preparation of Testimony • Drafting of Legislation and Regulatory Submissions when it matters most. K&L Gates combines one of the most experienced Investment Management groups in the U.S. with the policy and regulatory know-how of the (Legal Times, March 2008) sixth largest law and lobbying firm. 3 Investment Management/Hedge Fund Alert February 2009 Authors: Gordon F. Peery gordon.peery@klgates.com The Term Asset-Backed Securities Loan Facility in Sharper Focus +1.617.261.3269 Daniel F. C. Crowley dan.crowley@klgates.com +1.202.778.9447 Anthony R.G. Nolan anthony.nolan@klgates.com +1.212.536.4843 Michael S. Caccese michael.caccese@klgates.com +1.617.261.3133 Drew A. Malakoff drew.malakoff@klgates.com Details concerning the Term Asset-Backed Securities Loan Facility (“TALF”), a leading U.S. government initiative to bring about the return of capital to the financial system, continue to emerge. The purpose of TALF is to revitalize the U.S. securitization market, thereby increasing credit availability to consumers and businesses and promoting economic growth. TALF directly addresses the breathtaking freefall of the securitization market, which fell from $2.1 trillion in deal volume in 2006 to $313.9 billion last year. Underscoring the critical need for securitization as a source of credit, the Department of Treasury recently announced that federal support of TALF will be dramatically expanded to potentially provide a monumental $1 trillion in financing. TALF therefore presents an unprecedented source of federal financing to investors in tranches of certain types of securitized debt issued in 2009. This Alert describes the TALF program with available details and provides action items for potential TALF participants, which may be able to invest using TALF proceeds as early as March 2009. +1.212.536.4034 Karishma S. Page karishma.page@klgates.com +1.202.778.9128 K&L Gates comprises approximately 1,700 lawyers in 29 offices located in North America, Europe and Asia, and represents capital markets participants, entrepreneurs, growth and middle market companies, leading FORTUNE 100 and FTSE 100 global corporations and public sector entities. For more information, please visit www.klgates.com. Background On November 25, 2008, the Federal Reserve Board (the “FRB”) announced the creation of TALF under Section 13(3) of the Federal Reserve Act. The initial design of TALF provided for one-year term lending for the purchase of newly securitized assets generating payment streams from auto, student, credit-card and small-business loans. Prior bailout efforts under the Troubled Asset Relief Program (“TARP”) focused on government capital injections to financial institutions in order to indirectly increase lending. Recognizing that a critical problem within the larger economic crisis is the seizure of the securitization market and the inability of banks to function within it, the FRB expanded TALF to create incentives for other market participants such as hedge funds to return to this market. On December 19, 2008, the FRB extended TALF loan terms from one to three years. On February 6, 2009, the FRB released specific TALF loan and collateral requirements following consultation with key players in the asset-backed securities (“ABS”) market. On February 10, 2009, Treasury Secretary Timothy F. Geithner announced a Financial Stability Plan that contemplates a broader, joint public-private investment program, and TALF is a cornerstone of the new plan. Specifically, the Plan calls for the expansion of the TALF facility up to $1 trillion for permitted investments. TALF may be further expanded to include commercial mortgage-backed securities, privatelabel residential mortgage-backed securities, and other ABS as well as additional funding from the Troubled Asset Relief Program (“TARP”). Investment Management/Hedge Fund Alert In a no-action letter dated February 17, 2009, the SEC’s Division of Trading and Markets granted facilitating relief to broker-dealers that act as primary dealers in government securities (“Primary Dealers”), which would otherwise be precluded by Section 11(d)(1) of the Securities Exchange Act of 1934 (the “1934 Act”) from arranging for the syndicated extension of credit under TALF for the purchase of a security other than an a security that is an exempted security under the 1934 Act. 1 A Summary of How TALF Will Work Each month that follows in 2009, the Federal Reserve Bank of New York (“FRBNY”) will offer a fixed amount of TALF loans to eligible borrowers based on a competitive, sealed bid auction process. The loans will be non-recourse to each borrower and will be fully secured by eligible asset-backed securities (“ABS”). Examples of assets underlying eligible ABS include one or more pools of auto loans, small business loans, credit card receivables and federally-guaranteed student loans, as well as possibly other assets such as commercial mortgage loans. It is expected that investors will be able to borrow TALF proceeds to purchase between 84 to 95 percent of certain tranches of securitized bond offerings, based on recent releases from the FRB. Loans under TALF will not be subject to variation margin, mark-to-market or re-margining. Remittance of principal or interest on eligible collateral must be used to pay interest due on, or reduce the principal amount of, the TALF loan. The FRBNY will charge an initial, non-recourse loan fee, and fund loans to borrowers for the purchase of qualified ABS, which will in turn be pledged to the FRBNY. TALF borrowers must use a primary dealer as an agent to the borrower, which delivers eligible collateral to a clearing bank. The FRBNY will create a special purpose vehicle (“SPV”) to purchase and manage assets delivered to the FRBNY in connection with the TALF loans. 2 While TALF is not a TARP program as such, the FRBNY exposure is backed initially by a $20 billion put facility provided by Treasury and funded from moneys appropriated under the Emergency Economic Stabilization Act of 2008 (“EESA”) for TARP. If more than $20 billion in credit protection is needed to support TALF, Treasury will increase the amount of credit protection that it provides to the FRBNY in excess of the initial allocation. The process for applying for a TALF loan creates an intricate mechanism in which the funding must be coordinated with the settlement of purchase of newissuance ABS. Prior to the subscription date, primary dealers will collect from prospective eligible borrowers the amount of each borrower’s loan request, the interest rate format for the loan (fixed or floating), the CUSIPs of the ABS the borrower expects to deliver to the Fed, and the offering documents of the ABS. On the subscription date, the primary dealer will submit this information to the Fed’s custodial agent for review. At least two business days before the loan settlement date, the custodian will send a confirmation to the primary dealer listing such information as the haircut, margin and administrative fee to be collected by the primary dealer and paid on the loan settlement date. On the loan settlement date, the borrower will deliver against payment the ABS collateral, administrative fee, and applicable margin to the Fed’s settlement account at the custodian. Potential borrowers may not know if their borrowing request has been accepted prior to agreeing to purchase the ABS, leaving them at risk for owning an ABS they cannot finance. From the view of the sponsor of the ABS, this issue translates into the question of how they arrange their issuance to make it attractive to potential investors. One potential solution available to sponsors will be properly managing the timeline of their transaction. Sponsors will probably have to time the pricing of their issuances to coincide with the Fed’s confirmation date for TALF loans. Eligible TALF Borrowers For an entity to be an “eligible borrower” of a TALF loan, it must be (i) organized under the laws of the U.S. or any political subdivision thereof and must conduct significant operation or activities within the U.S.; (ii) a U.S. branch or agency of a foreign bank (excepting a central bank) that maintains reserves with a Federal Reserve Bank; or (iii) a U.S.-organized investment fund managed by an investment manager with its principal place of business in the U.S. The TALF excludes any entity that is controlled by a foreign government or is managed by an investment manager controlled by a February 2009 2 Investment Management/Hedge Fund Alert foreign government. (The FRB has indicated that control is based on ownership, control, or holding with power to vote 25% or more of a class of voting securities of the borrower). Foreign investment funds that want their affiliates to borrow from the TALF would be able to do so by establishing a U.S.-based and U.S.-managed entity to originate and manage the assets. This structure allows the foreign-owned U.S. entity to borrow from the FRB and still be able to pass through to the offshore fund "portfolio" interest exempt from US withholding, which still raises tax and structuring issues. To the extent that the financed securities are backed by mortgage assets, some of these issues may be addressed to an extent by the borrower making an election to be taxed as a real estate mortgage investment conduit or REMIC. Because TALF is authorized under the Federal Reserve Act rather than EESA, borrowers under TALF should not be regarded as having received financial assistance under TARP, and consequently, they should not be subject to the executive compensation restrictions of section 111 of the EESA. However, several observers of both TALF and EESA have expressed the concern that borrowers under TALF may be considered to have received EESA funds because of the $20 billion in credit protection provided to the FRBNY under EESA, and thus, indirectly be subject to these executive compensation limits. On February 19, 2009 the Financial Services Roundtable asked Treasury Secretary Geithner and SEC Chairman Schapiro for guidance on this point (among others). Prospective borrowers should consider this uncertainty carefully in considering whether to fund securities purchases under the TALF. or floating (100 basis points over one-month Libor) interest rate; • Borrowers are eligible for one floating and one fixed rate loan per month; • Each loan will be subject to a five basis point administrative fee on the settlement date; • Haircuts will range from 5% to 16%, depending on the category of ABS offered as collateral; and • No substitution of collateral during the term of the TALF loan is permitted. Eligible TALF Collateral To be eligible for TALF loans, borrowers must be willing to post “eligible collateral.” Eligible collateral are ABS that: • Have been issued on or after January 1, 2009; • Have as underlying credit exposure either auto loans, student loans, credit card loans, or small business loans fully guaranteed by the U.S. Small Business Administration (“SBA”) or other assets such as commercial mortgages and residential mortgages, as may be encompassed in the expanded program; • Are U.S.-dollar denominated in cash (i.e., not synthetic); • Have a credit rating in the highest long-term or short-term investment-grade rating category from two or more nationally recognized statistical rating organizations (“NRSROs”); • Do not have a credit rating below the highest investment-grade rating category from any major NRSRO; • Are cleared through the Depository Trust Company; • Have all or substantially all of their credit exposure to U.S.-domiciled obligors; Eligible TALF Loans Borrowers holding or intending to hold “eligible collateral” (see below) are eligible for TALF loans with the following conditions: • The minimum loan amount is $10 million; • Loans have a three-year term, and will be prepayable at the option of the borrower; • Do not have underlying credit exposures that are themselves cash or synthetic ABS; • Borrowers are able to choose either a fixed (100 basis points over the three-year Libor swap rate) • Have underlying credit exposure that was originated or disbursed on or after certain dates; February 2009 3 Investment Management/Hedge Fund Alert • Are not be backed by loans originated or securitized by the TALF borrower or an affiliate; • Have an expected life of no more than five years (only if an auto loan or credit card ABS); and • The originators of the credit exposures underlying eligible ABS must have agreed to comply with (or already be subject to) executive compensation standards that are consistent with TARP guidelines and must have agreed to certain other conditions to the issuance of TALF-eligible securities, including providing an indemnification to the Treasury. Part of the reason that the recent updates to the TALF program have received a lukewarm reception from many observers relates to how these enumerated terms will impact investors who may seek TALF loans. For instance, the three-year limit to the term of the loans provides a significant impediment to any investor holding an eligible ABS with an expected term of longer than three years. For some collateral types such as auto loans and credit card receivables, a three-year-term may not present an issue. However, for collateral such as mortgage loans or student loans (which generally do not even begin paying down until the student is out of school four years later), it is highly unlikely that the ABS will mature in time to pay off the TALF loan at its three year maturity. As currently conceived, it seems that all of these ABS would be doomed to be the subject of a default. Thus, it appears that sponsors of TALF-eligible ABS will have to consider ways in which to structure transactions that normally have longer terms to maturity in order to make them attractive to potential investors seeking a TALF loan. Recommended Next Steps An announcement of the commencement of TALF by the FRB as well as other TALF details is imminent. We recommend that prospective TALF borrowers consider the following: 1. Monitor FRB Determinations of the Exact Cost of TALF Financing. An early consideration is the amount of the non-recourse loan fee that the FRBNY will assess at the inception of each TALF loan. We continue to actively monitor for our clients this key threshold term. 2. Monitor Valuation and Pricing of Securitized Assets that Qualify as Eligible Collateral under TALF. Another threshold consideration is the supply of TALF-eligible ABS collateral that will be available for purchase in connection with the TALF facility. We continue to monitor the origination of the credit exposures underlying eligible ABS under TALF against applicable TALF requirements. 3. Consider Other Factors that are Key for Determining Profit and Credit Risk. Prior to the next FRB announcement concerning TALF, we recommend further close focus on, and monitoring of other key factors, including: (i) the calculation of the monthly debt service for a TALF loan; (ii) availability of TALFcompliant collateral in the 2009 ABS market; (iii) the pricing and valuation of that collateral; (iv) the ratio of federal loan proceeds available under TALF to private sources of financing to purchase ABS; (v) the extent, cost and availability of other forms of credit support for TALF-based securitization, including ABSlevel and TALF-loan-level interest rate swaps and other derivatives; and (vi) the existence of additional FRB and Treasury incentives to further stimulate the securitization market, such as credit support or guarantees. 4. Prepare for the Bid Auction Process. The TALF Term Sheet indicates that a fixed amount of loans will be offered to qualified borrowers each month, “based on a competitive, sealed bid auction process.” Participation will depend on the preparation of bids. According to the TALF Term Sheet, “[e]ach bid must include a desired amount of credit and an interest rate spread over one-year OIS. The FRBNY will set minimum spreads for each auction. We recommend at least weekly consultation with approved primary dealers by prospective borrowers under TALF in preparation for monthly bidding that we expect will commence shortly following the announcement of the commencement of TALF. 5. Review TALF Transaction Documentation. Leading up to the FRB’s imminent announcement of the commencement of TALF, the FRB released from February 18, 2009 to February 2009 4 Investment Management/Hedge Fund Alert February 20, 2009, a Master Loan and Security Agreement, certification of eligibility, and auditor attestation, which should be carefully reviewed with qualified legal counsel. We continue to monitor the upcoming release of the next facility documents, including the form of loan request, assignment and assumption agreement, and collateral surrender and acceptance notice. Conclusion The early outlines of TALF point toward an imminent and unprecedented program to facilitate the revitalization of the securitization market as a source of broader support for consumer and commercial credit. There are a number of indicia of positive market reception for well-developed, TALF-sponsored securitization, including purchases of mortgage-backed securities under the MBS Purchase Program of the FRBNY, issuances and purchases of commercial paper, and large, successful bond offerings in 2009. Additional details of the TALF facility, forthcoming soon, can only facilitate the return of the securitization market. K&L Gates comprises multiple affiliated partnerships: a limited liability partnership with the full name K&L Gates LLP qualified in Delaware and maintaining offices throughout the U.S., in Berlin and Frankfurt, Germany, in Beijing (K&L Gates LLP Beijing Representative Office), and in Shanghai (K&L Gates LLP Shanghai Representative Office); a limited liability partnership (also named K&L Gates LLP) incorporated in England and maintaining our London and Paris offices; a Taiwan general partnership (K&L Gates) which practices from our Taipei office; and a Hong Kong general partnership (K&L Gates, Solicitors) which practices from our Hong Kong office. K&L Gates maintains appropriate registrations in the jurisdictions in which its offices are located. A list of the partners in each entity is available for inspection at any K&L Gates office. This publication is for informational purposes and does not contain or convey legal advice. The information herein should not be used or relied upon in regard to any particular facts or circumstances without first consulting a lawyer. ©2009 K&L Gates LLP. All Rights Reserved. 1 SEC No-Action Letter issued to Thomas C. Baxter, Jr., Executive Vice President and General Counsel, Federal Reserve Bank of New York (February 17, 2009), available at http://www.sec.gov/divisions/marketreg/mr-noaction/2009/frbny021709.pdf. The TALF term sheet sheds light on the way in which funds under the Troubled Asset Relief Program will be used in connection with TARP: The FRBNY will enter into a forward purchase agreement with the SPV under which the SPV will commit, for a fee, to purchase all assets securing a TALF loan that are received by the FRBNY at a price equal to the TALF loan amount plus accrued but unpaid interest. The U.S. Treasury’s Troubled Assets Relief Program (TARP) will purchase subordinated debt issued by the SPV to finance the first $20 billion of asset purchases. If more than $20 billion in assets are purchased by the SPV, the FRBNY will lend additional funds to the SPV to finance such additional purchases. The FRBNY’s loan to the SPV will be senior to the TAFP subordinated loan, with recourse to the SPV, and secured by all the assets of the SPV. All cash flows from SPV assets will be used first to repay principal and interest on the FRBNY senior loan until the loan is repaid in full. Next, cash flows from assets will be sued to repay principal and interest on the TARP subordinated loan until the loan is repaid in full. Residual returns from the SPV will be shared between the FRBNY and the U.S. Treasury. Board of Governors of the Federal Reserve System Release, February 6, 2009, available at http://www.federalreserve.gov/newsevents/press/monetary/20090206a.htm. This release includes a link to a revised FRB term sheet for the TALF facility (the “TALF Term Sheet”), which provides the basis for the details summarized in this Alert and is available at http://www.newyorkfed.org/markets/talf_terms.html. 2 February 2009 5 Investment Management & Public Policy Alert February 2009 Authors: Lawrence B. Patent lawrence.patent@klgates.com Opening Salvo Fired in Financial Market Reform Effort, But Many Battles Lie Ahead +1.202.778.9219 Introduction Anthony R.G. Nolan anthony.nolan@klgates.com +1.212.536.4843 Daniel F.C. Crowley dan.crowley@klgates.com +1.202.778.9447 Gordon F. Peery gordon.peery@klgates.com +1.617.261.3269 K&L Gates comprises approximately 1,700 lawyers in 29 offices located in North America, Europe and Asia, and represents capital markets participants, entrepreneurs, growth and middle market companies, leading FORTUNE 100 and FTSE 100 global corporations and public sector entities. For more information, please visit www.klgates.com. By voice vote on February 12, 2009, the House Committee on Agriculture approved H.R. 977, the “Derivatives Markets Transparency and Accountability Act of 2009.” Because of various provisions in this bill, portions of it will be referred to committees dealing with financial services, energy and justice, so there is not much chance that the bill will be enacted in its present form. Nevertheless, there is a great likelihood that legislation will be approved by this Congress that affects the way financial markets and participants in those markets do business. The bill was introduced by the House Agriculture Committee Chairman, Collin C. Peterson (DMinn.), who obviously wants to preserve a role for the Agriculture Committee “as the Committee with jurisdiction over derivative markets,” as he phrased it in his opening statement before the Committee’s consideration of the bill on February 12. A prior version of this bill passed the House last year by greater than a two-thirds vote, 283-133. That earlier version was drafted mainly in response to the run-up in energy and other commodity prices last year, and sought to put speculative limits on trading in futures and options in light of the alleged speculative excesses blamed for driving up prices. Some of those elements still remain in the revised bill, but, due to the other developments in financial markets during the past year, the focus is much more on derivatives. The importance of this initiative for the Agriculture Committee is reflected in the fact that amendments to the Commodity Exchange Act (CEAct) are normally made only in the context of reauthorization of the Commodity Futures Trading Commission (CFTC), the independent federal agency responsible for administration of that Act. The CFTC was reauthorized just last May through fiscal year 2013, yet already plans to amend the CEAct have been thrown in the hopper. The chief provisions of H.R. 977 would: 1. generally require the clearing of swap transactions; 2. require the CFTC to set position limits for all physically-deliverable commodities; 3. subject swaps to reporting and recordkeeping requirements; and 4. grant CFTC the authority to suspend credit default swap trading, with the concurrence of the President. The latter provision is a softening of an earlier version of the bill, which would have made it unlawful for any person to enter into a credit default swap unless the person would experience financial loss if a credit event occurs, and thereby would have effectively banned the credit derivative market by outlawing the trading of “naked” credit default swaps. Investment Management & Public Policy Alert Clearing Position Limits Clearing is the process by which trades are processed, guaranteed and settled by a clearing organization. Through a procedure known as “novation,” the clearinghouse takes both sides of each trade and becomes “the buyer to every seller and the seller to every buyer.” Having the clearing organization as the central counterparty substitutes the credit of the clearing organization for that of individual counterparties, and facilitates netting of obligations so that market participants can make a single payment to, or receive a single collection from, the clearing organization on a daily (and intraday) basis, rather than dealing with multiple funds transfers to all of their counterparties. Daily marking-to-market, requiring the posting of margin, and the ability to liquidate positions that are undermargined should help a clearing organization mitigate the impact of any single party’s default on other market participants. The bill approved by the House Agriculture Committee also retains the requirement from last year’s legislation that would require the CFTC to set speculative position limits for physically-deliverable commodities. Currently, the CFTC only has authority to set such limits for agricultural commodities, so this would expand CFTC’s authority to energy commodities and metals. The bill would also mandate that the hedging definition for these purposes require that the futures or option transaction represent a substitute for transactions made or to be made or positions taken or to be taken at a later time in a physical marketing channel, which would restrict the current broader view taken of what constitutes hedging and appropriate risk management. The CFTC also would have authority to impose speculative position limits for swaps that it finds to be fungible with contracts traded on exchanges and that have the potential to (1) disrupt an exchange’s liquidity or price discovery function, (2) cause a severe market disturbance in the underlying cash or futures market, or (3) prevent an exchange-listed contract from reflecting the forces of supply and demand. Although the House Agriculture Committee bill will generally require clearing of swaps through a CFTCregistered derivatives clearing organization (DCO) and would apply this to open transactions even if entered into prior to the bill’s effective date, certain exceptions are provided. If the swap agreement involves an “excluded” commodity under the CEAct, which is basically any financial instrument, a clearing agency regulated by the Securities and Exchange Commission (SEC) could do the clearing. The bill also provides an alternative to clearing that requires reporting the transaction to the CFTC. This alternative is presumably intended to cover specialized swap instruments that a DCO or clearing agency would not find profitable to clear due to its particular characteristics and lack of fungibility with other swaps. To qualify for this reporting alternative, the parties to the agreement and the agreement itself would have to meet financial integrity standards established by the CFTC, including a net capital requirement for the parties comparable to that imposed by a DCO on its clearing members. The CFTC could, therefore, make it very difficult -- if not impossible -- to engage in highly individualized swap agreements, depending upon how strict it makes the financial integrity standards. The requirements for clearing or reporting of transactions would not apply to spot or forward transactions, as defined by the CFTC. Procedural Provisions There are several procedural provisions in the bill that make it problematical from the standpoint of the potential new authorities to be given to CFTC, as well as with respect to prior CFTC actions. As noted above, existing swap agreements, entered into in good faith under existing federal law, could be impacted by the new clearing requirement. Older agreements may be more likely to have individualized terms that would not be that attractive to a DCO. If a DCO declines to clear such an agreement, and the agreement cannot meet the CFTC’s financial integrity criteria to qualify for the reporting exception, the validity of the agreement could be in doubt. CFTC would also be granted the power to “use emergency and expedited procedures (including any administrative or other procedure as appropriate) to carry out this Act if, in its discretion, it deems it necessary to do so.” This procedural power would apply to the authority to suspend trading of credit default swaps, unless the President disapproves, if “in the opinion of the [CFTC] the public interest February 2009 2 Investment Management & Public Policy Alert and the protection of investors so require.” It is unclear to what extent the CFTC would be bound by the Administrative Procedure Act or any other standards besides the President’s disapproval in making such determination. Some of the procedural requirements in the bill appear to be particular favorites of current CFTC Commissioners. One provision of the bill appears designed to satisfy Acting Chairman Michael V. Dunn by directing the CFTC to review all prior actions (including exemptions, guidance and noaction letters) taken by the CFTC, its staff, the exchanges, DCOs and the National Futures Association, to ensure that such prior actions are in compliance with the CEAct. There is no deadline set for this review, but it could create legal uncertainty about the validity of actions taken in good faith reliance on existing law. Separate and apart from swaps, certain exchange-traded funds that are based upon tracking the movements of agricultural futures have received exemptions from position limits. These exemptions would be subject to review and thus the bill would create uncertainty about the ability of the exchange-traded funds to carry out their role. Another example is a new final section to H.R. 977, which would grant the CFTC the authority to conduct criminal litigation relating to violations of the CEAct if the Attorney General has declined to do so. This appears to reflect a speech that Commissioner Bartholomew H. Chilton delivered in Washington on February 10, 2009. In this speech, he argued that the CFTC should have authority to prosecute alleged criminal violations of the CEAct and suggested that CFTC attorneys would be better able to bring such cases due to the highly specialized and complex nature of the futures markets, which the generalists at the Department of Justice could not be expected to master. Voilà! Two days later, the House Agriculture Committee added a provision to the bill that is directly responsive to this concern. Other Agencies’ Interest The criminal authority provision is just one of those in the bill that will cause not only several other Congressional committees to weigh in on this legislation, but several federal agencies as well. The Attorney General will certainly have an opinion on the last section of the bill. The Secretary of Agriculture may have something to say on the section of the bill dealing with emission allowances and offset credits, because CFTC is directed to enter into a memorandum of understanding (MOU) with the Secretary of Agriculture to ensure that the development of procedures and protocols for a market-based greenhouse gas (GHG) program, i.e., the trading part of any cap-and-trade system intended to reduce GHG emissions, are properly constructed and coordinated to maximize credits for carbon sequestration. Undoubtedly, the Environmental Protection Agency, as well as the Department of Energy and Federal Energy Regulatory Commission, may also be interested in this provision. (The bill would also remove GHG emissions and credits from the definition of “exempt commodity,” thus requiring futures and options thereon to be traded on designated contract markets only, and would not permit such trading on exempt commercial markets.) Of course, the other members of the President’s Working Group on Financial Markets in addition to the Acting Chairman of the CFTC, the Treasury Secretary, the Chairman of the SEC and the Chairman of the Board of Governors of the Federal Reserve System, will want to be heard on this legislation as well. The Fed Chairman may have something to say about the provision that bars the Fed from any authority to establish regulations about clearing swaps, particularly in light of the fact that the CFTC, the Fed and the SEC entered into an MOU on November 13, 2008, to establish a framework for consultation and information sharing on issues related to credit default swap central counterparties, facilitating the regulatory approval process, and promoting more consistent regulatory oversight. Conclusion The fact that H.R. 977 would have an impact on the jurisdiction of so many arms of the federal government illustrates why it is unlikely to become law in its present form. Nevertheless, there is a definite mood in Washington to “do something” to address the problems in the financial markets, whether it be with new laws, new regulations, new agencies, or all of the above. Thus, the provisions of H.R. 977 are out there as a marker with the unanimous approval of the House Agriculture Committee. Even if the bill itself does not make it February 2009 3 Investment Management & Public Policy Alert into law, some of its provisions may survive the legislative process in some form, and its author, Chairman Peterson, has established himself as a player to whom attention should be paid in the development of new rules of the road for the financial markets and participants. Taken together with the flurry of recent legislative initiatives to regulate the over-the-counter derivatives market, including a bill introduced by Chairman Tom Harkin (D-Iowa) of the Senate Committee on Agriculture, Nutrition and Forestry in January 2009 to require all swaps to be traded on regulated exchanges, as well as calls by the New York State insurance commissioner and the former chairman of the SEC for federal regulation of the credit default swaps market, this illustrates the pressure for increased regulation of the swaps market. Regardless of what happens to H.R. 977, the times they are a changing! K&L Gates comprises multiple affiliated partnerships: a limited liability partnership with the full name K&L Gates LLP qualified in Delaware and maintaining offices throughout the U.S., in Berlin and Frankfurt, Germany, in Beijing (K&L Gates LLP Beijing Representative Office), and in Shanghai (K&L Gates LLP Shanghai Representative Office); a limited liability partnership (also named K&L Gates LLP) incorporated in England and maintaining our London and Paris offices; a Taiwan general partnership (K&L Gates) which practices from our Taipei office; and a Hong Kong general partnership (K&L Gates, Solicitors) which practices from our Hong Kong office. K&L Gates maintains appropriate registrations in the jurisdictions in which its offices are located. A list of the partners in each entity is available for inspection at any K&L Gates office. This publication is for informational purposes and does not contain or convey legal advice. The information herein should not be used or relied upon in regard to any particular facts or circumstances without first consulting a lawyer. ©2009 K&L Gates LLP. All Rights Reserved. February 2009 4 Investment Management Alert October 2008 Author: Gordon F. Peery +1.617.261.3269 gordon.peery@klgates.com K&L Gates comprises approximately 1,700 lawyers in 28 offices located in North America, Europe and Asia, and represents capital markets participants, entrepreneurs, growth and middle market companies, leading FORTUNE 100 and FTSE 100 global corporations and public sector entities. For more information, visit www.klgates.com. www.klgates.com The Lifecycle of Lehman Trade Fails Prior to September 15, 2008, portfolio managers (“PMs”) placed thousands of trades with Lehman Brothers Inc. (“LBI”) in New York City. These trades, many of which were subsequently transferred for settlement to LBI affiliates throughout the world, eventually failed to settle last month (and are referenced in settlement parlance as “trade fails”) as a result of the worldwide collapse of Lehman Brothers and the landmark civil proceedings that followed on at least three continents. The circuitous routes taken by these trades prior to settlement failure and the legal and business implications along the way demonstrate the complexity of the global system of modern finance and the need to pay careful attention to protecting one’s rights. This Alert follows the path of two hypothetical trades placed with LBI for settlement in early September 2008 and introduces the legal analysis that is necessary to simultaneously protect portfolio managers and minimize fund exposure. PMs frequently place trades with brokers in accordance with brokerage contracts that include a fulsome description of rights, obligations and remedies. In many other cases, however, PMs merely call in trades with brokers that place the trades with affiliates in a complex electronic international network that is not governed by a formal, written contract. The PM in our example placed two trades with LBI during the first week of September 2008: a request to purchase a residential mortgage-backed security (“RMBS”) and a request to purchase one hundred thousand shares of a prominent European public company. In both cases the LBI broker returned to the PM via electronic mail a computer screen shot illustrating trade details. The PM subsequently readied the wire for settlement. Lehman Seeks Protection and Trades Fail to Settle Like thousands of other trades with LBI, the two trades in our example failed to settle; both buyer and seller on either side of LBI in the trades received little or no communication from LBI when the settlement failed on September 15, 2008, and the then-current state of legal play is unclear to the parties. In the absence of a written contract, the path forward and appropriate remedies were opaque. September 15, 2008 marked the beginning of a series of developments leading to massive liquidation proceedings simultaneously taking place on both sides of the Atlantic Ocean, in the Far East and elsewhere: • September 15, 2008: Lehman Brothers Holdings Inc. (“LBHI”), ultimate parent company of the Lehman group, voluntarily filed for protection under chapter 11 of the United States Bankruptcy Code. •September 16, 2008: six Lehman entities filed either for administration in the UK (Lehman Brothers International (Europe) (“LBIE”); Lehman Brothers Ltd; Lehman Brothers Holdings PLC; and LB UK RE Holdings Ltd) or civil rehabilitation in Japan (Lehman Brothers Holdings Japan Inc. and Lehman Brothers Japan Inc.) and PricewaterhouseCoopers (“PWC”) was appointed as joint administrator in the UK administration of LBIE. • September 17, 2008: the U.S. Trustee for the LBHI chapter 11 proceeding appoints a statutory committee of unsecured creditors. • September 19, 2008: the Securities Investor Protection Corporation (“SIPC”) filed a proceeding placing LBI in liquidation under the Securities Investor Protection Act (“SIPA”) and a SIPC trustee (the “SIPC Trustee”) was appointed. Investment Management Alert • September 26, 2008: SIPC published a settlement protocol for closing certain open trades and submitting claims to the Trustee in the LBI proceeding, which issued a clarifying statement concerning open trades and prime brokerage arrangements (“LBI Trustee Statement”). • October 9, 2008: the Securities Industry and Financial Markets Association (“SIFMA”) published Protocol 08-02 for resolving certain outstanding agency mortgage-backed security trades with LBI (the “SIFMA RMBS Protocol”). Handling Trade Fails In light of the foregoing developments, the short- and longterm tasks for handling Lehman trade fails are as follows: 1. U nderstand the Players, Law and Timing. The first step is understanding the critical roles played by the U.S. Trustee, SIPC, the SIPC Trustee, the limits of jurisdiction and responsibilities, the timing for actions as well as their respective short- and long-term objectives. It is critically important at this first step and beyond to retain qualified legal counsel in the appropriate jurisdiction(s), whose mission is to identify trades, secure rights and assist in the performance of obligations in the applicable process. Missing deadlines for filing claims in proceedings may very well result in the loss of rights, including the right to recover losses. After this first step, two steps follow and must be taken simultaneously: 2a. I dentify the Counterparty and Determine the Applicable Jurisdiction. Threshold steps include identifying the Lehman entity that is properly deemed the “counterparty” for the fund for the trades; this will determine the applicable jurisdiction and process or protocol for handing the failed trades. In the case of the first hypothetical trade, the purchase of the agency residential mortgagebacked security, the fund is to follow the SIFMA RMBS Protocol, which is a voluntary protocol designed to bring about the cancellation or settlement of open trades that failed in September 2008 according to the LBI Trustee Statement. In the case of the second hypothetical trade, the purchase of shares of a European public company through LBI, even though the call by the PM initially was to the LBI broker in New York City, that broker relayed the trade request to LBIE, which was the Lehman trading arm in the UK. Since LBIE is outside the United States and beyond the jurisdiction of the LBI SIPC proceeding, the SIPC Trustee has no jurisdiction to handle this failed trade. The PM and its fund must follow LBIE’s administration and direction from PWC. 2b. Identify a Contractual Obligation and Determine Whether it is Subject to a Stay. Early in the process, focus on establishing a legal, contractual obligation that is enforceable in light of applicable insolvency proceedings. When the PM places trades in connection with a set of properly executed and delivered prime brokerage agreements, those contracts often set forth remedies for trade fails and, so long as the transactions are not stayed by a chapter 11 proceeding, SIPC proceeding, UK or other administration (in which case a protocol for settlement may be announced), contractual rights may be pursued. In our example, no written agreement was entered into between the PM and the broker at LBI placing the two trades; the trades are processed electronically and a return email confirmed the order. If this scenario were to come before a court, a court would likely hold that a legal contract exists, but because of the absence of a formal, written contract between the fund or PM for the fund on the one hand, and LBI on the other, the remedies are somewhat uncertain. But, more importantly, in light of the SIPC proceeding filed on September 19, 2008, many legal claims have been stayed. 3. C ommunicate with the Applicable Trustee or Administrator. To illustrate how several of the foregoing concepts are put into practice, perhaps the most important step throughout the process is properly communicating with the appropriate trustee or administrator in a timely manner. In many cases the trustee, or legal counsel representing the trustee – or both—will communicate important milestones, deadlines and, with respect to the two trades analyzed here, settlement protocols. The Residential Mortgage-Backed Security Purchase The PM entered into a verbal agreement with a broker at LBI to purchase mortgage-backed securities in a transaction that both sides agreed would settle on September 15, 2008. LBI fails to deliver the securities in the course of the Lehman developments summarized above. The PM retains the cash proceeds for the trade and learns that LBI was to be an intermediary for the trade. The trade remains open and the legal status and remedies are unclear as there is no formal agreement or agreements between LBI and either party. With the foregoing short- and long-term tasks in mind, counsel to the PM identifies the Lehman entity (LBI), the jurisdiction and proceeding (on September 19, 2008, the United States District Court, Southern District of New York, issues an order and the SIPC Trustee is appointed). On October 9, 2008, without “covering” or “buying in” as a selfhelp remedy, the PM/fund learns of an industry-led settlement October 2008 | 2 Investment Management Alert protocol sponsored by SIFMA that facilitates the resolution (i.e., either cancellation or replacement of the trade) of agency mortgage-backed securities with LBI that were scheduled to settle in September 2008. The SIPC Trustee approved the SIFMA RMBS Protocol. Under the protocol, if the RMBS trade was replaced, then the protocol specifies that the termination date for the trade is the replacement date. If the trade is not replaced, then the PM may bring about the termination of the trade and determine loss or gain by following the protocol, which calls for three quotes to be obtained from dealers at 3:00 p.m. New York Time on the termination date. A notice of termination is submitted to the SIPC Trustee and other protocol formalities are followed. The RMBS trade fail is resolved with qualified counsel and accounting professionals handing valuation and accounting issues which are beyond the scope of this Alert. The Purchase of European Securities Not all trade fails are covered by industry, trustee or administrator settlement protocols such as the SIFMA RMBS Protocol in the preceding example. With some trades, each step corresponding to the tasks outlined above presents a variety of challenges. For example, the purchase of European securities may be documented by means of electronic communications in the absence of a formal brokerage agreement with LBI; this was the arrangement regarding many Lehman trade fails. If the electronic communication or computer screen shot does not include LBI as a broker (and in its place LBIE is listed), then the SIPC Trustee, or its outside counsel may take the position that the trade is outside of the jurisdiction of the SIPC Trustee. Trade confirmations or other documentation may indicate whether a trade is executed by a broker in its capacity as agent or principal, which may have a bearing on the appropriate jurisdiction for handling issues concerning the trade; accordingly, it is important to carefully examine all documentation to determine the capacity in which the broker is acting. The PM may, in the course of resolving this trade fail, receive a request from the exchange used by LBI or the subcustodian of the fund to withdraw instructions to bring about the settlement of the trade. It is important to note that exchanges used in effectuating trades frequently have rules that authorize the exchange to unilaterally void trades that do not settle within a certain period of time (e.g., twenty days, in the case of the Swiss Exchange SWX). Leading custodians have similar rules for voiding unsettled trades; a custodian may request that the PM unilaterally terminate the purchase of the European securities, in our example. Withdrawing settlement instructions may have important legal ramifications. Counsel must make the determination that a trade is outside stays imposed by bankruptcy court, administration and other civil procedures for Lehman entities in insolvency or other related proceedings. No action should be taken in contravention of applicable stays, procedures and contractual undertakings. On September 26, 2008, the SIPC Trustee and its outside counsel, Hughes Hubbard & Reed LLP, announced that, with respect to LBI trades that are subject to a stay, an expedited procedure has been established. Claims arising from closing out transactions under that procedure are to be submitted through the SIPC claims process (established by court order in the SIPC liquidation proceeding). The general counsel for SIPC and counsel for the SIPC Trustee confirmed that with respect to certain open, outstanding securities and commodity transactions, there is no prohibition against exercising contractual rights to terminate open trades with LBI. The key is to analyze the relevant contractual rights. In our second hypothetical example, involving shares of a European public company, counsel for the PM/fund needs to review and analyze any and all documentation that could be deemed a contract. If LBI is not listed as a broker in the computer screen shot (that is the only evidence of the trade in our example), then it is not likely that the SIPC Trustee will exercise jurisdiction over the trade and the fund would likely have to pursue rights that would be established in connection with other proceedings such as the LBIE administration in the UK. This example demonstrates the need for funds to negotiate, execute and retain more extensive documentation for trades (e.g., trading authorization agreements or other brokerage agreements that would in many cases provide better protection or at least more clarity in circumstances such as this one). Conclusion While many of the unprecedented around-the-clock, professional, regulatory and industry-led efforts today to resolve trade fails will in fact bring about the resolution of many open trades and the crystallization of related losses or gains, because of the rapid pace and increasingly global reach of modern finance, many of the current problems that we have recently witnessed will likely resurface in the future as traps for the unwary. October 2008 | 3 Investment Management Alert K&L Gates comprises multiple affiliated partnerships: a limited liability partnership with the full name K&L Gates LLP qualified in Delaware and maintaining offices throughout the U.S., in Berlin, in Beijing (K&L Gates LLP Beijing Representative Office), and in Shanghai (K&L Gates LLP Shanghai Representative Office); a limited liability partnership (also named K&L Gates LLP) incorporated in England and maintaining our London and Paris offices; a Taiwan general partnership (K&L Gates) which practices from our Taipei office; and a Hong Kong general partnership (K&L Gates, Solicitors) which practices from our Hong Kong office. K&L Gates maintains appropriate registrations in the jurisdictions in which its offices are located. A list of the partners in each entity is available for inspection at any K&L Gates office. This publication/newsletter is for informational purposes and does not contain or convey legal advice. The information herein should not be used or relied upon in regard to any particular facts or circumstances without first consulting a lawyer. Data Protection Act 1998—We may contact you from time to time with information on K&L Gates LLP seminars and with our regular newsletters, which may be of interest to you. We will not provide your details to any third parties. Please e-mail london@klgates.com if you would prefer not to receive this information. ©1996-2008 K&L Gates LLP. All Rights Reserved. October 2008 | 4 Financial Services Alert April 2008 Authors: Robert T. Honeywell 212.536.4863 robert.honeywell@klgates.com Anthony R. G. Nolan 212.536.4843 anthony.nolan@klgates.com Donald W. Smith 202.778.9079 donald.smith@klgates.com Robert A. Wittie 202.778.9066 robert.wittie@klgates.com K&L Gates comprises approximately 1,500 lawyers in 24 offices located in North America, Europe and Asia, and represents capital markets participants, entrepreneurs, growth and middle market companies, leading FORTUNE 100 and FTSE 100 global corporations and public sector entities. For more information, please visit www.klgates.com. www.klgates.com Key Insolvency Issues for Broker-Dealers, Custodial Banks and Counterparties to Repos, Swaps and Other Financial Contracts The recent volatility in the credit markets has led to many inquiries on how clients should protect their holdings with brokers and custodial banks, and how they can protect their financial contracts (repos, swaps, securities lending, etc.) in the event a counterparty becomes insolvent. This outline is provided as a general summary of the main insolvency issues involved in protecting these types of assets and contracts, but is not intended as legal advice. The specific actions that a client should take to protect itself will of course depend on the provisions in their contracts, the applicable laws governing their contracts (and any amendments to those laws), and the facts of each case. The information herein should not be used or relied upon without first consulting an attorney. I. Know Your Broker & Your Brokerage Contracts • U.S. or Offshore? Registered U.S. brokers are subject to SEC minimum capital and customer protection rules (e.g., restrictions on pledging, commingling or trading in customer securities). Their customers are entitled to some protection for their securities accounts by the Securities Investor Protection Corporation (SIPC), which may file a liquidation proceeding in federal court against any registered U.S. broker that becomes insolvent. In such event, SIPC funds any deficits in customer accounts after distributing available customer securities to the broker’s customers, subject to certain limits. (Distribution priorities and account protection limits in SIPC liquidations are discussed below.) Offshore and unregistered U.S. brokers are not subject to SEC customer protection rules or SIPC protection. Instead they are subject to the rules of their governing jurisdictions, which might not be as restrictive as SEC customer protection rules. Depending on its jurisdiction’s bankruptcy rules and its contacts with the U.S., an offshore broker might be subject to a stockbroker liquidation proceeding under the U.S. Bankruptcy Code (Chapter 7, Subchapter III, 11 U.S.C. §§ 741 et seq.), which may be filed voluntarily by the broker or involuntarily by petitioning creditors. A Bankruptcy Code stockbroker liquidation provides priority to securities customers similar to that provided in a SIPC liquidation proceeding – but without SIPC account protection. Whether a case qualifies for a Bankruptcy Code stockbroker liquidation will depend on the facts of the case. U.S. brokers that use offshore broker affiliates for significant financial transactions should also be considered carefully. Prior bankruptcy cases have sometimes involved difficulties tracing U.S.-based assets that were then used by offshore affiliates not subject to SEC rules or SIPC protection. Financial Services Alert •“ Customer Name” or “Street Name” Securities? Securities that are registered in a customer’s name and not endorsed for transfer by the broker are entitled to the greatest level of protection. These are referred to as “customer name” securities and must be returned to the customer in a SIPC or Bankruptcy Code liquidation. They are not included in the pool of “customer securities” that are distributed pro rata to a broker’s customers (see below). However, the prevailing practice is for customer securities to be held in the name of the broker at a custodian or clearinghouse – i.e., in “street name” – to permit maximum trading flexibility. Securities held in street name are still considered customer securities (rather than the broker’s own property) and are given priority distribution in a SIPC or Bankruptcy Code liquidation. In this case all customer securities are pooled and distributed, first to pay administrative expenses and then pro rata to customers based on their net positions with the broker. SIPC distributions are generally made in kind with securities (to the extent possible), and any resulting deficits in customer accounts are funded by SIPC, up to a limit of $500,000 per customer and a sublimit of $100,000 for claims to cash in securities accounts. Bankruptcy Code distributions are generally in cash and do not include the SIPC account protection. In either a SIPC or Bankruptcy Code liquidation, any shortfalls in customer accounts after the pro rata distributions to the broker’s customers are considered general unsecured creditor claims against the broker. These claims share with other creditors out of the broker’s remaining assets. •F ully Paid or Margin Securities? Any contract provisions allowing the broker to pledge or commingle securities? Fully paid securities and securities provided as excess margin (with a market value above 140% of the customer’s debit balance) are subject to SEC customer protection rules and may not be sold, loaned or pledged by the broker. (An exception applies if a broker “borrows” such securities under a written agreement in exchange for providing the customer with certain types of collateral.) Margin securities may be used or pledged by a broker and may be commingled with other customers’ securities if a customer consents in writing. This consent is customarily included in the broker’s account agreement. Review your broker’s account agreement carefully regarding any provisions permitting the broker to use, pledge or commingle customer securities. Pledged or commingled securities are the most vulnerable in the event of a bankruptcy or liquidation, since other customers and creditors might assert claims against them. •A ny cross-default, cross-collateralization, setoff or netting provisions? Brokerage account agreements customarily include clauses stating that any securities and other assets held by the broker for a customer may be used as collateral not just for the specific contract under which the broker is holding the assets (e.g., the securities account contract), but for all contracts that the customer has with the broker and with any of the broker’s affiliates. Similarly, a broker and its affiliates might have the right to set off or “net” collateral held under one contract with a customer against obligations owed by the same customer under other types of contracts with the broker and its affiliates. Review your brokerage account agreements carefully to determine which of your securities and other assets may be withdrawn and which might be securing other contracts you have with the broker and its affiliates. •A ny contracts involving assets other than securities (e.g., commodities or currencies)? Any repos, swaps or other financial contracts? Only securities (and cash balances in securities accounts) are subject to SIPC protection and priority distributions in a SIPC or Bankruptcy Code liquidation. Other types of assets are not entitled to such protection or priority: for example, commodities and related contracts (including commodities futures and options),1 foreign currency, and unregistered investment contracts and joint venture interests. 1 Commodity brokers (including futures commission merchants (FCMs)) are subject to customer segregated funds rules of the Commodity Futures Trading Commission (CFTC) and to separate liquidation proceedings under the Bankruptcy Code (Chapter 7, Subchapter IV, 11 U.S.C. §§ 761 et seq.), which are governed by special CFTC rules for managing and distributing customer property (Part 190, 17 CFR §§ 190.01 et seq.). Brokers that are registered as both stockbrokers and commodity brokers (including FCMs) are subject to both SEC and CFTC rules and could be subject to both types of liquidation proceedings. April 2008 | 2 Financial Services Alert Similarly, certain types of contracts will not necessarily be considered “customer” securities contracts, for purposes of making the securities and other assets covered by the contracts “customer property” entitled to SIPC protection and distribution priority. These might include repurchase and reverse repurchase agreements (“repos”), swaps, securities lending agreements, and other types of financial contracts. For example, SIPC takes the position that repo counterparties are not securities “customers,” but some courts have found them to qualify for SIPC protection (and priority in a Bankruptcy Code liquidation) if the facts suggest a broker-customer fiduciary relationship between the broker and the counterparty. Review your brokerage accounts to determine which are entitled to SIPC or Bankruptcy Code protection and which are not. Whether or not your different types of brokerage accounts will qualify for SIPC or Bankruptcy Code protection will depend on the specific terms of each contract and relevant facts and circumstances. • Excess SIPC Insurance? One form of protection that some brokers provide to their customers is “excess SIPC” insurance – i.e., insurance obtained by the broker for its clients’ benefit to cover amounts greater than the SIPC coverage limits noted above ($500,000 per customer; $100,000 for cash claims). Review your broker’s materials to determine if it carries excess SIPC insurance. If it does carry excess SIPC insurance, review its terms to determine how much excess coverage is available: For example, is there a per customer limit? Is there an aggregate limit, that might be spread among all of the broker’s customers to cover their account deficits? • If Your Broker Becomes Insolvent and Liquidates If a broker goes into liquidation, the recoveries for its customers will depend largely on the available pool of customer securities for pro rata distribution and their market value. Not all securities listed in the accounts of a broker’s customers will necessarily be available for distribution to its customers. As noted above, if a broker uses, pledges or commingles any of its customers’ securities, these are the most vulnerable and may be subject to competing claims by the broker’s creditors. This is likely, for example, if a broker has pledged margin securities to its secured lenders or sold them to bona fide purchasers (including repo counterparties). In such event, these secured lenders and purchasers will usually take priority over the claims of customers who originally held the securities with the broker, and those securities will not be included in the pool for customer distribution. There have also been cases where brokers did not fully comply with customer protection rules against using, pledging or commingling customer securities, either because of inadequate internal controls or because they were not subject to SEC rules (e.g., offshore brokers), resulting in shortfalls of securities available for distribution. The result is that in the event of a broker’s liquidation, the pool of available securities for pro rata distribution to customers might not be sufficient to satisfy all customer claims. Any shortfalls would then have to be covered by SIPC funding (up to the limits noted above), “excess SIPC” insurance (if any), and the customers’ unsecured creditor recoveries against the broker’s remaining assets (i.e., assets other than customer property). The actual recoveries for the customers of a liquidated broker will vary depending on the facts of the case, and can range from cents on the dollar to closer to 100%. The timing of recoveries will also likely be delayed in a broker liquidation, as the SIPC or Bankruptcy Code proceeding can take time to gather all of the broker’s assets, resolve outstanding contracts, and pursue potential litigation claims. Cases involving broker affiliates in a large corporate bankruptcy case can take a particularly long time, as intercompany claims within the corporate family are often part of the mix and may be heavily litigated. In the event of a liquidation of your broker or any bankruptcy proceeding involving your broker’s affiliates, pay close attention to any notices and court procedures for filing claims (usually referred to as “proofs of claim”) in the court proceeding. Any missed deadlines for filing such claims can result in April 2008 | 3 Financial Services Alert the elimination of your claims and no recoveries from the broker. II. K now Your Custodial Bank & Your Bank Contracts •N on-Cash Assets: Held in trust, custodial or fiduciary accounts? Are they segregated and/or traceable? Similar to “customer name” securities (discussed above), the most protected assets held by a custodial bank will be those that have been registered in a customer’s name and are required to be segregated and held in trust specifically for that customer. In the event of the custodial bank’s receivership or conservatorship, these types of “trust,” “custodial” and “fiduciary” assets should not be considered part of the bank’s property subject to receivership. However, not all client assets held by a bank are held in a protected capacity. Whether assets are held by a bank in trust or in a custodial or fiduciary capacity will depend on the terms of the relevant contract with the bank, as interpreted under the state law governing the contract. Review your bank contract to determine if it provides that the assets are segregated and held in trust or otherwise in a custodial or fiduciary capacity, and if it specifically identifies the assets being held (e.g., by CUSIP and certificate numbers). In order to “trace” the assets of an insolvent bank to the customer, it is important to identify the customer’s assets with specificity. •C ash Accounts: Trust accounts or General (commercial) deposit accounts? Cash deposits held in a trust account, through a bank’s trust department, must generally be collateralized by the bank – i.e., the bank must back up trust cash with U.S. treasury securities or other specific types of collateral. However, this protection is available only for accounts that expressly provide for the cash to be held in trust. Review your deposit account agreements to determine if they expressly provide for deposits to be held in trust. Otherwise, cash deposits held by a bank will generally be considered to be held in general (commercial) deposit accounts. These types of accounts are subject to FDIC insurance limits of $100,000 per individual or corporate entity, per bank. FDIC rules permit pass-through of account insurance to some types of equityholders (e.g., limited partners) in some circumstances. III. K now Your Remedies Under Your Repos, Swaps and Other Financial Contracts •A bankruptcy filing imposes an automatic stay that prevents termination of any of the debtor’s contracts, but certain types of financial contracts are exempt If a company or individual files for bankruptcy (either a Chapter 11 reorganization or a Chapter 7 liquidation), an automatic stay applies to all contracts held by that company or person. No counterparties to those contracts may terminate or accelerate the contracts or foreclose on any collateral or take other collection efforts, unless the bankruptcy court consents (after the filing of a “motion to lift the stay”) or a specific statutory exemption is available. Instead the counterparties must wait for the debtor to “assume” or “reject” its contracts (i.e., keep or terminate them) under specific procedures in the Bankruptcy Code. However, Congress has provided several “safe harbors” for certain types of financial contracts,2 through exemptions from the automatic stay in the Bankruptcy Code (available under specified conditions and in some cases only to certain counterparties, as discussed below). These were designed to minimize disruptions in the financial markets from a company’s bankruptcy filing, by permitting counterparties to that company’s financial contracts to close out their positions and collect on pledged collateral. •A n FDIC receivership or conservatorship also imposes an automatic stay, but a similar exemption for financial contracts is available A receivership or conservatorship of an FDIC-insured depository institution also imposes an automatic stay for an initial period – 90 days for a receivership and 45 days for a conservatorship – which may be extended by the FDIC in certain circumstances upon its taking affirmative administrative or court action. Similar to 2 ecurities contracts, commodity contracts, forward contracts, repurchase S agreements and swap agreements, and master netting agreements covering these five types of contracts. April 2008 | 4 Financial Services Alert the bankruptcy right to “reject” contracts, the FDIC as receiver or conservator has the right to “repudiate” (i.e., terminate) certain agreements of the insured depository institution. However, in the case of financial contracts such as those described above, the FDIC’s only right is to immediately transfer all financial contracts with a counterparty and its affiliates to another financial institution. If the FDIC does not complete the transfer within one business day, the counterparty is free to terminate or accelerate the financial contracts and foreclose on any collateral. The types of financial contracts subject to the FDIC exemption are generally consistent with those described in the Bankruptcy Code. •R epos and swaps are generally exempt from the automatic stay and the FDIC’s repudiation power Repos and swaps are included in the statutory exemptions (subject to the qualifications discussed below). If a repo or swap counterparty files for bankruptcy, the other counterparty is generally free to exercise its termination remedies, including setting off net amounts owed against any collateral it holds. Similarly, if a repo or swap counterparty is subject to an FDIC receivership or conservatorship, the other counterparty may exercise its termination remedies if the FDIC fails to immediately transfer the contract as described above. However, these termination remedies are limited to those set forth in the contract. Review your contracts to determine exactly which remedies are available. •S waps are broadly defined to qualify most types of derivatives for the Bankruptcy and Receivership exemptions Swaps qualifying for the bankruptcy and receivership exemptions described above are broadly defined to include interest rate, currency, equity, debt, credit and commodity swaps and options, as well as many other types of swaps, options, futures and forward agreements, whether presently in use or which later become common in the derivatives markets. The Bankruptcy Code and FDIC statute (the Federal Deposit Insurance Act (FDIA)) should be reviewed to confirm that your specific type of derivative is covered by the swap exemption. •R epos are subject to specific exceptions: (1) If the repo assets do not qualify under the Bankruptcy Code or FDIA, or (2) if the counterparty is a broker and SIPC stays termination or foreclosure Repos qualify for the bankruptcy and receivership exemptions only if the covered repo assets are certain types: CDs, mortgage related securities or mortgage loans (or interests in them), eligible bankers’ acceptances, U.S. government securities, or foreign government securities (OECD members). A repo might otherwise qualify as a “securities contract,” which is also entitled to the stay exemptions. However, to qualify for the bankruptcy stay exemption for a “securities contract,” the terminating counterparty must be a stockbroker, securities clearing agency, financial institution or “financial participant” (either a clearing organization, or an entity holding $1 billion in aggregate notional or principal amount outstanding on all contracts entitled to the bankruptcy exemption3 or $100 million in gross mark-to-market positions in such contracts, determined at the time the terminated contract was entered into or at any time during the 15 months prior to the bankruptcy filing). In addition, if a repo counterparty is a broker, SIPC may seek a stay of repo termination or foreclosure on repo collateral notwithstanding the stay exemption. If a broker goes into a SIPC liquidation proceeding, SIPC commonly imposes a freeze order on open contracts and seeks to transfer all active accounts as quickly as possible to a working broker-dealer. However, there may still be a delay in access to capital and securities. Clients who use a suspect broker as their exclusive prime or clearing broker should consider back-up or contingency plans. •O ther types of financial contracts are exempt from the automatic stay, but the bankruptcy exemption is available only to specific types of counterparties Securities contracts (including securities lending contracts), commodity contracts and forward contracts are also included in the statutory exemptions from the automatic stay described above. However, the “safe harbor” right to exercise termination remedies 3 i.e. The types of contracts listed in footnote 2 above. April 2008 | 5 Financial Services Alert after a bankruptcy filing is limited to specific types of counterparties: • T he type of security-holding arrangement: “customer name” or street name; Securities contracts – Only stockbrokers, securities clearing agencies, financial institutions, and “financial participants” (see the exposure thresholds discussed above) may exercise termination remedies. However, SIPC may seek a stay of termination or foreclosure on securities contracts, notwithstanding the stay exemption. (See the above note on SIPC liquidations and considering back-up or contingency plans.) • T he amount of leverage on a securities account: fully paid or on margin; Commodity contracts & forward contracts – Only commodity brokers, forward contract merchants, and “financial participants” (see the exposure thresholds discussed above) may exercise termination remedies. • T he type of contract: securities brokerage or other types (repos, swaps, etc.); Master netting agreements that cover the other five types of contracts included in the “safe harbor” – securities contracts, commodity contracts, forward contracts, repurchase agreements and swap agreements – are also covered by the “safe harbor,” but only to the extent of the contractual remedies in those contracts and subject to the same limitations on the types of counterparties that may exercise them, as described above. Each of these contracts and counterparty types are specifically defined in the Bankruptcy Code and FDIA, which should be reviewed as applicable to confirm that the stay exemption is available. Summary A key to evaluating whether your assets and financial contracts with a broker, custodial bank or counterparty are sufficiently protected is to know your contractual and statutory remedies. As shown above, these vary with: • The type of broker: U.S. or offshore; • T he existence of other contracts with a broker and its affiliates, which might be cross-collateralized by the same assets; • T he type of assets covered: securities or other types (commodities, currency, etc.); • W hether the broker carries “excess SIPC” insurance, and if so the coverage limits; • W hether assets and cash at a bank are held in a trust or fiduciary capacity; • W hether a financial contract is the type that qualifies for the “safe harbors” from the automatic stay in a bankruptcy or an FDIC receivership or conservatorship; • W hether your institution is the type that qualifies for exercising termination remedies under the “safe harbors” from the bankruptcy stay. This list illustrates that the degree of exposure for financial arrangements with brokers, custodial banks and counterparties can vary widely. Some assets and contracts will be entitled to greater protection, in terms of distribution priorities, account insurance and termination remedies. Others may be more vulnerable and risk a lower percentage recovery in the event of an insolvency. Each asset and contract must be evaluated separately to determine where it lies on that continuum. K&L Gates comprises multiple affiliated partnerships: a limited liability partnership with the full name Kirkpatrick & Lockhart Preston Gates Ellis LLP qualified in Delaware and maintaining offices throughout the U.S., in Berlin, and in Beijing (Kirkpatrick & Lockhart Preston Gates Ellis LLP Beijing Representative Office); a limited liability partnership (also named Kirkpatrick & Lockhart Preston Gates Ellis LLP) incorporated in England and maintaining our London office; a Taiwan general partnership (Kirkpatrick & Lockhart Preston Gates Ellis - Taiwan Commercial Law Offices) which practices from our Taipei office; and a Hong Kong general partnership (Kirkpatrick & Lockhart Preston Gates Ellis, Solicitors) which practices from our Hong Kong office. K&L Gates maintains appropriate registrations in the jurisdictions in which its offices are located. A list of the partners in each entity is available for inspection at any K&L Gates office. This publication/newsletter is for informational purposes and does not contain or convey legal advice. The information herein should not be used or relied upon in regard to any particular facts or circumstances without first consulting a lawyer. Data Protection Act 1998—We may contact you from time to time with information on Kirkpatrick & Lockhart Preston Gates Ellis LLP seminars and with our regular newsletters, which may be of interest to you. We will not provide your details to any third parties. Please e-mail london@klgates. com if you would prefer not to receive this information. ©1996-2008 Kirkpatrick & Lockhart Preston Gates Ellis LLP. All Rights Reserved. April 2008 | 6 4 CDS ON BCLEAR Liffe Credit Default Swaps - some FAQs January 2009 1. Is this an exchange-traded product? Liffe launched Credit Default Swaps on Bclear on 22 December 2008. This factsheet provides answers to some Frequently Asked Questions (FAQs) about Liffe CDS. 2. Are these true credit default swaps? In the past other exchanges have offered credit futures or binary credit options instead. 3. What is Bclear? 4. What are the advantages of Bclear for CDS? 5. What is the lifecycle of a Bclear transaction? CDS ON BCLEAR Liffe Credit Default Swaps - some FAQs 6. What are the clearing arrangements for Liffe CDS? Further information 7. How are you able to offer central counterparty clearing to the customer, as well as the dealer, community? Bclear Technology Partnerships 8. What is your product set? CDS ON BCLEAR Liffe Credit Default Swaps a cost-effective solution Liffe’s Credit Default Swaps (CDS) provide an efficient and cost-effective means of processing and clearing OTC CDS business within the secure framework of an exchange and clearing house, using our proven OTC service, Bclear. January 2009 Offering you a more efficient service FEE CAPS PER TRANSACTION FEE PER LOT CDS ON BCLEAR Liffe Credit Default Swaps a cost-effective solution Further information Bclear Technology Partnerships CDS ON BCLEAR Liffe Credit Default Swaps - January 2009 more about our high tech approach Liffe’s Credit Default Swaps (CDS) provide an efficient and cost-effective means of processing and clearing OTC CDS business within the secure framework of an exchange and clearing house, using our proven OTC service, Bclear. Bclear – a clearer way forward Credit trading for up to 10 years is available Liffe CDS on Markit iTraxx Europe Index contracts No credit events have occurred for this index Easy give-ups, splits and trade management Cash ‘up-front’ payment agreed by pre-negotiation Standard coupon payment Trades submitted for registration and if validated, cleared by LCH.Clearnet Ltd. CDS ON BCLEAR Liffe Credit Default Swaps more about our high tech approach Connecting to Bclear Further information The Bclear API Bclear The Bclear GUI Technology Partnerships Cleared by LCH.Clearnet Ltd CDS ON BCLEAR A safer, clearer route for OTC. Liffe Credit Default Swaps on Bclear: an overview Bringing more to market Supporting market conventions Liffe CDS contracts introduce a number of key benefits to the multi-trillion dollar CDS marketplace, whilst also maintaining those enjoyed in today’s OTC market: Liffe CDS complement the existing conventions of the OTC market by: More convenient • Trading activity follows the current OTC market convention of bilateral pre-negotiation, before being easily and securely processed. • Trade processing, including automatic coupon payments, occurs via Bclear, our well established service for registering OTC derivative trades. More secure • Liffe’s back office technology makes T+0 confirmations the standard and greatly simplifies position management, close outs and assignments, reducing operational risk. • LCH.Clearnet Ltd acts as a central counterparty for CDS, managing counterparty credit risk. More efficient • Trades in the same contract with different counterparties can be netted down into a single position and margined, allowing for more efficient capital allocation. • With a competitive fee structure, fee caps on all products, and no minimum activity charge, Liffe CDS provides excellent value for money. More customers • By providing benefits of an exchange environment, with some significant barriers to entry removed (for instance, bilateral legal agreements are not required), Liffe has made CDS products available to a wider range of customers. • allowing trades to be pre-negotiated on a bilateral basis, without displaying buy and sell orders • allowing trade submission to take place anonymously, ensuring that no prices are published to the rest of the market • supporting the cash flow conventions of the current index CDS market by featuring two distinct cash flows: • a one-off ‘up-front’ Initial Premium payment, expressed as a cash amount and paid on the day following the trade • regular quarterly Fixed Premium coupon payments, expressed in basis point per annum of surviving notional principal (SNP) • referencing ISDA Credit Derivatives Definitions and using credit event cash settlement. Processed using Bclear Bclear is Liffe’s wholesale service for processing OTC derivative trades. CDS trades are pre-negotiated on a bilateral basis and submitted to Bclear. Once validated, trades are then processed and cleared. Since it was launched, Bclear has been used extensively by leading investment banks and buy-side firms to register OTC derivative business. • registration and clearing of CDS contracts takes place anonymously, ensuring that no prices are published to the market • CDS trades can be processed via Bclear using either our secure web based front end, or by connecting to Liffe via an API. Bclear offers the ideal solution for CDS business: • provides a service where pre-negotiated and agreed business can be booked without displaying buy and sell orders • once booked, trades are registered and passed to LCH.Clearnet Ltd who acts as the central counterparty Credit trading for up to 10 years is available Liffe CDS on Markit iTraxx Europe Index contracts Cash ‘up-front’ payment agreed by pre-negotiation Standard coupon payment No credit events have occurred for this index Easy give-ups, splits and trade management Trades submitted for registration and if validated, cleared by LCH.Clearnet Ltd. A secure and centrally cleared product Once CDS trades have been processed by Bclear, they are then passed to LCH.Clearnet Ltd which acts as central counterparty for all of Liffe’s London market derivatives’ business. This is one of the main advantages of the Bclear approach. For a Liffe CDS trade: Protection Seller Protection Buyer LCH.Clearnet Ltd becomes the central counterparty to both the buying and the selling clearing member: Protection Buyer LCH.Clearnet Ltd. Protection Seller As well as managing counterparty credit risk, Liffe CDS offers considerable advantages for risk and back office managers, including position netting and more effective position management. Margining iTraxx Europe Index contracts An initial margin deposit is required by LCH.Clearnet Ltd in order to provide a central clearing and margining service. In addition: Liffe CDS contracts are based on Markit iTraxx Europe indices, the benchmark for European credit protection. The rules-based Markit iTraxx Europe indices are comprised of the most liquid names in the European markets. The selection methodology ensures that the indices are replicable and represent the most liquid, traded part of the market. • positions are marked-to-market daily, with the daily profit/loss credited/debited in full • positions are margined on a portfolio basis so that the level of margin required is assessed on the basis of the overall portfolio held and not individual positions. Flexible trading With Liffe CDS, offsetting transactions can result in positions being closed out. No ongoing margin deposit is required, and any initial/variation margin deposited on the original position is returned. Furthermore, positions can be closed out regardless of the identities of the counterparties to the original transactions. Liffe’s Trade Registration System Liffe CDS contracts are cleared and managed using Liffe’s Trade Registration System/Clearing Processing System (TRS/CPS), the technology used for all Bclear and Liffe’s London market LIFFE CONNECT business. TRS/CPS is easily connected to custom built or third party back office systems to ensure fully integrated position and risk management. Markit iTraxx Europe indices are easy and efficient to trade investors can express their bullish or bearish sentiments on credit as an asset class and portfolio managers can manage their credit exposures actively. Credit event settlement Liffe CDS contracts reference ISDA Credit Derivatives Definitions and use credit event cash settlement. Credit Default Swap Index Contracts – Summary Contract Specification1 Indices Contract Size Contract Maturity Protection Period Protection Coverage Initial Payment Fixed Payments (‘Coupon’) Fixed Payment Dates Accrual Periods Reporting Hours Daily Valuation Last Trading Day Credit Event Settlement arrangements iTraxx Europe Index iTraxx Europe Crossover Index iTraxx Europe Hi-Vol Index Credit Event protection on €100,000 notional principal 3¼ year, 5¼ year, 7¼ year and 10¼ year maturities on each index series with June or December maturity as appropriate In respect of a Contract Maturity, the period from 00.01 hours Greenwich Mean Time (“GMT”) on the First Trading Day to 23.59 hours GMT on the Last Protection Day provided that the Protection Period for a Successor to a Reference Entity (which is not the same entity as the original Reference Entity) shall commence on the day a Notice is published by the Exchange identifying that Successor. Contract offers protection on Credit Events (Bankruptcy, Failure to Pay and Restructuring) for the Reference Entities • Upfront amount paid by the Buyer to the Seller, or by the Seller to the Buyer, reflecting any difference between the Fixed Rate and rate agreed between the parties to the transaction. • Valued in €per lot • €0.01 minimum price movement • Paid in full on the Clearing House Business Day following the Exchange Confirmation Date • Amount paid by the Fixed Rate Payer (the Buyer of the CDS Index Contract) to the Floating Rate Payer (the Seller of the CDS Index Contract) over the life of the Contract Maturity. Based on the Fixed Rate expressed in basis points per annum of Notional Principal • A pre-defined single Fixed Rate will be established by the Index Sponsor for each Contract Maturity • The Fixed Payment Amount per lot will be calculated based on the following formula: Days in Accrual Period x Notional Principal x Fixed Rate 360 • Fixed Payments are calculated in Euro and paid in arrears on a quarterly basis on the Fixed Payment Dates 20th calendar day in each quarterly month (March, June, September and December) during the lifetime of a particular Contract, or the following Business Day if the 20th is not a Business Day The accrual periods used to calculate the Fixed Payment Amount will be determined as follows: (i) First Accrual Period - From the 20th day of the quarterly month preceding the Exchange Confirmation Date, or such amended date, as published by the Exchange from time to time, to the day preceding the next Fixed Payment Date (inclusive). (ii) Last Accrual Period - From the Fixed Payment Date to the 20th day of the next quarterly month (inclusive). (iii) All other Accrual Periods - From the Fixed Payment Date to the day preceding the next Fixed Payment Date (inclusive) 08:00 – 18:00 hours London time • Value established at 16:00 hours (London time) for margin purposes • Valuations quoted in € per lot • Value represents net liquidating value of each position – can be positive or negative 20th calendar day of Contract Maturity month, or preceding Business Day if that day is not a Clearing House Business Day • Delivery of ‘Event Protection Contracts’ in affected Contract Maturities • EPCs are delivered in sufficient number to maintain the notional value of the combined CDS and EPC position • The number of units in an Event Protection Contract issued per CDS lot is determined according to the following formula: Reference Entity Weighting x Original Notional Principal of the life of CDS Contract Size of one unit of EPC • Payment of Fixed Payments continues at lower pro rata amount based on reduced Surviving Notional Principal • Exchange Final Settlement Price for Event Protection Contracts: 100% minus the Final Price or, where the Exchange determines that no Final Price is available, the EFSP shall be 100% minus a fixed recovery rate of 90% in the case of Restructuring and 40% for Bankruptcy and Failure to Pay2. 1 2 This document is only a summary of the full Contract Specification. Potential users should familiarise themselves with the full Contract Specification before entering into transactions in respect of LIFFE Credit Default Swap Index Contracts. If there is more than one of a Bankruptcy, Failure to Pay or Restructuring, the Credit Event and Succession Event Policy shall determine which shall prevail. Further information Bclear +44 (0)20 7379 2222 cds@liffe.com www.nyx.com/cds +44 (0)20 7379 2200 equities@liffe.com www.nyx.com/bclear Contacts Amsterdam Brussels Lisbon London Paris 5 Shaping the new financial services marketplace series Integrated Compliance and Risk Management: Rethinking the approach E=mc ? 2 Produced by the Deloitte Center for Banking Solutions Shaping the New Financial Services Marketplace A new financial services marketplace that’s very different from the old is emerging from the credit crisis. The new market will be more transparent, simplified, standardized, and regulated with fewer intermediaries. In this series, entitled Shaping the New Financial Services Marketplace, the Deloitte Center for Banking Solutions will examine the rules, regulations, and operating models that evolve as the industry sails uncharted waters. Specifically, these articles will focus on strategies for success in the new marketplace, different types of global regulatory systems, the gap between financial innovation and risk management, the burden on compliance as change occurs, and steps for integrating compliance and risk management. In this paper, we examine the extent to which financial services firms can increase the effectiveness and reduce the costs of compliance management. Most firms can achieve both simultaneously by streamlining their compliance management while taking a riskbased, enterprise-wide approach to compliance. Integrated Compliance and Risk Management: Rethinking the approach Foreword Last year, we presented the results of our survey on compliance management at major financial institutions. The study explored some of the challenges facing banks as they attempt to navigate what we called “the compliance labyrinth.” Since that time, the challenges of risk and compliance management have grown with the crisis in the financial markets and the increasing role of government and regulatory agencies. This current report reflects these changes, as well as more recent insights from the field. What has emerged from our work is a new, more integrated approach to compliance and risk management. Such an approach encourages a complete view of risk, including the need to implement and apply compliance management across the enterprise to ensure it is truly effective and efficient. Anything less only adds to the risks the enterprise faces and the costs of operating in a more transparent and, in all likelihood, more regulated market. We trust that the information and insights presented in this report will further discussion of compliance and risk management in your organization, and with your industry peers. The need for effective, efficient methods of compliance has never been greater and we expect that need only to intensify in the future. Sincerely, Don Ogilvie Independent Chairman Deloitte Center for Banking Solutions February 2009 Deloitte Center for Banking Solutions 1 Integrated Compliance and Risk Management: Rethinking the approach Executive summary The current crisis is likely to place compliance and risk management in the forefront of the market’s priorities. New regulatory requirements will compel financial institutions to rethink existing compliance programs, many of which have failed to keep pace with evolving levels of risk. Given the increased demand on compliance resources, this paper addresses the need for a fresh approach to the compliance challenge. New regulatory initiatives are already pending. For example, the Basel Committee on Banking Supervision has proposed new measures for stronger risk protocols and improved procedures for valuing and disclosing assets, including the capital treatment of complex structured products.1 The Senior Supervisors Group has issued a report2 with observations on successful risk management practices based on a sample of leading banks and securities firms. The Institute of International Finance (IIF) has published recommendations for improvements in risk management,3 while the U.S. Treasury has recommended an overhaul of the U.S. regulatory structure.4 As new regulations and requirements are added, the cost of compliance continues to grow, while increased risks mean that the cost of non-compliance may be growing even more. Today, many financial services firms conduct compliance management in silos. The likely results are redundancy, overlap and an increased burden on the business, in addition to potential non-compliance with critical regulatory requirements. Large organizations typically respond at a line of business level to jurisdictional regulatory mandates rather than globally coordinating efforts. Additionally, compliance management is often handled outside the traditional risk management process in most financial institutions. This leads to a fragmented approach that separates the management of compliance risk from management of other risks. New regulatory requirements will compel financial institutions to rethink existing compliance programs, many of which have failed to keep pace with evolving levels of risk. Adding further stress to an already inefficient process, the cost of compliance for many financial institutions has increased substantially. Research conducted by the Deloitte Center for Banking Solutions5 shows that compliance management spending for some larger U.S. financial services firms increased on average by 159% from 2002 to 2006. For these same firms, compliance management costs can be anywhere between $200 million and $400 million a year, representing a conservative estimate which could be understated by up to 30%. Given the magnitude of investment, even a 10% savings becomes significant. This also does not take into account indirect costs associated with line management becoming increasingly involved in compliance management. In this paper, we examine the extent to which financial services firms can increase the effectiveness and reduce the costs of compliance. Most firms can achieve both simultaneously by streamlining their compliance and risk management while taking a risk-based, enterprise-wide approach to compliance. Based on our research and client experiences, we also provide a roadmap for financial services firms seeking to achieve a more effective outcome from their compliance management at a more appropriate cost. This approach to compliance risk management is part of Deloitte’s risk intelligence philosophy.6 Bank for International Settlements Web site, www.bis.org/press/p080416.htm April 16, 2008. Observations on Risk Management Practices during the Recent Market Turbulence, March 6, 2008, The Senior Supervisors Group. Final Report on the IIF Committee on Market Best Practices, July 17, 2008, IIF. 4 Blueprint for a Modernized Financial Regulatory Structure, March 31, 2008. US Treasury Web site, www.treas.gov/offices/domestic-finance/regulatory-blueprint/. 5 Navigating the Compliance Labyrinth – The Challenge for Banks, Deloitte Center for Banking Solutions. 6 Visit www.deloitte.com/RiskIntelligence for additional information on Risk Intelligence. 1 2 3 Deloitte Center for Banking Solutions 3 Integrated Compliance and Risk Management: Rethinking the approach Current state of compliance and risk management in financial services Clearly a new approach is called for that brings compliance and all other risks into a framework that enables management to measure, prioritize and manage them efficiently and effectively. The integration of compliance and risk management In financial services, innovation in products and services has often outpaced the development of compliance and risk management capabilities. As a result, compliance and risk management remains in constant flux and risk managers must understand current risks as well as evolving ones. Defining the full extent of the risks the organization faces and how they should be managed is one of the key challenges of a senior risk executive. Clearly a new approach is called for that brings compliance and all other risks into a framework that enables management to measure, prioritize and manage them efficiently and effectively. Such an approach must consider the full spectrum of risks across the enterprise. Defining compliance and risk management is preferably done through an enterprise-wide approach. Yet enterprise risk management in many firms remains a work in progress. A study by Deloitte7 of major financial firms globally revealed that only 35% of executives reported their financial institution had implemented an enterprise risk management program. Many still had significant work to do in reaching Basel II standards and only a quarter considered their operational risk management systems to be very capable in terms of reporting and data gathering. 7 8 4 An enterprise-wide approach does pay off. The Senior Supervisors Group report8 observed that during periods of market turmoil firms that had made the most progress towards implementing such an approach outperformed those that had not. Given the events of 2008, financial institutions face increasing pressure to improve compliance and risk management capabilities. Compliance defined Compliance itself can be defined narrowly or broadly. For example, a narrow definition of compliance management might be compliance with all banking “laws, rules and standards” such as the USA PATRIOT Act, Basel II or the Bank Secrecy Act (BSA). A broader definition, by comparison, might include compliance with all external and internal regulations and requirements such as Sarbanes-Oxley. It might also include the separation of roles and responsibilities for accessing bank systems and encompass compliance responsibilities from operations to technology. Exhibit 1 is an illustration of a typical financial institution’s structure. In this example, traditional financial risk management is managed by a single manager, the Chief Risk Officer (CRO), while the departments across which compliance responsibilities extend each have a manager. Compliance in the broader sense includes all activities in the light blue box. This traditional approach often results in a siloed and fragmented process that can lead to significant gaps in the compliance and risk management functions. Deloitte Global Risk Management Survey: Fifth Edition ,2006. Observations on Risk Management Practices during the Recent Market Turbulence The Senior Supervisors Group, March 6, 2008 Deloitte Center for Banking Solutions Integrated Compliance and Risk Management: Rethinking the approach Exhibit 1: An evolving definition of risk management (Illustrative) Chief Risk Officer Credit Risk Management Market Risk Management Liquidity Risk Management CRO/CCO CFO CCO Chief Auditor CIO Operational Risk Management Finance/ SarbanesOxley Regulatory and Compliance Internal Policies Internal Audit Department Technology Broad Definition of Compliance Management CIO - Chief Information Officer CFO - Chief Financial Officer CCO - Chief Compliance Officer Source: Deloitte Center for Banking Solutions Risk management is growing in importance The risk management landscape has undergone a seismic shift in recent years, driven by five primary factors: •Dramatic growth in the number and complexity of risks •Continuing consolidation and diversification of banking organizations •Continuing globalization of the industry •Greater scrutiny by government regulators •Increasing business volatility with systemic implications There has been serious financial market instability over the last 25 years in equities (1987, 2001 and 2007/8), currencies (Mexico in 1994 and Asia in 1997), government debt (Russia in 1998) and the failure or difficulties of various financial institutions and markets (Continental Illinois National Bank in 1984, S&L failures in 1987-89 and the junk bond crisis, Long Term Capital Management in 1998, and Northern Rock in 2007 and IndyMac in 2008). Many of these crises have been followed by a regulatory response designed to ensure that similar crises will not reoccur. These factors make risk more difficult to identify and measure while magnifying the exposure and effects of unforeseen developments. Deloitte Center for Banking Solutions 5 Integrated Compliance and Risk Management: Rethinking the approach The cost of compliance In our previously noted survey, Navigating the Compliance Labyrinth, we asked leading financial firms to assess their cost of compliance, how it had changed over recent years (2002-06), what their current approach to compliance management had been and how they have invested in their compliance management activities. In summary, the results were: •There was a 159% increase in compliance costs between 2002 and 2006 •Ninety percent of respondents said their compliance information was not timely enough and 85% said it was not always comprehensive enough •Seventy percent of respondents agreed that there had been a greater demand for public transparency around compliance activities and they expected that trend to continue over the next three to five years. Eighty-five percent of respondents expected penalties to continue to rise •Most of the increase in compliance costs has come through compensation costs implying that most institutions have responded to increased compliance responsibilities by adding more people to rather, than through process improvement and technology. This is also reflected in a substantial growth in administrative and management costs (See Exhibit 2.) laundering activities more than issues concerning market dislocation, they nevertheless represent compliance issues. Fourteen of these cases could be defined as high profile, with fines varying between $5 million and $100 million.9 More than 3,500 actions have been taken by the OCC alone during this period. Since 1998, the Department of Housing and Urban Development (HUD), at first an unlikely bank regulator, has imposed fines of at least $57 million in more than 290 actions against mortgage lenders focusing on fraudulent lending activities.10 The role of HUD emphasizes the risk of the regulatory “perfect storm,” where multiple regulators come together to impact an individual institution. Exhibit 2: Compliance spending by category Compliance Spend by Category 3% 18% Penalties To provide further “incentives,” regulators have turned to warnings, censure, dismissal from the industry and even penalties to force financial institutions to implement stronger risk management and compliance systems. In such circumstances, fines imposed at a federal level can be dramatically increased by the impact of state and other government agencies. 60% 19% Compensation Between 2000 and 2007, the Federal Reserve Board and the Office of the Comptroller of the Currency (OCC) imposed civil penalties on over 350 banks for more than $450 million. While many of these penalties represent failures concerning of money Other Capital Out of Pocket Legal and Compliance Costs Source: Deloitte Center for Banking Solutions 40% 30% 30% Management and Administration Costs 15% 25% 55% Federal Reserve Civil Penalties, Federal Reserve Web site, www.federalreserve.gov, and OCC Enforcement Actions, OCC Web site, (www.occ.treas.gov). 10 HUD Web site, www.hud.gov. 9 6 Deloitte Center for Banking Solutions 50% increase 26-49% increase 11-25% increase 0-10% increase 5% Integrated Compliance and Risk Management: Rethinking the approach The dangers of a traditional approach How do these additional compliance costs arise and how does the traditional approach to compliance management fail to manage them well? One reason is the siloed nature of financial services firms and their failure to fully explore the common elements of regulations and internal processes. Often, when regulations are strengthened or added, the firm adds levels of oversight, testing and interfaces, which result in redundant, overlapping functions, processes and controls. The businesses then need to comply through multiple compliance groups, testing the same processes at different times and frequencies, often to different standards and with different outcomes. Exhibit 3 contrasts two approaches to compliance management. Exhibit 3A illustrates the traditional compliance-related approach employed by many financial services firms. The lack of alignment and coordination creates multiple layers of compliance activity. The result is additional direct and indirect costs, as well as an inability to produce complete and timely information. Exhibit 3B represents a more integrated structure where duplicative activities are eliminated and the compliance effort is more clearly focused on individual lines of business and the overall enterprise. Exhibit 3: From a traditional to an integrated approach to compliance management 3B. Organized Process 3A. Existing Process Regulators Federal, State, SEC, etc. Regulators Federal, State, SEC, etc. Functions SOX IA IS Comp QAC ORM CRM Functions QAC ORM Line of Business Corporate Information Technology Observations •Underestimated cost of compliance-related activites •Overlap, redundancy, inefficient, inconsistency, non-compliance •Legacy systems and poor coordination with technology •Lack of standardized risk-related definitions •Design and framework of day-to-day activities inconsistent with leading practices Corporate Information Technology Comp Line of Business IS Shared Services Utility IA Center of Excellence SOX CRM Results •Improved effectiveness at lower cost •Improved operational efficiency •Clear accountability and defined reactions •Standardized risk assessment •Consolidated reporting •Streamlined governance and coordination SOX-Sarbanes-Oxley IA-Internal Audit IS-Information Security Comp-Compliance QAC-Quality Assurance & Control ORM-Operational Risk Mnagement CRM-Credit Risk Managment Source: Deloitte Center for Banking Solutions Deloitte Center for Banking Solutions 7 Integrated Compliance and Risk Management: Rethinking the approach In many financial services firms, risk and compliance management remain not only separate, but also fragmented. In many financial services firms, risk and compliance management remain not only separate, but also fragmented. As a result, activities are dispersed across functions and managed by various entities. This is particularly true where functional areas and lines of business coincide. Many firms will appoint specialists to address compliance and risk issues both on behalf of the function and the line of business. These separate resources unknowingly often perform similar activities, but use different approaches for collecting, gathering, and presenting information. During our work with clients, one organization had more than 25 such areas with limited or no integration. Generally, there may be overlap between 10%-30% of testing and assessment activities and 40%-50% of operational risk and SOX controls, both operational risk and SOX are considered compliance-related functions. This often leads to a fragmented technology infrastructure. Improvements in the relationship between compliance management processes and technology not only increase effectiveness, but may reduce costs by up to 15%.11 Additionally, some financial services institutions may fail to fully leverage the similar elements in regulations such as BSA, SOX, and Basel II. This creates costs without a corresponding increase and perhaps even a decrease in efficiency and effectiveness. For example, each of these regulations has common requirements regarding the design and implementation of fraud programs, the testing of internal controls, and the process for transaction disclosures. Creating separate processes for each adds costs without increasing effectiveness. In attempting to control costs and integrate compliance and risk management, many firms face challenges in the following areas: 11 8 Individual results will vary by institution. Deloitte Center for Banking Solutions 1.Evolving material risks. Deloitte recognizes the existence of “rewarded” and “unrewarded” risks. Unrewarded risks are the minimum obligations expected of financial institutions fulfilling their responsibilities. There may be limited value creation in meeting these expectations, but consequences if the expectations are not met. The primary incentive is thus value protection, not value creation. Conversely, rewarded risks represent the strategic choices that institutions make to develop their businesses. These strategic decisions are often associated with new products, markets and services with value creation. 2.Inconsistent definition of risk. In a Risk Intelligent EnterpriseTM, a common definition of risk, which addresses both value preservation and value creation, is used consistently throughout the organization. When risks are defined at a line of business or a product level, there is no common standard for compliance and risk management across the enterprise. This makes it difficult to measure and prioritize risks. The resulting lack of oversight and governance makes it easier for local managers to favor short-term business considerations over risk considerations. Leading practices in managing compliance and risk across the business become harder to identify and transplant. Also, what might be considered a serious risk in one part of the business might be treated as minor in another although it might be essentially the same risk. Lack of consistency in defining risks makes it difficult to leverage common processes and makes technology integration particularly difficult. 3.Inefficient technology. When processes are redundant or ineffective, technology is as well. The current state of many compliance infrastructures reflects an “accidental architecture” of technologies. This generates manual information gathering and reporting tasks, which often add costs, delays and errors. In many organizations disparate systems make it hard to generate timely reports and analyze information. For example, one organization we worked with had a 50% overlap in its processes for managing Section 404 and IT risk responsibilities. Another institution had more than 250 separate applications for addressing similar risk and compliance responsibilities. Many of those applications needed to be integrated or eliminated. The various Integrated Compliance and Risk Management: Rethinking the approach Case study: taking an integrated approach applications were developed and implemented over the last 30 years and cost the organization about $240 million annually to maintain. Technology “work-arounds” typically comprise a significant portion of the total cost within the compliance functions. 4.Redundant functional activities. In a traditional compliance structure, there are many common activities across different areas. In our experience, 10%-30% of testing and assessment activities overlap as a result. Many regulations contain similar elements (e.g., SOX, BSA, Gramm-LeachBliley) that allow similar information to be provided only once. Eliminating redundancy can significantly reduce the cost of compliance monitoring. It can also help produce more timely and wide-ranging compliance information. 5.Manual Work-Arounds. Many compliance activities lend themselves to automation, particularly through integrated databases and dashboards that provide a single view of the risks, responsibilities and adequacy of controls across the enterprise. Testing procedures and results can be recorded and areas of deficiency highlighted for attention. Integrating databases will foster common information standards and reduce duplicative and inconsistent reporting. 6.Cost. Our research has attempted to pinpoint the cost of compliance, but our discussions with clients suggest that even these numbers may be significantly underestimated, often by as much as 30% or more.12 Typically there are a number of “shadow” employees involved in the process, numerous databases and testing processes kept on individuals’ computers, manual processes, duplicative functions, roles and technologies all pointing to a significant effort to quantify the compliance cost baseline. An effective compliance management process should achieve efficiency and cost-effectiveness, and accommodate future obligations. Indeed, with the need to address increasing regulation and the rising level of unanticipated risk, efficiency is critical for any compliance program. These challenges are certainly numerous and difficult, particularly given other strategic and operational priorities. Yet the return on solutions to these challenges—costs reduced, risks averted and goals achieved—is not only significant, but realizable. 12 A series of new and stronger regulatory controls and supervisory guidance had caused a bank to review its compliance structure across finance, SOX, and the compliance and internal audit departments. Having gone through a diagnostic process, they found that their response to new regulations had been to increase the number of inefficient, redundant and overlapping processes and controls. Lacking enterprise-wide oversight, the compliance functions placed an increasing burden on individual lines of business. Three main recommendations came out of the diagnostic analysis: • Implement a standard view of risk to gain consistency across the organization. Multiple risk assessments throughout the organization focused on similar or identical attributes, yet resulted in different risk ratings. It was difficult to understand whether risk assessment had any impact on control-related activities. • Develop a shared services approach. Duplicative compliance-related activities occurred throughout the organization. The core processes needed redesigning prior to wholesale elimination and the enabling technologies adjusted to support a shared services design. • Continue building utilities. This would help to increase efficiencies, improve process governance, allow for consistent measurement metrics, enhance service delivery and reduce costs. Such considerations should be based on strategic value, and the ability to standardize, achieve scale and address internal customer needs. The bank realized the following benefits. • A much clearer view of the existing compliance structure. A greater understanding emerged of what compliance activities were conducted, where and why the activities were conducted and the risks embedded in the current processes. • A better understanding of compliance costs and a plan for significant cost savings. The legacy compliance architecture revealed numerous quick fixes and manual processing, representing a 10%-15% cost saving opportunity. • A future-state compliance management function. A monitoring approach across the enterprise was combined with new processes to help keep the organization’s compliance and risk management functions on track. With its new compliance management function in place, the bank saw a significant increase in compliance effectiveness at a significantly reduced cost. This confirmed that compliance resources was in place where they could be most effective. An opportunity for cost savings of 15% was identified, which were later raised to 30%. Actual savings may vary from institution to institution. Deloitte Center for Banking Solutions 9 Integrated Compliance and Risk Management: Rethinking the approach Transforming compliance and risk management – an integrated approach Creating a compliance and risk management process A more efficient compliance management approach employs a streamlined framework that integrates compliance activities across lines of business and shared service functions, and eliminates redundancies and overlap. Such an approach starts with a clear understanding of existing compliance activities and their environment and a solid business case for change. It then works to align and streamline compliance activities by addressing the functions, programs, processes and infrastructure. This Integrated Compliance and Risk Management (ICRM) approach is the basis for our solution for improving compliance effectiveness and efficiency across the enterprise, and is outlined in Exhibit 4. ICRM is one of the tools designed as part of Deloitte’s risk intelligent framework. Exhibit 4: Integrated compliance and risk management process Challenges Rising costs Legacy Infrastructures • Evaluate existing business operations footprint • Develop baseline cost of resources and activities 2 Analysis • Evaluate the effectiveness of the risk and compliance-related programs business vs. compliance • Evaluate the effectiveness of the risk and compliance-related programs business vs. costs/initiatives/resources • Identify the appropriate risk and compliance filter • Align the opportunities/benefits with business operating model • Estimate savings and cost implementation 3 Implementation Transparent and coordinated organization governance Streamlined and standardized program/ processes Effective and efficient infrastructure New risk and compliance operating model Extensive industry and regulatory requirements Potential Benefits 1 Diagnosis Current and unanticipated material risks Ineffective risk and compliance activities ICRM Transformation • Build new program processes and infrastructure Source: Deloitte Center for Banking Solutions The first column in Exhibit 4 depicts the major challenges that ICRM addresses, while the third column highlights the typical benefits it may deliver. The second column defines the three stages of the ICRM transformation process. 10 Deloitte Center for Banking Solutions Integrated Compliance and Risk Management: Rethinking the approach Three key steps in an ICRM transformation 1. Diagnosis. The transformation begins with an evaluation of current business operations and the compliance implications. This step identifies compliance resources, technologies and activities and develops an initial baseline cost of compliance. The existing risks, regulatory requirements and controls are divided into work streams and catalogued. This step defines the baseline business operating model and establishes a starting point for the development of a new model. 2. Analysis. This step analyzes the effectiveness of the existing compliance programs against the existing risks. This analysis identifies a compliance gap (programs not addressing identified risks) and the potential need for additional controls. By analyzing the current work streams in place and the new ones to be developed, potential synergies can be identified and leveraged. Duplicative activities can be eliminated. This rationalization of work streams and the processes within them makes it possible to rationalize the infrastructure that supports them and to quantify the impact to the bottom line through improvements in effectiveness and efficiency. Our experience indicates that cost savings of this process can be up to 10%-15%, over a 6-12 month period, although this will vary based on the individual circumstances of each client. This step finalizes with prioritization of the risks to the business implied by the compliance gap. Additional cost savings and implementation costs may be identified and resources allocated by risk and compliance priorities.13 These three steps should generate greater compliance effectiveness at a lower cost. The model can be modified to suit the changing needs of the enterprise through periodic reviews. With performance metrics in place, investments can be made with a clearer understanding of the outcome and enable monitoring so anticipated cost reductions are achieved. In this way, compliance expenditures can be justified based on potential returns; an issue with which many banks have struggled with. The benefits of a structured approach are illustrated in our two case studies, “Taking an Integrated Approach” and “Rationalizing Compliance at a Major Finance Firm.” In each of the case studies, an institution completely redesigned its approach to compliance and risk management, simultaneously improving effectiveness and reducing costs. 3. Implementation. Once the new compliance operating model (business operating model) has been developed, it can be implemented with a governance structure to facilitate alignment with the firm’s strategy. To ensure performance standards are met, metrics should be established with periodic benchmarking against a defined “leading class” peer group. 13 Individual results will vary by institution. Deloitte Center for Banking Solutions 11 Integrated Compliance and Risk Management: Rethinking the approach Exhibit 5: Original and new risk intelligent operating models New Risk Intelligent Operating Model Risk Management Commitee Audit Commitee Compliance Information Technology Operational Risk Management Credit Risk Management Sarbanes Oxley Training Oversight / Governance Audit and Risk Commitees Corporate Compliance Internal Audit Operational Risk Management Information Technology Legal Information Security Line of Business Internal Audit Compliance Technology Infrastructure Line of Business Credit Risk Management Sarbanes Oxley Information Security Center of Excellence Existing Operating Structure Shared Service Utility Compliance Technology Source: Deloitte Center for Banking Solutions. Developing a new risk intelligent operating model What might a new risk intelligent operating model look like? How might it differ from current compliance activities? To answer these questions, in Exhibit 5 we contrast an example of a baseline business operating model with a desired end-state design. Certain elements clearly distinguish the new operating model from the traditional one. •Integrated compliance functions. In the traditional model, specialist compliance functions are separately organized and managed much as they might be in the framework outlined in Exhibit 1. In the new Risk Intelligent operating model, they are integrated under a single manager. This facilitates a more consistent approach to compliance management across the enterprise ensuring that standards are consistently being met. •Compliance and risk center of excellence. We have developed a center of excellence in which specialists provide compliance support to lines of business. A center of excellence promotes a common approach to testing and reporting by providing a consistent set of key performance indicators. Compliance management 12 Deloitte Center for Banking Solutions controls can be assessed against a common enterprisewide standard that replaces individual standards set at a line of business level. •Shared services utility. Common elements of compliance management are concentrated within a shared services utility, which manages the interface with the lines of business. Duplication and unnecessary activities are reduced, if not eliminated and therefore, costs are reduced. Activities such as testing of internal controls can be performed to a common standard across compliance functions and lines of business. •Integrated compliance technology. With process rationalization and clearer priorities, the technology infrastructure can be more closely aligned with compliance needs. The institution can automate manual activities and eliminate duplicative applications, potentially further driving down its cost structure. In our experience, financial institutions often delay sun-setting of applications and systems. This is more likely to occur at the more decentralized the institution. Traditional compliance management systems may feature multiple databases or standards of information, which can be eliminated in an integrated system. Integrated Compliance and Risk Management: Rethinking the approach Case study: rationalizing compliance at a major finance firm •Transparent enterprise-wide structure. Integration of reporting relationships across risk and compliance management functions improves communication about risk and compliance issues. These issues are no longer buried within individual lines of business or obscured from management attention. A more integrated and transparent structure creates a more informed dialogue and increases awareness of risk and compliance issues, which fosters a stronger risk and compliance management culture. This transparency also improves an organization’s ability to quantify costs when making compliance business decisions. From here, management can build additional value-added activities based on priorities. The needs of individual businesses can be compared through a common framework. This more streamlined approach is designed to limit the burden on the lines of business, provides management with more timely and accurate information and offers an enterprise-wide view of compliance risk. Compliance effectiveness is dramatically increased and costs may be significantly reduced. An example of how this might work in practice is provided by our case study “Rationalizing Compliance at a Major Finance Firm.” The institution faced increasing compliance requirements over several years, reflecting multiple lines of business and diversified consumer and commercial customers in various geographic locations. New regulations had resulted in a fragmented program with overlapping compliance groups and processes generating growing compliance burdens and costs. Management had recognized the problem, but previous efforts had resulted in little savings. It was time for a more holistic, sustainable approach. The institution started by tailoring an ICRM program to identify what, where, and why testing activities were being performed, the overlaps and redundancies, and the desired end state. The goals were to simplify compliance-related activities, ease the burden on the lines of business, and close effectiveness gaps. •Implement a new business operating model. The diagnostic and assessment process within ICRM provided the design and development of a new business function model. The ICRM analysis found that as much as half of compliance processes were overlapping across internal groups. •Develop an overarching governance structure. This was required to determine the areas of focus for compliance resources to decide optimal allocation. •Develop common terminology. Different compliance groups used different compliance languages, methodologies, and policies, obscuring an enterprise-wide view of compliance risks and their status. To coordinate reporting, the institution created common compliance terminology. •Employ risk-based testing. Many employees were performing duplicative tasks. Implementing such testing led the firm to eliminate 80% of its FTEs in certain areas and to define risk tolerances more consistently. •Streamline reporting. The lack of a defined view of risk had resulted in 20% of the compliance group’s time spent generating more than 200 summary management reports annually. The institution is now designing dashboards for different levels of management to reduce the number of reports they receive and to focus attention on high-priority issues. Results Within the next year, these and other enhancements are expected to generate annual savings of approximately 20%. As compliance becomes more efficient, management is gaining a clearer picture of risks and a greater ability to assign more resources to higher priority areas and fewer to lower risk priorities. This has allowed the firm to improve its compliance effectiveness largely on a self-funded basis. Deloitte Center for Banking Solutions 13 Integrated Compliance and Risk Management: Rethinking the approach Reaping the benefits An enterprise-wide approach facilitates a constant dialogue among risk management areas regarding improvements, enables the development of a true cost of compliance and fosters a compliance culture at all levels of the firm. Employing an integrated, risk-based approach to compliance may boost effectiveness, target resources to high-priority areas and give executives visibility into the state of enterprise-wide compliance. An effective compliance risk management process frees up financial resources and senior management time for revenue generation, customer service enhancements, and other business opportunities. This framework may generate significant benefits over the short term (0-180 days) and medium term (181 to 360 days), which may yield a 10% to 20% reduction in compliance cost. In these time frames, savings result from risk-based testing, eliminating overlapping activities, and streamlined reporting. Longer term, firms can reduce compliance expenditures by up to 20% to 30% through consistent risk assessment and improved supporting technology.14 These efforts can include standardizing processes and controls and automating workflows. The cost savings and efficiency gains will depend on decisions made to reallocate resources and invest in infrastructure and technology changes. Beyond this, there are additional benefits. A holistic approach to compliance and risk management better positions financial institutions to address future risks and anticipate the impact of changing conditions. An 14 Individual results will vary by institution. 14 Deloitte Center for Banking Solutions enterprise-wide approach facilitates a constant dialogue among risk management areas regarding improvements, enables the development of a true cost of compliance and fosters a compliance culture at all levels of the firm. Understand your costs. Again, many financial firms underestimate compliance costs—by up to 30%. Determining the current costs of compliance can be challenging, but it’s critical to making the business case for ICRM. Be realistic about what can be accomplished. While a comprehensive, enterprise-wide program will likely deliver the best results, this may be more change than the institution can manage at one time. A phased approach or one of limited scope is not only acceptable, but at times preferable. Focus on what matters. We often see too many resources focused on low risk areas and not enough on higher risk areas. Assess risks carefully and set priorities accordingly. Win C-suite buy-in. A C-suite executive must understand the ICRM effort, ensure sufficient resources, communicate with other senior-level stakeholders, and help manage or resolve any conflicts. Integrated compliance and risk management may increase effectiveness, efficiency and reduce costs. At the same time, compliance becomes more effective as firms view requirements across the enterprise and assess risks more accurately. The cost savings and improved risk management may provide a competitive advantage. As markets become more risky, it may provide the most important basis for competitive success. Integrated Compliance and Risk Management: Rethinking the approach A roadmap for compliance proficiency Financial services firms often have difficulty assessing their baseline compliance proficiency without a guide. Such a guide is outlined in the ICRM Maturity Matrix (see Exhibit 6). By assessing their current and desired levels of compliance effectiveness, firms can assess the degree of change and the major steps required to achieve their desired level. Exhibit 6: ICRM maturity matrix 15 Unaware Fragmented Top-Down Systematic Risk Intelligent Awareness Firm has limited awareness of its compliance responsibilities and activities. Firm is aware of compliance responsibilities and activities but has limited prioritization. Firm has prioritized compliance activities consistent with its business footprint. Firm is consistently testing the extent and adequacy of its compliance activities. Firm regularly reviews and redefines its definition of risk and compliance activities. Full self-governing model. Accountability/ Organization Role and responsibilities not clearly defined. Accountability confused. Limited structural oversight. Narrow definition of compliance. Oversight structure exists but duplicative with LOB. Duplication of roles and responsibilities. Narrow definition of compliance. Clear oversight structure. Clear roles and responsibilities. Transparent accountability. Broader definition of compliance. Independent oversight perspective. Compensation structure in place to incent behavior. Deeply ingrained compliance ethics culture across the enterprise sponsored by C-suite. Process and Controls Limited process and controls in place. Significant manual activity. Processes and controls in place but highly duplicative and fragmented. Shared services structure in place with prioritized resource allocation based on degree of risk. Firm constantly audits its business function model and stress tests it against its updated compliance risk footprint. Processes and controls are constantly revisited through RCSA or similar process. Measurement Metrics in place to measure compliance management effectiveness are limited or nonexistent. Metrics established by some or all lines of business but are inconsistent across the enterprise. Metrics in place are consistent across the enterprise and subject to regular management review. Metrics are in place and benchmarking takes place to compare firms against best-in-practice institutions within the industry. Metrics and benchmarking are in place and constantly reviewed for effectiveness. Benchmarking is with best-in-class independent of industry. Technology Limited resource allocation to compliance. Fragmented and siloed IT approach. Heavy dependence on manual activities. IT has compliance systems in place but they are largely LOB specific. Limited integration between process improvement and IT development. Integrated approach between process improvement and IT development across the enterprise. Common systems for compliance independent of LOB. Alignment and leverage of compliance platform to achieve continually enhanced business benefits of improved efficiency and technology utilization. Have language and set of metrics to continually improve the compliance infrastructure year on year. Compliance activities are embedded in all enterprise systems across the firm. Culture No clearly defined ethics culture within the firm. Some degree of awareness around the importance of adhering to external regulations, subject to overriding business priorities. Strong culture of ethics compliance with consequences for serious breaches. Aggressive ethics culture for compliance seeking out new areas of exposure as part of the management DNA of the enterprise. Strong ethics leadership throughout the industry. Strong commitment by the C-suite to ethics as part of the external brand identity of the firm. We have added culture to the familiar elements in the chart, such as awareness, oversight, processes, measurements, technology, and accountability. That is because behavior, which is determined by culture, is essential to the success of any compliance program. The leadership creates the culture and sets the tone. For instance, some firms have established a strong ethics culture to reinforce their brand identity, seeing an opportunity to build customer relationships, strengthen counterparty engagement and instill confidence among regulators. This is easier to do with clearly defined roles, responsibilities, accountability and performance metrics. 15 Based on the OCEG Corporate Compliance Maturity Model. Deloitte Center for Banking Solutions 15 Integrated Compliance and Risk Management: Rethinking the approach Deloitte risk intelligence framework The Risk Intelligent EnterpriseTM Financial institutions are in the business of taking risks, but can falter when those risks are not managed effectively. One way of addressing this is to have a framework in place for risk management. The Deloitte risk intelligence framework suggests such an approach. The risk intelligence framework envisages three lines of defense: risk ownership, infrastructure and oversight, and finally governance to ensure the effectiveness and efficiency of the whole process. Risk infrastructure and oversight •Design, implement and maintain a common risk and compliance infrastructure •Establish an enterprise-wide approach Risk ownership •Identify and manage risks at a business line and enterprise level •Integrate risk and compliance management activities Board-level risk governance effectiveness •Assess ethics, risk and compliance programs •Set the right tone for effective risk and compliance management TM The Risk Intelligent Enterprise •Improve Board Oversight Risk Governance Board of Directors Su ies Tone at the top loy Common Risk Infrastructure ep tin Process Technology us People uo dD Executive Management on an dC pro De Im ve ly lop an Str a in teg sta Risk Infrastructure and Management ve Risk Process Risk Ownership Identify Risks Governance Assess & Evaluate Risks Integrate Risks Strategy & Planning Source: Risk Intelligence EnterpriseTM. Visit www.deloitte.com/RiskIntelligence for additional information on Risk Intelligence. Copyright © 2009 Deloitte Development LLC. All rights reserved. 16 Deloitte Center for Banking Solutions Respond to Risks Risk Types Operations/ Infrastructure Design Implement & Test Controls Compliance Monitor, Assure & Escalate Reporting Business Units and Supporting Functions Integrated Compliance and Risk Management: Rethinking the approach Authors A. Scott Baret Partner Regulatory & Capital Markets Consulting Deloitte & Touche LLP sbaret@deloitte.com +1 212 436 5456 Julia Kirby Director Regulatory & Capital Markets Consulting Deloitte & Touche LLP jukirby@deloitte.com +1 202 879 5685 David Cox Director of Research Deloitte Center for Banking Solutions dcox@deloitte.com +1 212 436 5805 Contributors Industry Leadership James H. Caldwell Partner Regulatory & Capital Markets Consulting Deloitte & Touche LLP jacaldwell@deloitte.com +1 704 227 1444 Jim Reichbach Vice Chairman U.S. Financial Services Deloitte LLP jreichbach@deloitte.com +1 212 436 5730 Paul Legere Principal Financial Services Deloitte Consulting LLP plegere@deloitte.com +1 312 486 2289 Deloitte Center for Banking Solutions Vincent Tarantino Manager Regulatory & Capital Markets Consulting Deloitte & Touche LLP vtarantino@deloitte.com +1 212 436 2462 Laura Breslaw Executive Director Deloitte Center for Banking Solutions Two World Financial Center New York, NY 10281 lbreslaw@deloitte.com +1 212 436 5024 Don Ogilvie Independent Chairman Deloitte Center for Banking Solutions dogilvie@deloitte.com About the Center The Deloitte Center for Banking Solutions provides insight and strategies to solve complex issues that affect the competitiveness of banks operating in the United States. These issues are often not resolved in day-to-day commercial transactions. They require multi-dimensional solutions from a combination of business disciplines to provide actionable strategies that will dramatically alter business performance. The Center focuses on three core themes: public policy, operational excellence, and growth. To learn more about the Deloitte Center for Banking Solutions, its projects and events, please visit www.deloitte.com/us/bankingsolutions. To receive publications produced by the Center, click on “Complimentary Subscriptions.” Deloitte Center for Banking Solutions 17 Disclaimer These materials and the information contained herein are provided by Deloitte and are intended to provide general information on a particular subject or subjects and are not an exhaustive treatment of such subject(s). Accordingly, the information in these materials is not intended to constitute accounting, tax, legal, investment, consulting, or other professional advice or services. 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Please see www.deloitte.com/us/about for a detailed description of the legal structure of Deloitte LLP and its subsidiaries. Copyright © 2009 Deloitte Development LLC. All rights reserved. Item #9012 Member of Deloitte Touche Tohmatsu Shaping the new financial services marketplace series Risk management in the age of structured products: Lessons learned for improving risk intelligence ent m e d nag arne a k M ns Le s i R so Les Produced by the Deloitte Center for Banking Soultions Shaping the New Financial Services Marketplace A new financial services marketplace that’s very different from the old is emerging from the credit crisis. The new market will be more transparent, simplified, standardized, and regulated with fewer intermediaries. In this series, entitled Shaping the New Financial Services Marketplace, the Deloitte Center for Banking Solutions will examine the rules, regulations, and operating models that evolve as the industry sails uncharted waters. Specifically, these articles will focus on: strategies for success in the new marketplace, different types of global regulatory systems, the gap between financial innovation and risk management, the burden on compliance as change occurs, and steps for integrating compliance risk management. In this report, we examine the recent experience with structured credit products to provide a perspective on lessons learned in risk management and how those lessons can be applied by financial institutions. Risk management in the age of structured products: Lessons learned for improving risk intelligence Foreword As this paper goes to press, the challenges facing the global financial services industry continue to increase. The U.S. Federal government has taken unprecedented actions, including plans to buy up to $700 billion in mortgage related assets; other governments globally are stepping in with their own stabilization efforts; and major government-sponsored entities and financial institutions have been effectively nationalized. The situation continues to evolve and financial markets are reacting strongly as takeovers, bailouts, and other major changes continue to take place at the industry’s most venerable financial institutions. Also, credit, liquidity, and capital remain in short supply. The overriding message from this escalating credit and liquidity crisis is that no one is immune. Why were so many companies so vulnerable? Could this have been prevented? Most importantly, how can financial institutions learn from this going forward? This paper explores what happened and why, using the recent experience with structured credit products as an illustration to provide a perspective on lessons learned and how those lessons can be applied by financial institutions in their quest to become truly Risk Intelligent Enterprises . TM Sincerely, Don Ogilvie Independent Chairman Deloitte Center for Banking Solutions October 2008 The outward evidence of events is well known. While many speculate as to how events were allowed to mushroom into a crisis of global impact, recognition is growing within the financial services industry that many factors coalesced into a risk management perfect storm that included: • The high degree of complexity inherent in structured credit products and corresponding valuation and risk measurement challenges; • A drop in trading volumes and liquidity resulting in decreased pricing transparency; and • The magnitude of aggregate exposures and their impact on capital. Deloitte Center for Banking Solutions Risk management in the age of structured products: Lessons learned for improving risk intelligence Contents Introduction 4 Looking back An abbreviated history of risk management in financial services The credit crisis and structured credit products The meltdown — a synopsis 5 5 7 11 Lessons learned Governance, risk oversight, and risk management Building risk and return into the business practice Risk capability to identify, measure, monitor, and control risks Transparency and disclosure 12 12 15 16 19 Conclusion 21 Additional references and resources 24 Deloitte Center for Banking Solutions Risk management in the age of structured products: Lessons learned for improving risk intelligence Introduction While it is tempting to lay blame on the structured credit products1 themselves, the causes of the current environment appear to be much more far-reaching. Key underlying issues in the recent credit crisis include: the prolonged maintenance of low short-term interest rates, a resulting housing price bubble and subsequent bust, modified approaches to underwriting and a reduced emphasis on traditional underwriting standards, high levels of leverage in many areas of the financial system, valuation and risk measurement analytics which did not fully keep pace with product complexity, and questions about risk management effectiveness. We believe it is time to take a fresh look at the risk management capabilities of financial institutions and the processes in place to support financial risk management. This is not the first time individual firms or the financial services industry has experienced a downturn that could be traced to such issues. It is the magnitude of the losses and the number of firms that seemingly did not fully understand their aggregate risk exposures that make this market collapse different. Given the enormity of losses to date, the global financial system surely does not want to see this happen again. The financial system has not yet moved beyond the effects of this broad downturn. A Deloitte2 survey of senior executives, including chief risk officers (“CROs”), of top global financial services companies conducted from December 2007 to April 2008 found that more than 91% of respondents believe that both the likelihood and the potential economic impact of systemic risk events have increased.3 One-third of the executives do not look for improvement in the credit and liquidity crisis until 2009 or later. The top four sources of systemic risk cited were: • Increased use of leverage to finance investments (44%); • Credit risk cycles and asset valuation bubbles (40%); • The inability of markets and regulators to identify excessive aggregate risk (39%); and • The increase in linkages and interconnectedness of markets produced by globalization (30%). We believe it is time to take a fresh look at the risk management capabilities of financial institutions and the processes in place to support financial risk management.4 It would appear that some firms lack a clearly stated risk philosophy or framework, risk appetite, relevant risk policies, and the necessary capabilities to support an accurate, aggregated, enterprise-wide understanding of the risks they face. Other financial institutions have effectively addressed these risk management issues. These firms view risk management not as a drag on strategy, but as an integral part of a strategic discussion where decision-makers look at risk and return collectively. Risk appetite is clearly stated and understood, with practices to put that expression of risk tolerances into action. Risk is part of the daily conversation and viewed from an enterprise-wide perspective. These are the firms where risk management not only has a seat at the table, but is also an active participant in all key business decisions. Now is the right time to undertake a fairly rigorous examination and begin implementing the kinds of organizational and process changes necessary to enable effective risk management. A change in the way risk management methodologies and processes are executed within many financial institutions is needed and will help companies move from a position of vulnerability to a place where risk management is executed more holistically and the company is not exposed to material unknown risks. “Structured credit products” are broadly defined here to refer to a spectrum of cash and/or synthetic credit derivative instruments used in the business of acquiring, distributing, and trading credit-sensitive assets for purposes such as value generation (e.g., cash collateralized debt obligations or “CDOs”), arbitrage (e.g., single-tranche synthetic CDOs for correlation trading), balance sheet management (e.g., synthetic CDOs for purposes of capital reduction), and credit intermediation (e.g., credit default swaps for buying/selling super senior risk with different counterparties). 2 As referred to in this document, “Deloitte” means Deloitte & Touche LLP, a subsidiary of Deloitte LLP. Please see www.deloite.com/US/about for a detailed description of the legal structure of Deloitte LLP and its subsidiaries. 3 “Systemic Financial Risk, Surveying the Market,” Deloitte Touche Tohmatsu, 2008. 4 Risk management can be interpreted very broadly to include all risks that an organization confronts, including financial risks, such as market, credit, and liquidity risks, as well as broader risks such as compliance, operational, strategic, reputational, and legal, etc. Within the context of this paper, however, risk management refers primarily to the management of market, credit, liquidity, and operational risks relating to traded financial instruments. 1 Deloitte Center for Banking Solutions Risk management in the age of structured products: Lessons learned for improving risk intelligence Looking back An abbreviated history of risk management in financial services Regulatory guidance Prior to the credit crunch, many risk management expectations and practices were driven primarily by regulatory guidance, as regulators have for some time focused on spurring financial institutions to improve their enterprise-wide risk management capabilities. One of the more significant banking regulatory programs has been to strengthen risk-based capital requirements and regulation through the banking industry’s Basel Capital Accords. Basel I, released in 1988, was the first global banking capital standard and introduced elements of risk-based regulatory capital for credit risk in a consistent way for the first time on a worldwide basis. Over time, it became clear that these simplistic, risk-based approaches were inadequate in the context of financial engineering innovation and the creation of products like structured credit products. Basel I encouraged growth in securitization and other techniques to reduce capital charges through limitations identified in the original capital rules, and “arbitraging” Basel I became commonplace. Basel I was amended in 1996 to include market risk; it allowed banks to use internal risk models for capital calculation for the first time based on Value at Risk (“VaR“) methodologies, which rely on statistical techniques. Partially as a result of the Basel Market Risk Amendment, major global banks widely adopted VaR in the mid to late 1990s, and it became the industry standard approach for measuring market risk. But there are known limitations with VaR. Inherently, VaR is not a predictive tool — it cannot foretell catastrophe from so-called stress or tail events, as it is usually based on historical data, which creates an overly sanguine picture in prolonged boom periods. Basel II5 was the product of extensive discussions by members of the Basel Committee on Banking Supervision (the “Committee”); various consultative papers and proposals were released, culminating in the revised framework introduced in June 2004, which has itself been subsequently revised and amended. The fundamental objective of the Committee’s work to revise the 1988 Accord has been to develop a framework that would further strengthen the soundness and stability of the international banking system while maintaining sufficient consistency to prevent capital adequacy regulation from becoming a significant source of competitive inequality among internationally active banks.6 Basel II introduced more sophisticated measurements for credit risk capital and also accommodated more complex products, such as securitized transactions. Because Basel II was subject to individual country regulator adoption timetables, it was not fully rolled out globally at the time of the credit crisis; Basel II was not in effect in the U.S., for example. Due to the U.S. system of bifurcated regulation of 1) banks and 2) investment banks and securities firms, the Securities and Exchange Commission (“SEC”) introduced in 2004 its own capital adequacy rules specifically for large securities firms and investment banks; these are known as Consolidated Supervisory Entity (“CSE”) rules7 and are generally similar to those of Basel II. “International Convergence of Capital Measurement and Capital Standards A Revised Framework,” Basel Committee on Banking Supervision, June 2004. “International Convergence of Capital Measurement and Capital Standards A Revised Framework, Comprehensive Version,” Basel Committee on Banking Supervision, June 2006. “Alternative Net Capital Requirements for Broker-Dealers That Are Part of Consolidated Supervised Entities,” Securities and Exchange Commission, final rule effective date August 20, 2004. 5 6 7 Deloitte Center for Banking Solutions Risk management in the age of structured products: Lessons learned for improving risk intelligence The European Union’s Solvency II proposals have recently started to have a transformational effect on many insurance companies’ risk and capital management processes. The effect of Solvency II on the insurance industry’s risk management capabilities may be roughly akin to that of Basel II on the banking industry. Risk measurement methodologies Risk measurement methodologies for trading products were heavily focused on VaR, especially for market risks and related techniques for counterparty credit risks. Generally risks were measured using separate methodologies and “risk engines” for different types of risks, e.g., market risk or credit risk. Some risk measurement methodologies required simplifying factors in their risk estimation, rather than a full revaluation of the individual positions. Simplification, however, often tended to underestimate exposures, as specific risks resulting from unique product features may not have been captured. Also, across any given firm, multiple risk management systems often operated independently, whether for different types of risk or for different trading desk units; this meant that those responsible for risk management had to manually cobble together an aggregated picture of enterprise risk. As a result, the risks for complex products were not always captured or fully estimated, and it was often not possible to get an overall view of the exposures they posed to the firm. Market and credit risk methodologies were siloed in many cases, using separate approaches, which limited the comparability of different risk exposures for the same business. The modeling of the underlying collateral of complex credit products, such as collateralized debt obligations or CDOs, often did not fully address factors like correlations in the underlying collateral, the impacts of a potential rise in defaults, or changes in expected recovery values. More than one institution assumed these risks were fully captured when, in fact, they were not. This problem did not begin with the advent of structured products. Historically, the quality of data and data processes available to some risk managers has tended to be imprecise and inconsistent, making aggregation difficult and undermining the credibility of resulting valuations and analysis. In some firms, the data challenges were exacerbated due to trading and operations technology infrastructure that did not provide a consolidated view of trades. This was due to limitations in the capture of all relevant trade information upon trade execution, as well as gaps in integration of the data that was captured. Structured credit products themselves challenged the prevailing approach to risk management in many organizations — separate market risk and credit risk engines run by generally siloed risk management groups. Because many of these products were considered trading assets and held in the trading book, they were not subject to the fundamental credit analysis requirements of banking book assets. Due to the combination of fundamental credit analytic needs in a traded product subject to market risk, a much more integrated approach was required. Too often, it seemed, risk management responsibility for these products fell between the market and credit risk functions — this lack of coordination between the risk functions wasn’t clear until it was too late and the losses became apparent. Deloitte Center for Banking Solutions Risk management in the age of structured products: Lessons learned for improving risk intelligence Additionally, investment in risk management technology varied considerably, not only from firm to firm, but also within different risk management functions of the same company. As new products proliferated, the limitations of the technology infrastructure became more critical. New products were introduced more quickly than the technological systems required to evaluate them could be developed, making it difficult to capture all relevant risks. Organization and governance While many firms were proud of their risk management programs, in hindsight, risk management was not always a fully developed or well-integrated function within some financial institutions prior to the credit crunch. In some institutions, central governance over business lines was largely ceded to the business units, which tended to operate more autonomously. The businesses were focused on increasing revenues; investment in infrastructure and processes to measure and monitor risk exposure appear to have been given a lower priority. New product approvals may have been pushed through without sufficient understanding of the risks or required supporting infrastructure. One should not overestimate the effect of an inordinate emphasis on short-term revenues to the detriment of risk management. Driven by pressure to maintain strong growth in quarterly revenues and the stock price, some firms found it understandably difficult to “get off the treadmill.” Even as warning signs became more abundant and individual firms started reporting losses, many market participants were unable to alter their operating models. Other considerations There are a few other notable factors that contributed to the size and scope of the credit crisis. First, there is a generally prevailing “agency problem” in major trading operations, whereby an asymmetry exists between risk and reward for traders. There are significant rewards and opportunities to the upside and limited risk to the downside, e.g., loss of employment at most, while a financial institution itself could be imperiled. As a result, the incentives of those actually taking and managing the risks (the traders) have not always been sufficiently aligned with those of shareholders and the institution itself. One should not overestimate the potential impact of an inordinate emphasis on short-term revenues to the detriment of risk management. Second, focus on risk management capabilities in general tends to be cyclical and episodic. Attention to broader risk management areas usually increases after major negative events, and therefore, generally occurs on a lag basis. An example is the series of major risk events that followed one after the other during 2000 and 2001: the technology bust; the collapse of Enron, WorldCom, and Tyco; and 9/11. The corporate accounting fraud from some of these events turned the spotlight on accounting controls and corporate governance, culminating in the enactment of the Sarbanes-Oxley Act of 2002 in the U.S. But soon thereafter, a lengthy benign period and sustained boom began that lasted until recently. During these years, there tended to be much less focus on risk management than during periods of greater market uncertainty and volatility. This is not unexpected. Third, many risk management agendas and budgets in recent years tended to be driven by the need to meet regulatory expectations set by such initiatives as Basel II, CSE, and Sarbanes-Oxley. While these are undoubtedly worthy efforts, they nonetheless had the effect of dominating the focus of many risk management resources…until the credit crisis became inescapable. The credit crisis and structured credit products Structured credit products are inherently complex to value when considering the modeling sophistication required to incorporate the correlation risk from thousands of underlying assets of differing quality. While, in general, this complexity created significant obstacles to fully comprehending risks, very specific developments in the structured credit products business contributed to the crisis that ensued. Deloitte Center for Banking Solutions Risk management in the age of structured products: Lessons learned for improving risk intelligence S&P/Case-Shiller Home Price Index Expectation of a rising residential market — The prolonged period of home price appreciation and historically low delinquencies were a significant factor affecting the valuation and risk measurement estimation of structured credit products. Analytical models dependent on historical data were often overwhelmed by the effect of rising home prices, which had been increasing in value for more than half a century, as shown by the S&P Case-Shiller Home Price Index and U.S. Census Bureau median home value data. Prices finally started to decrease around March 2007, as early signs of the credit crunch emerged. Home Price Index 250 200 150 100 50 0 87 9 /1 1 89 9 /1 1 91 1 9 /1 93 1 9 /1 95 1 9 /1 97 9 /1 1 99 1 9 /1 01 1 0 /2 03 1 0 /2 07 05 0 /2 1 0 /2 1 Source: Standard & Poor’s, Composite-10 CSXR; January 1987 - May 20088 Analytical models dependent on historical data were often overwhelmed by the effect of rising home prices, which had been increasing in value for more than half a century, as shown by the S&P Case-Shiller Home Price Index and U.S. Census Bureau median home value data. Revenue focus of management — Both product innovation and product complexity developed rapidly, driven in large part by the profitability of these products. There were sometimes few curbs in place, and a front office, empowered by success, could be subject to less oversight and prevail over risk management objections. As stated above, the technology to support risk analysis tended to lag new product development, limiting many financial institutions’ ability to monitor and control their exposures for certain new products. Easy funding and high yields — In general, there was an abundance of money available at very low rates to finance everything from the underlying mortgages to the structured product transactions themselves. Risk premiums (spreads over risk-free assets, such as treasuries) were at historic lows, evidence of the abundance of money and risk appetite chasing deals. Many investment grade CDOs offered debt returns that far exceeded yields on other investment grade alternatives. In 2006, the BBB-rated portions of CDOs yielded 7 to 9 percentage points above LIBOR or about a 13% annual return.9 The Case-Shiller composite-10 CSXR Home Price index measures the nominal value of the residential real estate market in the United States based on an aggregation of 10 major metropolitan areas. ”The Rating Charade,” David Evans and Richard Tomlinson, Bloomberg Markets, July 2007. 8 9 Deloitte Center for Banking Solutions Risk management in the age of structured products: Lessons learned for improving risk intelligence At the same time, changes in the approach to underwriting led to less emphasis on traditional underwriting standards for the mortgages, spurring growth in subprime and other nonstandard loans. These included 2/28 adjustable rate mortgages or ARMs, where the interest rate resets in two years, Alt-A or lowdocumentation loans that often did not require income verification, and even products that allowed borrowers to choose their payment amount (so-called “option ARM” or “pick-a-payment” products). More important, the combined loan-to-value (“LTV”) ratio for many of the mortgages originated between 2005 and 2006 approached the 90s range, which provided a very thin equity margin of collateral on the underlying home loan.11 Within some financial institutions, low internal funding costs allowed “carry” strategies where no alpha was created. Also, there was a lack of consideration of certain risks in some firms’ transfer pricing. As a result, large positions were built up to capture small spreads, further adding to leverage. These growing positions ultimately exposed firms to large concentrations of risk. Securitization — There was a virtual explosion of securitization transactions whereby large volumes of complex securities backed by mortgages and other receivables were created. The securitization operating model allowed for the transfer of risk from the originator’s or distributor’s balance sheet to the end user investor with little risk “retained” by the originator in the process, except for those loans put back to originators through early payment defaults (EPDs). The securitization business model presumed deals were not to sit on the bank’s balance sheet. Over time, the assumption proved incorrect, as firms increasingly had to retain unsellable tranches, and, ultimately, the warehoused collateral for entire deals in the pipeline had to be retained when deals were unable to be brought to market. As a result, firms ended up taking on substantial risks that were not anticipated in the original business model. ABX 06-1 Implied Spreads bps 1400 1200 AAA AA A 1000 800 600 400 200 0 6 00 2 2/ 6 00 2 5/ 6 00 2 8/ 06 20 / 11 7 00 2 2/ 7 00 2 5/ 7 00 2 8/ 07 20 / 11 08 20 2/ 08 20 5/ 08 20 8/ Source: Lehman Brothers/Markit Partners10 Additionally, securitized assets were spread across many investors of varying sophistication and geographic locations around the world. Investors’ constant search for alpha drove some issuers to create increasingly more complex products with more and more esoteric features and, ultimately, with questionable underlying collateral. The buyers of these securities did not always fully understand or have the ability to independently value the transactions or measure the underlying risks, and, as a result, there was an overreliance on rating agencies. It was estimated that approximately half of the $412 billion of CDOs sold in the U.S. in 2006 contained subprime debt, and, on average, 45% of the contents of those CDOs consisted of securities backed by subprime home loans.12 The ABX index, created by London-based Markit Group Ltd., measures the cost, or spread, of credit default swaps based on bonds secured by so-called subprime mortgages and home-equity loans. 11 “Why We Are Still in the Early Innings of the Bursting of the Housing and Credit Bubbles,” T2 Partners LLC, March 16, 2008. 12 “The Rating Charade,” David Evans and Richard Tomlinson, Bloomberg Markets, July 2007. 10 Deloitte Center for Banking Solutions Risk management in the age of structured products: Lessons learned for improving risk intelligence Valuation — Trading positions, including structured credit products, depend on mark-to-market valuation. As the origination and trading of these products declined, so did the liquidity in the structured credit products markets. As a result, the valuation of structured credit products moved from transactionbased information to model-based efforts that relied on broader indices, creating less reliable valuations and greater pricing risk. Valuation was often made inherently more challenging by the complexity of these products and a range of other factors, including, but not limited to, unreliable ratings and incomplete collateral assumptions and supporting analytics. Valuation was often made inherently more challenging by the complexity of these products and a range of other factors, including, but not limited to, unreliable ratings and incomplete collateral assumptions and supporting analytics. As a result, not only did the originating firms end up warehousing deals they hadn’t intended to but investors who sought increasingly complex instruments providing high yields also experienced a concentration of real estate-related risk. The diversification of risk originally assumed from securitized assets did not protect them against a deep and widespread decline in real estate values nor from unexpected correlations and concentrations of risk. Quarterly CDO Issuance in $ Billions 200 180 160 140 120 100 80 60 40 20 Source: SIFMA, Global CDO Market Issuance Data; Total Issuance; first quarter 2004 - second quarter 2008. 10 Deloitte Center for Banking Solutions 2008Q2 2008Q1 2007Q4 2007Q3 2007Q2 2007Q1 2006Q4 2006Q3 2006Q2 2006Q1 2005Q4 2005Q3 2005Q2 2005Q1 2004Q4 2004Q3 2004Q2 2004Q1 0 Risk management in the age of structured products: Lessons learned for improving risk intelligence The meltdown — a synopsis The rapid evolution in the complexity of structured credit products was accompanied by a decrease in the quality of underlying collateral and by a broader capital markets credit liquidity freeze. The combination was too much, in many instances, for the evolving practices of and attitudes toward risk management. The credit meltdown, which continued as structured credit products losses became widely apparent, exposed previously hidden risk management weaknesses. Before this crisis is over, the aggregate industry write-downs are variously estimated to range from approximately $400 billion to $2 trillion. The lower end of the forecast has already been exceeded. Financial institutions have raised more than $300 billion of new capital in response at the time of this writing, with more capital undoubtedly needed. The wide range of estimates for the potential losses may reflect differences in opinion as to what losses are really attributable to the subprime mortgage crisis, but it is also further evidence of the continuing challenges of valuing the underlying financial instruments. One of the most significant issues appears to have been incomplete views of a financial institution’s full range of risks from these products: • The methodologies used to value, measure, and monitor structured credit trading positions often did not adequately evaluate the underlying collateral, leading to underestimated risk exposures. • Newer, complex products were often not built into the existing risk infrastructure and were being monitored on spreadsheets or via simplified risk approaches that did not take into account certain specific risks, such as the credit and prepayment risks of specific underlying loans. • Approaches for related analytics in different areas, e.g., structuring models, front-office valuation models, market risk models, and counterparty risk models, could produce incompatible results, making it difficult to compare their analyses. The exposure of limitations in some risk management practices brought into question the validity of industry models and highlighted a reliance on historical data that included the recent “cheap-money,” “easy-credit,” and “home-price-inflation” boom period; thus, the inherent risk of a typical structured credit product originated between 2004 and 2007 was frequently underestimated. It was, however, the lack of trading liquidity that focused attention on dangerous concentrations and overexposure to risk. Without observable market prices, as discussed above, valuation of these instruments became challenged. As the size and scope of exposures were identified, financial institutions were forced to take unprecedented write-downs. The combination of these events raised the potential for systemic risk and a global financial system meltdown. This, in turn, led to unprecedented Federal Reserve actions to provide liquidity for nonbank financial institutions, such as investment banks for the first time and for certain mortgage-related and other assets, to relieve stress in funding markets and reduce systemic risk. What can we learn from these events? What can we do differently? Where should financial institutions focus to improve their risk management effectiveness? Deloitte Center for Banking Solutions 11 Risk management in the age of structured products: Lessons learned for improving risk intelligence Lessons learned With the benefit of 20/20 hindsight and awareness of regulators’ guidance, our analysis suggests that the lessons fall generally into four areas: 1. Revamping governance, risk oversight, and risk management; 2. Integrating both risk and return into decision making; 3. Building capacity to understand and manage risk; and 4. Revisiting the need for improved transparency and disclosure. From the lessons that follow come both prescriptive actions and food for thought. Governance, risk oversight, and risk management Issue: Risk oversight and direction A key issue in the credit crisis relates to the role of senior management and the board. In some cases, it appears that senior management and the board were not adequately informed of the risks their firms faced in structured products and the aggregate risk contained on their balance sheets. This was not necessarily a failure of the risk management function, although there were cases where informational alerts weren’t sufficiently forthcoming, but of the organization’s management oversight and risk governance, and related management systems, policies, and procedures. In other cases, senior management and the board were given notification, but did not take timely action, perhaps due to limitations in relevant risk information or a belief that the potential risk was not as large as was subsequently demonstrated. Because risk management culture and approaches were not, in some cases, sufficiently embedded throughout the organization, risk and reward perspectives were not brought together in a way that would have allowed a more accurate, enterprise-wide understanding of the firm’s risks. This lack of understanding across the organization of the true magnitude of its risks laid the groundwork for failure. 12 Deloitte Center for Banking Solutions Second, some boards were not in a position to provide adequate risk oversight, due in large part to a lack of complete and timely information — “they didn’t know what they didn’t know.” As a result, these boards were not asking questions related to the growing crisis until it was too late. Furthermore, there were board members who appear not to have been sufficiently risk literate, i.e., they lacked the understanding of the risks inherent in the products creating the firm’s revenue. While their general acumen was not in question, they were not well versed in the specifics of risk management or in the new and complex area of structured products. Third, risk appetite definitions as well as their enforcement and linkage to risk tolerances were a work in progress for the industry. Many financial institutions had a detailed set of limits on the trading floor, but there may not have been a clear, overall articulation or measurement of risk appetite and risk return. In addition, the linkage of the risk appetite statement to the actual tolerances and limits was sometimes imprecise. Issue: CRO and risk management function While the CRO position had been widely adopted, it remained the newest C-Suite position and, implicitly or explicitly, did not always have sufficient authority, especially relative to senior business management. Some of the original CROs were still building their organizations’ risk capabilities at the time of the crisis. CROs tended to be primarily focused on monitoring, measuring, and reporting risk and were often not in a position to challenge or manage risks more proactively. Inadequate communication between risk management and the business as well as powerful front-office influence added to the ultimate lack of authority of this position. A number of risk organizations structured themselves primarily by risk type, e.g., market risk, credit risk, etc., thus they did not act as true enterprisewide risk management functions. While effective for tactical issues, this organization encouraged risk management departments to operate in silos, independent of one another, and was inadequate for larger events. This siloed risk organization structure contributed to the limited sharing of knowledge and data between risk management and the businesses. Risk management in the age of structured products: Lessons learned for improving risk intelligence Recommendation: A firm should have, in writing, a clear, detailed, board-approved risk management charter or framework that defines risk management roles and responsibilities, which is clearly communicated throughout the organization. The charter should cover the key definitions of roles and responsibilities outlined below as well as other issues: The board • The board or board-designated risk management committee should provide oversight and guidance. This role should be reflected in the relevant committee charter as well as documented in related policies. While board committees are not responsible for managing risk, they do have responsibility for its oversight. • The board should provide guidance and have access to risk management in order to understand its objectives and perspectives. Senior management • Overall responsibility for risk management belongs with the CEO. In many financial institutions, a CRO position has been established that provides leadership for and executes the organization’s risk management plans. • Senior management should establish and support a CRO position reporting to the CEO who is viewed as a true part of the C-Suite level executive management team. • Senior management should ensure that a periodic meeting between the board and the CRO is routinely scheduled as a recurring board agenda item. These meetings between the CRO and board should be conducted as executive sessions, without management present and be conducted “off the record” in order to allow frank discussion. • There should be a corporate risk management committee that takes an active role in reviewing the firm’s risk profile. The committee should be held accountable for determining that policies and procedures are followed. It should include appropriate members from the C-Suite as well as management from the business lines and major risk management disciplines (market, credit, liquidity, operational risk, etc.). There should be a corporate risk management committee that takes an active role in reviewing the firm’s risk profile. ,Risk management • The CRO should have written veto power over transactions, counterparties, and other key risk-related decisions, including the ability to recommend cutting positions or hedging, with an appropriate escalation and resolution process (in writing) that includes the CEO and/or the risk management committee or executive committee, as appropriate. • The CRO and central risk management function should be independent of the business units. • The heads of the major risk disciplines should report to the management risk committee in order to provide a complete picture of the institution’s risks. • Risk management should focus primarily on risk management activities and not be drawn into unrelated areas. The risk management agenda should not be sidetracked by initiatives that should be managed elsewhere. While some risk management analyses may be viewed as value-added information by business units — and in many cases, this usage should be encouraged — the risk management team’s responsibilities must be carefully managed to ensure that they are properly focused on their core mission, both from a segregation of duties perspective as well as from a resourcing perspective. • Risk management organizational silos, such as the specific risk disciplines of market, credit, liquidity, and operational risk, should be broken down so that all risk areas operate in an integrated way to address the risks of businesses, and the company’s overall risk management organization acts as a true enterprise-wide risk management function. Deloitte Center for Banking Solutions 13 Risk management in the age of structured products: Lessons learned for improving risk intelligence Business lines The business units are responsible for taking and managing their risk. The risk management function should be a referee, using the risk appetite, tolerances, and limits as guidelines in monitoring, reporting, and measuring the firm’s exposures. Conflicts are inevitable, but having clear statements of responsibility will reduce ambiguity and unwanted exposures. • The business lines should work with risk management as trusted partners and active participants in business and strategy discussions. • Regular reporting and communication procedures should be documented in policies and procedures to determine compliance. This includes appropriate discussion between risk management and the operating units, and between the front and back offices of the business lines. Ideally, everyone at all levels of the firm should understand his or her role and accountability for risk management in line with the organization’s stated risk appetite and risk framework. When different groups in the same firm perform functions, such as structuring, trading, or investing in securitized instruments, they should operate under an institutional code of conduct that will reduce or eliminate the potential for conflicts of interest. Strengthening risk management is everyone’s job. Financial institutions with strong risk management functions often use a “three lines of defense” strategy where business management, risk management, and the internal audit function reinforce overall attention to risk and control issues. Business units must take their own risk management role seriously and devote sufficient resources and management attention to make risk management effective. Important questions every board member should ask Oversight and reporting • Are the risk oversight functions of the board committee with delegated risk oversight responsibility clearly defined in its charter? •Are all relevant risk exposures appropriately aggregated into board and senior management risk reporting? •Does the board understand the risk information it receives? Does the board understand what actions it should take in its oversight role if it receives adverse risk information? • Does the board’s risk committee have enough members with experience and understanding of risk management issues? Does their experience include multiple business cycles? • Is there a defined and documented reporting line of the CRO to the CEO? Roles and responsibilities • Are the firm’s policies and procedures clearly defined in writing? Do they include all major categories of risk, including risk governance and oversight as well as processes for managing each type of risk? • Has the board reviewed and approved the risk appetite and key risk management policies? Does senior management review them on a periodic basis? • Are the CRO and risk management supporting staff adequately compensated? • Does the CRO have implicit or explicit authority to veto trades and drive risk reduction as necessary? • Are the firm’s traders open and communicative with risk management? Do they proactively bring risk managers into their discussions? • Does risk management systematically provide training to develop competencies around risk management and through different business unit levels? Processes • Are risk and return part of strategic discussions? • Is the new business and new product approval process documented? • What mechanisms exist to monitor compliance with policies? • What procedures exist to identify new or emerging risks that may impact the company, and how is their potential impact assessed? • Does risk management periodically conduct stress tests to evaluate the firm’s sensitivity to tail risks? • Do board risk committees have regularly scheduled risk management review discussions? • Does the board have regular communication with risk management, including: - In-person presentations and discussions with the CRO, including executive sessions without management present? - Regular reports showing key risks measured relative to their risk tolerances? 14 Deloitte Center for Banking Solutions Risk management in the age of structured products: Lessons learned for improving risk intelligence Building risk and return into the business practice Issue: Placing risk and return in proper balance Focused as they were on generating revenues, a number of financial institutions did not fully understand their exposures that generated the losses. It is time to build risk and return more effectively into the business practice. The operating model used by some financial institutions drifted to one where the business evaluates (and is rewarded for) the return, while risk management evaluates the risk, primarily from a loss avoidance viewpoint. What we now see is that these financial institutions did not achieve an operating consensus regarding the appropriate balance between risk and return. Robust forums for discussion of risk issues among risk management, business, and senior management were not developed; nor were escalation procedures fully accepted and utilized to bring risk concerns to higher levels of the organization. Recommendation: A risk management culture with decision-making based on risk and reward should be embedded throughout the organization, from the risk management group to corporate functions to business units. There are specific steps financial institutions can take to embed risk management more fully in the company and to bring risk and return into better balance: • Independent measurement and monitoring of riskadjusted returns using calculation input from risk management. • Periodic independent analysis of results against planned business strategy with senior management and the board. • Joint discussions of the CRO and CFO with the board regarding risk and return, including a process to ensure these discussions take place. • Revised incentive structures that base financial rewards on a risk-adjusted basis. • Establishment of a CRO-led group with decision-making authority for new product approval, i.e., that cannot be overturned by the business unit developing the product; there should, however, be a higher-level formal escalation process which involves an authority such as the firm’s risk management committee. Both the relevant business units and the risk management function should continuously monitor new or emerging risks and escalate focus and attention on them within the firm as they arise. Focused as they were on generating revenues, a number of financial institutions did not fully understand their exposures that generated the losses. It is time to build risk and return more effectively into the business practice. As financial institutions use more integrated risk and reward analysis, the focus of individual businesses may change. At an industry level, it appears that changes to the entire securitization business model will be required to develop a more sustainable business model, although a discussion of such is beyond the scope of this paper. Recommendation: Senior management — with board input and approval — should set the direction of the institution’s risk appetite as part of its written risk framework. Direction must come from the top. It is senior management’s job, with input and approval from the board, to explicitly state how profit and risk will be balanced. The corporate risk appetite then should be translated into a detailed set of risk tolerances and limits at the business operating level. The business units need clear guidance from senior management, so that they understand the corporate risk appetite and how it translates to the operating level. Integrating risk management into the business is an ongoing process. It’s not about having a few checkpoints. It’s about incorporating risk and reward into the decision-making process and allowing risk decisions to be reviewed by an independent risk management function. It’s about embedding risk awareness in the day-to-day operation of the business. Deloitte Center for Banking Solutions 15 Risk management in the age of structured products: Lessons learned for improving risk intelligence Risk capability to identify, measure, monitor, and control risks Issue: Valuation and risk measurement systems for complex products It has been widely reported that a lack of sufficiently sophisticated analytical systems and a clear methodology for assessing liquidity risk contributed significantly to delays in management’s response to the credit crunch. It now appears that valuation and measurement systems did not fully capture risk at the product level, impeding the formulation of a complete view of the financial institution’s aggregate exposure. The limitations of some specific valuation and risk models used are worth noting: • Some valuation and risk models were unable to “pierce” the security-level analysis of structured credit products, which meant they were not capable of analyzing the underlying collateral and, due to the lack of sufficient granularity, they were unable to capture the correlated risk associated with these components. • Some valuation and risk models only used historical default experience and not current spread information; as a result, they were not sensitive to movements in related credit spreads. Some models also assumed a generally rising housing market and continued availability of cheap funding. • Some risk models used simplifying assumptions that mapped complex instruments to general index type exposures. This had the effect of ignoring specific risks attributable to these products. It is also important to recognize that risks cannot be aggregated across the enterprise if data and analyses of different types of risk and from different businesses are incompatible. 16 Deloitte Center for Banking Solutions • Concentrations and correlations between different credit products, underlying collateral, counterparties, credit providers, and other factors were insufficiently modeled or analyzed. • Liquidity risks were insufficiently modeled and considered in general; this was especially true with regard to contingent liquidity events. • Stress tests and tail risks were often not incorporated sufficiently in some models. More importantly, stress tests lacked properly constructed action plans. • Risks associated with monoline insurers and other guarantors were not sufficiently analyzed in some cases. Given that monoline insurers were exposed to subprime assets, their structured credit products insurance constituted a classic “wrong way exposure;” just when their insurance was needed most, it was ultimately not available due to the weakened condition of the monolines. • Generally, agency ratings of the securities were highly relied upon, in some cases without significant internal analysis and validation. It is also important to recognize that risks cannot be aggregated across the enterprise if data and analyses of different types of risk and from different businesses are incompatible. Systems that can’t speak to one another, that use different types and formats of data and produce results that cannot be aggregated will not be able to do the job needed. Recommendation: A firm should be able to value and robustly measure the risks associated with all transactions. To do this, a firm should have a consistent set of models, data, and related systems for pricing and risk management that fully captures, to the extent practicable, all relevant drivers of value and risk. Risk management in the age of structured products: Lessons learned for improving risk intelligence These models should be developed to have applicability for the range of related risks for structured credit products, such as market, credit, and liquidity risk. The modeling framework should be flexible and extendable enough to incorporate new products as they are developed and to allow for new, meaningful, and timely analyses of risks as they emerge, looking into various correlation and concentration risks, for example. Valuation modeling should occur with sufficient frequency, generally daily. In addition, this entire model framework should be managed with a process for periodic review and independent validation, including review of key valuation assumptions. Where possible, profit-andloss explanation processes should be developed to provide transparency and management information about the sources of profit (and loss) for the business. This will help identify drivers of risk and value inherent in the business and build a greater understanding of their importance. Liquidity — Firms need to be looking more closely at liquidity, both individual product liquidity risk and the liquidity risk associated with their funding. Liquidity has often not been considered a core risk management function as there have been no regulatory capital requirements for liquidity. The importance of liquidity management is rising as it is now regarded as a critical risk management issue, not strictly as a treasury issue. Risk management and the treasurer’s office should be working closely with each other to monitor liquidity risk. Contingent liquidity risks from products, off-balance-sheet structures, or other activities should be identified and captured in the liquidity risk systems as well as having mitigating action plans in place. Models should measure the liquidity of the business under stress scenarios, taking into account that liquidity exposure is different for every firm, depending upon its business. Credit — Firms active in markets such as structured credit products should have the capability to perform their own credit risk and other analyses to reduce their reliance on external parties for key risk determinations. The importance of liquidity management is rising as it is now regarded as a critical risk management issue, not strictly as a treasury issue. Risk management and the treasurer’s office should be working closely with each other to monitor liquidity risk. The determination of credit risk for counterparty or for a transaction is a significant management opinion that the firm should be capable of reaching on its own. Rating agency ratings should be considered as just one source of information, not as the sole source of information. New products — Enhanced policies and procedures for new product approvals are necessary to determine that the new products can be properly valued, evaluated for risk, accounted for, and processed in the firm’s systems. Given that a firm’s existing technology is inherently challenged to capture new product risks, it makes sense to establish clear limits, including notional limits that mitigate the possibility of irreparable harm if things go wrong. Overlooked exposures — Firms also should conduct rigorous analyses of products and business portfolios to expand their view of risk to accommodate exposures not previously captured, such as various contingent risks, correlation and concentration risks, wrong-way exposures, and contagion risk. All of these should be incorporated in stress scenarios and stress testing in order to build an accurate, holistic view of the firm’s risk. New and emerging risks — The institution should have a continuous process in place that assesses ongoing market, business, legislative, regulatory, political, and other conditions and identifies new and emerging risks that may impact its operations. Once such risks are identified, scenario analysis and planning techniques, along with other methodologies, should be used to assess the potential impact and identify relevant risk management and mitigation approaches. Deloitte Center for Banking Solutions 17 Risk management in the age of structured products: Lessons learned for improving risk intelligence Because credit, market, liquidity, and other risks are interrelated, they cannot be analyzed independently. They should be considered from a broader, enterprisewide perspective. Limits should be developed and monitored in a way that the overall risk tolerance for products are represented in an integrated way. Finally, the risk analytics alone are not enough. Management throughout the company — from risk management personnel to business unit and senior management — should understand the drivers of risk and value in different businesses and the implications of the results of the models. Thus, the application of well-grounded business judgment and common sense to the results of quantitative analysis is as important as the analysis itself. This understanding is necessary in order to incorporate the results of the models into the company’s overall decision-making regarding risk and return. The application of well-grounded business judgment and common sense to the results of quantitative analysis is as important as the analysis itself. Recommendation: The firm should have consistent approaches to data, models, and processes. If a financial institution hopes to compile an aggregated, enterprise view of its risk, its technology and data should be consistent across business units and across specific risk functions. Procedures to achieve data, model, and process consistency should be commonly understood and in use, including processes for the approval of new products, for legal and reputation risk review, and for overall valuation and risk measurement. 18 Deloitte Center for Banking Solutions Recommendation: Greater investment in risk management infrastructure is essential. Implied in the above discussion is the need for further investment in risk management infrastructure. Technology needs and the types of transactions and risks involved vary by financial institution. Large financial institutions may have systems for credit risk, for example, or to handle specific asset classes, but they may still lack the ability to get a broad view of risk across asset and risk classes; to link derivatives to underlying securities; to capture tail risk, for instance; or to look at market and credit risk using consistent methodologies. There are implementation guidelines of general value to all financial institutions. First, all tools and analytics should be able to accommodate the analytical requirements of existing transacted products and those reasonably anticipated in the near future. That in and of itself is no minor issue. While off-the-shelf packages do exist, it is likely that customization by an in-house IT department will be required. The technology should also be scalable and extendable in order to accommodate new products, new risks, and higher volumes. Most companies don’t have enough capability for the business that may ultimately result from new products, which is understandable, given that a major technology investment doesn’t make sense until the product is proven. But letting the business get too far out in front of risk management and its supporting infrastructure carries its own dangers, as we have seen. This is a bit of a “chicken-and-egg” proposition, but it can also be a ready excuse for not investing adequately during boom times. The firm may need both to build a proprietary application or data warehouse and to enhance system integration. In the face of such a technologically daunting (and financially costly) proposition, it is easy to understand why companies have delayed making this investment. Only in light of recent events has it become evident how important it is to bring systems up to speed and to determine whether they are compatible with each other. It is difficult to overestimate the value of complete, compatible, consistent data. Risk management in the age of structured products: Lessons learned for improving risk intelligence Transparency and disclosure Issue: Receiving or considering relevant riskrelated information in decision making Risk management infrastructure limitations, plus the complexity of structured credit products themselves, meant that essential risk-related information often did not reach the right levels or enter into key decisions regarding risk, at either the business or corporate level. Improved risk management processes, clarified responsibilities, consistent data, and better models will do much to rectify the situation. Issue: Disclosure to both internal and external constituencies Given the problems in internal communication regarding risk in some firms, it is not surprising that external disclosure was incomplete. This was compounded by the limited regulatory requirements in some areas, although in the U.S., the Financial Accounting Standards Board (“FASB”) did have a FASB Staff Position13 (“FSP”) posted December 19, 2005, to improve disclosures about certain loan products that may give rise to a concentration of credit risk. Recommendation: The firm should demonstrate clear intent to provide transparency and appropriate disclosure to all constituencies. Internally, the following guidelines are recommended in structuring these efforts: • The risk-related information relevant to key decisions, including current and potential exposures, stress scenario results, correlations, concentrations and contingent exposures and funding requirements, should be conveyed to senior management and authorized bodies like the management risk committee and board risk committee on a timely basis and in an understandable format. • Senior management should actively monitor contingent exposures and have prepared action plans in place. Structured investment vehicles are a good 13 14 example. While they may have been structured as off balance sheet, management should understand the circumstances under which they might be reconsolidated on balance sheet, as many were. • Reporting should be customized for the audience — informative, transparent, and relevant to possible action, but drawn from standard source data. • Standard risk management reports should be disseminated beyond the risk management function to reach front office and other appropriate managers, so there is consistency in risk exposure analysis. • Board members and senior management should have the opportunity to participate in CRO-sponsored workshops covering the financial institution’s exposures and the associated risk management approaches. External constituencies, including shareholders, regulators, rating agencies, and counterparties, should receive relevant risk-related information, especially in times of stress. Regulatory bodies and rating agencies have made it clear that greater disclosure lies ahead, guided by more specific requirements, as the side bar on page 20, “What the regulators are saying,” indicates. In the meantime, some financial institutions have recognized that improved disclosure practices are not dependent on regulatory requirements. On April 11, 2008, the Senior Supervisors Group, a cooperative effort of leading regulatory authorities in several countries, issued a survey report on the disclosure practices of 20 large, internationally oriented financial firms. The survey identified a set of leading practices for financial disclosure.14 Clearly, financial institutions should be prepared to present information to regulators — to all constituencies, for that matter — in a way that is clear, easily understood, and at the appropriate level of detail for the audience. “Terms of Loan Products That May Give Rise to a Concentration of Credit Risk,” Proposed FASB Staff Position (FSP) No. SOP 94-6-1. “Leading-Practice Disclosures for Selected Exposures,” Senior Supervisors Group, April 11, 2008. Deloitte Center for Banking Solutions 19 Risk management in the age of structured products: Lessons learned for improving risk intelligence What the regulators are saying A number of regulatory and industry bodies, including the Basel Committee on Banking Supervision, the Senior Supervisors Group, the Institute of International Finance (IIF), and the Counterparty Risk Management Policy Group III have completed postmortem and “lessons learned” assessments and have suggested steps aimed at reducing the likelihood of similar crises happening in the future. A number of recommendations from multiple sources include the following: • Improving the overall risk management process; • Incorporating stress and scenario testing into the risk management and senior management dialogue; • Strengthening liquidity risk management; and • Improving transparency and disclosure. These recommendations reinforce the lessons learned that are presented in this document. Additionally, there are a number of macro issues raised that require the attention of regulators, legislatures, and others. Efforts to broaden capabilities to monitor and address systemic risk will be called for; these may include changes to markets and their underlying infrastructure to reduce sources of risk. Significant changes to the U.S. regulatory oversight structure are likely, although this is most likely a longer-term initiative. Key oversight regulations like Basel II will likely be amended to incorporate lessons learned for structured credit products, including the addition to the regulatory framework of liquidity risk in a much more significant way. The nature of regulatory examinations will most likely change, regardless of the time it takes to adjust regulations, with increased focus on: • Risk management oversight; • Valuation models and processes and related controls; • New product approval processes; • Heightened credit risk management processes and practices; and • An enterprise-wide view of liquidity management. e the r a t a Wh ying? a s s r to regula 20 Deloitte Center for Banking Solutions Risk management in the age of structured products: Lessons learned for improving risk intelligence Conclusion The world has become painfully aware that effective risk management is critical in a marketplace where complex financial products are increasingly commonplace. The commitment to risk management cannot be a passing one. It requires focused effort and significant resources during both boom and bust periods to create the proper infrastructure, and it may require a culture change on top of ongoing diligence to make it work. Risk management is a process that requires direction and support from the highest levels of the organization, but everyone in the firm shares responsibility for it. The tone is set at the top by senior management and the board. The board must be sufficiently risk literate if it is to fulfill its responsibility for risk oversight. The board and senior management drive the firm’s risk governance oversight and direction, and their views, expressed not only in written and spoken words, but also in actions, cascade down through the organization. How seriously risk management is taken at the top determines how seriously it is taken throughout the organization. Senior management and the board need to provide clear guidance, which should be reflected in explicit policies and procedures. They should also communicate a clear expectation of compliance. The most sophisticated technology and detailed processes are useless if the results they produce are ignored or not taken seriously. Senior management should enforce stated risk policies and listen to risk management. How seriously risk management is taken at the top determines how seriously it is taken throughout the organization. Similarly, clear, fully disclosed, risk-related information should feed up from the business units to senior management and the board. Both the transparency and the range of perspectives of the information flowing up to senior management and the board depend on well-defined policies and procedures and on strong analytic capabilities with consistent methodologies unencumbered by individual risk silos. Reliable quantitative and qualitative information, seasoned by experience and common sense and delivered to decision makers in a timely fashion, is key to building a betterinformed, more confident basis on which to review the corporation’s risk appetite and adjust it to take best advantage of market conditions. Having this kind of information is what differentiates those “risk intelligent” financial institutions (see page 23) that use their understanding of possible outcomes strategically, both to seize opportunities and mitigate risks. Deloitte Center for Banking Solutions 21 Risk management in the age of structured products: Lessons learned for improving risk intelligence Summary of lessons learned Governance & risk oversight Balancing risk & reward Building risk capability Transparency & disclosure • The board should clarify and • Risk management should • Senior management, with board • A firm should be able to capture, formalize its risk management input and approval, should set value, measure, aggregate, and provide accurate, complete, and oversight role. the direction and articulate the monitor the risk associated with timely information to senior firm’s risk appetite. all its transactions. management, the board, and • Senior management, with board input and approval, should set • Risk management should • Firms should have a single set of business units. the direction and articulate the monitor, report, measure, and models, data, and related systems firm’s risk appetite. manage exposure against risk for pricing and risk that fully easily understood, risk-related appetite. captures relevant drivers of value information to external audiences and risk. in an appropriate level of detail. • Roles and responsibilities should be articulated in written policies. • The CRO and CFO should have a periodic joint dialogue with the • The CRO should have both board regarding risk and return. implied and explicit authority and visibility for risk management. • Risk and reward must be embedded throughout the • Risk management should actively company. participate in business and strategy discussions. • The firm should have an independent measurement and • The corporate risk committee monitoring of risk-adjusted should include C-Suite members returns. and business leaders. • Risk management should be • Firms should have revised incentive structures that base embedded in the front office and financial rewards on a risk- deal-approval committees. • Risk management should seek guidance from and have access to adjusted basis. • There should be periodic independent analysis of results the board in order to understand against planned business strategy their objectives and perspective. They should have guidance from the board in its oversight role. • The CRO should report to the regularly scheduled executive sessions with the board. • Risk management organizational silos, such as the specific risk disciplines, of market, credit, liquidity, and operational risk, should coordinate their measurement activities to address all the risks of businesses. 22 Deloitte Center for Banking Solutions actively monitor contingent liquidity risk measures at a exposures and be prepared to product level and institution take action. funding level. • Firms should be able to reports should be disseminated beyond the risk management and have properly constructed function to reach front office action plans. and other appropriate managers • Investment in technology infrastructure is needed in good times and bad. • Firms should have enhanced policies and procedures for new product approvals. • Firms should conduct rigorous board. portfolios to expand their view of new product approval, and a • Standard risk management appropriately stress test products analyses of products and business with the decision authority for • Senior management should incorporate contingent and with senior management and • There should be a CRO-led group CEO and board and should have • Analytical systems should • The firm should provide clear, risk to accommodate exposures not previously captured. • Firms should have the capability formal escalation process which to perform their own credit risk involves an authority, such as and other analyses to reduce the firm’s risk management their reliance on external parties committee. for key risk determinations. so there is consistency in risk exposure analysis. • Board members and senior management should have the opportunity to participate in CRO-sponsored workshops covering the financial institution’s exposures and the associated risk management approaches. Risk management in the age of structured products: Lessons learned for improving risk intelligence The Risk Intelligent Enterprise Deloitte believes all companies should strive to be “Risk Intelligent Enterprises.” This belief is predicated on the assertion that organizations that are most effective and efficient in managing risks to both existing assets and to future growth will, in the long run, outperform those that are less so. Without doubt, financial institutions are considerably more mature in their risk management views and practices than many other industries. However, we believe there is always room for improvement and recent events would appear to support that view. In our view, Risk Intelligent Enterprises adopt a balanced perspective of risk management, supported by the following fundamental principles: 1. A common definition of risk, which addresses both value preservation and value creation, is used consistently throughout the organization. 2. A common risk framework, supported by appropriate standards, is used throughout the organization to manage risks. 3. Key roles, responsibilities, and authority relating to risk management are clearly defined and delineated within the organization. 7. Business units (departments, agencies, etc.) are responsible for the performance of their business and the management of risks they take within the risk framework established by executive management. 8. Certain functions (e.g., finance, legal, IT, HR, etc.) have a pervasive impact on the business and provide support to the business units as it relates to the organization’s risk program. 9. Certain functions (e.g., internal audit, risk management, compliance, etc.) provide objective assurance as well as monitor and report on the effectiveness of an organization’s risk program to governing bodies and executive management. We believe there is always room for improvement and recent events would appear to support that view. In our view, Risk Intelligent Enterprises adopt a balanced perspective of risk management, supported by our principles. 4. A common risk management infrastructure is used to support the business units and functions in the performance of their risk responsibilities. 5. Governing bodies (e.g., boards, audit committees, etc.) have appropriate transparency and visibility into the organization’s risk management practices to discharge their responsibilities. 6. Executive management is charged with primary responsibility for designing, implementing, and maintaining an effective risk program. Deloitte Center for Banking Solutions 23 Risk management in the age of structured products: Lessons learned for improving risk intelligence Additional references and resources Given the evolving nature of this subject, resources are cited in order of publication; the most recent articles appear first. “Lessons Learned, Relearned, and Relearned Again from the Credit Crisis — Accounting and Beyond,” Robert H. Herz, chairman of the Financial Accounting Standards Board (FASB), September 18, 2008. “Putting risk in the comfort zone: Nine principles for building the Risk Intelligent Enterprise ,” Deloitte LLP, 2008. TM “A personal view of the crisis; Confessions of a risk manager,” The Economist, August 9-15, 2008. “Containing Systemic Risk: The Road to Reform, The Report of the CRMPG III,” August 6, 2008. “Final Report of the IIF Committee on Market Best Practices: Principles of Conduct and Best Practice Recommendations,” Institute of International Finance, July 17, 2008. “Regulatory Update 2008,” Deloitte & Touche LLP, July 8, 2008. “Principles for Sound Liquidity Risk Management and Supervision,” Basel Committee on Banking Supervision, June 17, 2008. “Fair value measurement and modeling: An Assessment of Challenges and Lessons Learned from the Market Stress,” Basel Committee on Banking Supervision, June 12, 2008. “Professionally Gloomy,” The Economist, May 15, 2008. “Steps to Strengthen the Resilience of the Banking System,” Basel Committee on Banking Supervision, April 16, 2008. “Leading-Practice Disclosures for Selected Exposure,” Senior Supervisors Group, April 11, 2008. “Interim Report of the IIF Committee on Market Best Practices,” Institute of International Finance, April 9, 2008. “The Risk Intelligent Board,” Steve Wagner and Maureen Errity, Deloitte Review, April 9, 2008. “Global Financial Stability Report on Containing Systemic Risks and Restoring Financial Soundness,” International Monetary Fund, April 8, 2008. “Report of the Financial Stability Forum on Enhancing Market and Institutional Resilience,” Financial Stability Forum, April 7, 2008. “Credit Risk Transfer – Developments from 2005 to 2007,” Joint Forum of the Basel Committee on Banking Supervision, April 1, 2008. “Policy Statement on Financial Market Developments,” President’s Working Group on Financial Markets, March 13, 2008. “Observations on Risk Management During the Recent Market Turbulence,” Senior Supervisors Group, March 6, 2008. “The Rising Risk of a Systemic Financial Meltdown: The Twelve Steps to Financial Disaster,” Nouriel Roubini, RGE Monitor, February 5, 2008. “Is the 2007 U.S. Subprime Financial Crisis So Different? An International Historical Comparison,” Carmen Reinhart and Kenneth S. Rogoff, February 5, 2008. “Global Risk Management,” Formulas to Success in Financial Services Series, Deloitte Touche Tohmatsu, 2008. “Risk Management: An Overview of Practices,” Edward Hida, Directors Monthly, July 2007. “A Simple Guide to Subprime Mortgages, CDO, and Securitization,” Citigroup Global Markets, April 13, 2007. “Global Risk Management Survey: Fifth Edition Accelerating Risk Management Practices,” Deloitte & Touche LLP, 2007. 24 Deloitte Center for Banking Solutions Risk management in the age of structured products: Lessons learned for improving risk intelligence Authors Edward T. Hida II, CFA Global Leader Risk & Capital Management Partner Regulatory & Capital Markets Consulting Deloitte & Touche LLP ehida@deloitte.com +1 212 436 4854 A. Scott Baret Partner Regulatory & Capital Markets Consulting Deloitte & Touche LLP sbaret@deloitte.com +1 212 436 5456 Industry Leadership Contributors Tom Rollauer Director Regulatory & Capital Markets Consulting Deloitte & Touche LLP trollauer@deloitte.com +1 212 436 4802 Ricardo Martinez Senior Manager Regulatory & Capital Markets Consulting Deloitte & Touche LLP rimartinez@deloitte.com +1 212 436 2086 Jim Reichbach Vice Chairman U.S. Financial Services Deloitte LLP jreichbach@deloitte.com +1 212 436 5730 Carol Larson Deputy Managing Partner Financial Services Industry Deloitte & Touche LLP clarson@deloitte.com +1 412 338 7210 Scott Devine Senior Manager Regulatory & Capital Markets Consulting Deloitte & Touche LLP sdevine@deloitte.com +1 212 436 7742 Deloitte Center for Banking Solutions Craig Brown Director Regulatory & Capital Markets Consulting Deloitte & Touche LLP cbrown@deloitte.com +1 212 436 3356 Don Ogilvie Independent Chairman Deloitte Center for Banking Solutions dogilvie@deloitte.com Laura Breslaw Executive Director Deloitte Center for Banking Solutions Two World Financial Center New York, NY 10281 lbreslaw@deloitte.com +1 212 436 5024 About the Center The Deloitte Center for Banking Solutions provides insight and strategies to solve complex issues that affect the competitiveness of banks operating in the United States. These issues are often not resolved in day-to-day commercial transactions. They require multidimensional solutions from a combination of business disciplines to provide actionable strategies that will dramatically alter business performance. The Center focuses on three core themes: public policy, operational excellence, and growth. To learn more about the Deloitte Center for Banking Solutions, its projects and events, please visit www.deloitte.com/us/bankingsolutions. To receive publications produced by the Center, click on “Complimentary Subscriptions.” Deloitte Center for Banking Solutions 25 Disclaimer These materials and the information contained herein are provided by Deloitte and are intended to provide general information on a particular subject or subjects and are not an exhaustive treatment of such subject(s). Accordingly, the information in these materials is not intended to constitute accounting, tax, legal, investment, consulting, or other professional advice or services. 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Please see www.deloitte. com/us/about for a detailed description of the legal structure of Deloitte LLP and its subsidiaries. Copyright © 2008 Deloitte Development LLC. All rights reserved. Item #8239 Member of Deloitte Touche Tohmatsu 6 Deriv/SERV Delivering Automated Solutions and Risk Management to OTC Derivatives The Depository Trust & Clearing Corporation DTCC Deriv/SERV Family of Services What is DTCC Deriv/SERV? Deriv/SERV’s Matching and Confirmation Service automates the legal confirmation process for OTC DTCC Deriv/SERV is the leading provider of automation derivatives. Today, more than 90% of credit deriv- solutions for the global, over-the-counter (OTC) atives traded worldwide are electronically confirmed derivatives market. We offer a family of services with Deriv/SERV. that increases the efficiency and reduces the risk of processing a wide range of credit, equity and Greater industry adoption of Deriv/SERV allows interest rate derivatives products. market participants to process all three primary asset classes – credit, equity and interest rates – with all Since launching its matching and confirmation service major derivatives dealers on a single platform. in late 2003, DTCC has aggressively expanded Deriv/SERV. Our goal is to provide a one-stop, Novation Consent allows participants to notify and centralized, automated environment for the OTC obtain electronically the agreements required when derivatives market, from matching and confirmation a party to an OTC derivative transaction wants to of a trade through to final settlement. assign, or novate, its obligation to a new firm. The service streamlines assignment processing by We’ve broadened the range of OTC derivatives consolidating consents, retrieving trade data from products supported, rolled out several new services, the Warehouse and then submitting an assignment for and expanded our community of customers globally. automated confirmation. ISDA’s Novation Protocol SM Our service offerings are described below. requires prior to transferring their obligations on an OTC derivative contract to a third party, participants MCA-Xpress is an automated application that gain the consent of their original counterparties. ® streamlines the negotiation and execution of ISDA published Master Confirmation Agreements (MCAs) The Trade Information Warehouse is the industry’s between counterparties of an OTC equity derivative first and only centralized and secure global infrastruc- transaction. The service also maintains all existing ture for processing OTC credit derivatives over their MCAs in a centralized location. MCAs are the legal multi-year life cycle. It consists of two components: documentation that market participants must complete before moving to an electronic processing platform such as Deriv/SERV. • A comprehensive trade database containing the primary record of each contract; • A central technology infrastructure that automates AffirmXpressTM is a single-screen post-trade and standardizes trade processing, such as record- affirmation platform that lets front-office and keeping, notional adjustments and contract term operations staff efficiently review and affirm OTC changes, payment calculation and netting and derivatives trades from multiple inter-dealer centralized settlement of payments through a brokers (IDBs). partnership with CLS Bank International. Initially supporting credit derivatives, the Flexible Technology Options: We offer customers Warehouse is designed to be expanded to other several ways to connect to DTCC, including a com- OTC derivatives products. puter-to-computer interface for high-volume users, real-time spreadsheet uploads via the Web, Why use Deriv/SERV? and an online Web application with workflow management tools. Largest Global Community of Users: Our customers, from 31 countries, include all major global derivatives Unparalleled Resiliency and Security: DTCC, which dealers and 1,100+ investment managers and hedge has a critical role ensuring the safety, certainty and funds, more than any other service provider in the soundness of the capital markets, has an extensive, OTC derivatives market. state-of-the-art business continuity program. This includes a fully redundant, self-healing telecom Customer- Centric: DTCC develops solutions for network, multiple data centers and operating sites, the OTC derivatives market using a consultative, and innovative data replication technology. collaborative approach, working closely with dealers, buy-side firms and industry groups that have in-depth Strategic Partners: To extend the reach of our knowledge of complex market needs. services, DTCC actively pursues strategic partnerships with OTC derivatives service providers globally. Breadth and Depth of Platform: Deriv/SERV delivers Deriv/SERV’s open architecture facilitates cost-effec- a fully-integrated, single gateway through which tive integration with a growing number of providers market participants can automate processing for a offering complementary services. wide range of OTC derivatives products. To keep pace with the market’s innovation, we regularly add What are the benefits of Deriv/SERV? new products and functionality to our service. Reduces Operational Risk by increasing the At-Cost Pricing: DTCC operates for the sole benefit transparency of contract terms confirmed through of our customers on an “at cost” basis, returning Deriv/SERV and housed in the Warehouse. excess revenue from transaction fees to customers. Enhances Operational Efficiency by eliminating labor- DTCC drives down costs through economies of scale, critical mass and a continuing focus on containing costs and process management. intensive, paper-based confirmations and complicated bilateral reconciliations between counterparties. Increases Accuracy and reduces processing errors, Trusted Service Provider: DTCC has an outstanding discrepancies and delays through automation. reputation for reliability, certainty and trust with Lowers Operational Costs through streamlined, nearly 35 years experience guarding the privacy of industry-standard, automated processing. trade data. In 2007, DTCC supported the trading and settlement of more than $1.8 quadrillion in securities transactions. Quick to Market: DTCC has been quick to respond and roll out innovative solutions to meet the OTC derivatives market’s needs for automation, operational efficiency and risk mitigation. DTCC brought Streamlines Payment Recordkeeping by using current contract data and tracking payment flows. Who can I contact? For more information, contact Deriv/SERV Relationship Management: the Deriv/SERV platform to market in nine months, E-mail: derivserv_rms@dtcc.com while the Warehouse was built in an aggressive New York: +1 212 855 2027 10-month timeframe. London: +44 (0) 20 7650 1410 DTCC’s derivatives services are offered through DTCC Deriv/SERV LLC. 3/2008 The Depository Trust & Clearing Corporation Deriv/SERV Trade Information Warehouse What is the Trade Information Warehouse? DTCC continues to add other functions to the Warehouse in response to market demand. DTCC The Trade Information Warehouse (Warehouse) is the built the Warehouse with a flexible, open architec- market’s first and only comprehensive trade database ture to enable third-party service providers to link and centralized electronic infrastructure for post- to it and offer complementary services. trade processing of OTC derivatives contracts over their multi-year lifecycles, from confirmation to Initially supporting credit derivatives, the Warehouse payment calculation and netting to final settlement. is designed to be extended to interest rates, equities and other OTC derivatives asset classes. DTCC, collaborating with global dealers and asset managers, developed the Warehouse to automate What are the benefits of the Warehouse? market participants’ manual, paper-based and often divergent methods of managing OTC derivatives Operational Risk Reduction: transactions over the life of these contracts. Helps reduce errors in corporate and regulatory reporting. The Warehouse comprises: Increases transparency by maintaining up-to-date A comprehensive trade database containing the contract information. primary record of each contract; and Promotes accuracy and comprehensiveness based An electronic platform that provides an expanding on the most current contract records, and facili- array of post-trade processing capabilities. tates tracking of payment flows between firms. In the Warehouse, post-trade processing flows automatically from the agreed trade terms that are maintained in the database. The Warehouse currently performs the following post-trade functions: • Payment calculation for one-time fees and coupons. • Multi-currency payment netting and central settlement of payments provided in partnership with CLS Bank International. • Centralized processing of credit events such as bankruptcies and defaults. • Novation Consent that automates the approval process when one party to a transaction assigns its position to another. Helps firms simplify management of credit events by eliminating ad hoc reconciliation and supporting standardized messaging. Cost Savings: Standardizes and automates trade capture and post-trade processing of payments and events over a contract’s life. Eliminates paper-intensive processing, which can result in errors and delays. Promotes efficient collateral management processing by minimizing collateral disputes due to portfolio or valuation discrepancies with counterparties. Reduces the number of cash movements through Payments are made automatically, in multiple cur- bilateral payment netting. rencies. All payment instructions generated by the Increases efficiency of portfolio management tools and processes, including bulk tear-ups. Warehouse and settled by CLS are final and irrevocable in immediately available central bank funds. 6. The Warehouse provides customers with a com- How does the Warehouse work? prehensive suite of reports that deliver snapshots of all their trades registered in the Warehouse. 1. New contracts that have been matched and Daily reports are delivered electronically overnight. confirmed, through Deriv/SERV or other confirm The Warehouse also offers a range of online work- services, flow into the Warehouse. Unconfirmed flow management and inquiry tools. trades are designated “pending.” 7. In the instance that the market determines that 2. The Warehouse assigns a unique DTCC reference a credit event has occurred, the Warehouse notifies identifier to each contract and performs automated parties of their exposure and allows them to register recordkeeping to maintain the “current state” con- for and adhere to the processing of the event through tract terms, taking into account post-trade events. the Warehouse by transaction and event type. For This number provides the starting point for reconcil- single-name CDS products, the process includes iations and processing over the life of the contract. coupon adjustments, recovery calculations and cash settlement and exits between parties. For CDS 3. The Warehouse maintains the official legal, or index products, the process performs an accrued “gold,” record of all contracts eligible for automated calculation of the event component of the index, legal confirmation. creates a new coupon for the remaining components of the index, performs the recovery calculation and 4. The Warehouse calculates payments due on provides for cash settlement. “gold” contracts. Who can I contact? 5. DTCC in partnership with CLS Bank International provides central, automated settlement of payments For more information, please contact Deriv/SERV for contracts processed in the Warehouse. The Relationship Management: Warehouse receives real-time information on the status of all payment instructions submitted to E-mail: derivserv_rms@dtcc.com CLS, nets payments by customer account, currency New York: +1 212 855 2027 and counterparty, and settles bilateral net amounts. London: +44 (0) 20 7650 1410 DTCC’s derivatives services are offered through DTCC Deriv/SERV LLC. 3/2008 DTCC Deriv/SERV Trade Information Warehouse e-Trading Trade Confirm or Affirmation Platforms Trade Data Input Trade Status Dealer Other Automated Confirm Services AffirmXpress Deriv/SERV Automated Matching & Confirmation Deriv/SERV Trade Information Warehouse Credit Event Processing Recordkeeping and Reporting Payment Calculation or Payment Matching Payment Netting External Data Sources (e.g., Notional Factors) Trade Data Input Trade Status Dealer or Buy-side Firm Backloading (Contracts executed prior to Warehouse launch) (Depending on record type) Central Settlement CLS Bank International Settlement Members DTCC’s derivatives services are offered through DTCC Deriv/SERV LLC. 3/2008 Warehouse The Depository Trust & Clearing Corporation OTC Derivatives Matching and Confirmation What is Deriv/SERV Matching and Confirmation? Lowers the Operational Costs arising from laborintensive manual processing and allows staff to focus on value-added responsibilities. DTCC Deriv/SERV automates matching and confirmation for a wide range of over-the-counter (OTC) How does Deriv/SERV work? derivatives products, including credit, equity and interest rate contracts. It is the only post-trade Customers can connect to Deriv/SERV either through processing platform used by virtually all major direct, computer-to-computer, real-time messaging, a global dealers to electronically match and confirm spreadsheet upload capability via the Internet, or a transactions in all three primary asset classes. Web-browser interface. Internet connections are secured via a digital certificate issued by DTCC Specific instruments covered include single-reference- Deriv/SERV and a high-security encryption connection. entity credit default swaps (CDS), CDS indices, CDS index tranches, equity options, equity swaps, Users can also access Deriv/SERV through links variance swaps, and dividend swaps, interest rate with a variety of complementary service providers swaps, inflation swaps and swaptions. Deriv/SERV that have links with the service. regularly expands matching and confirmation coverage to additional instruments. Matching and Confirmation: Matching is used by most dealers and some buy-side firms. Parties submit Deriv/SERV supports a wide range of trade events transaction details to Deriv/SERV. Once Deriv/SERV including new trades, full or partial terminations, has received details from both sides to a trade, it assignments, increases, amendments and exits. automatically compares the stated terms of the transaction and provides each party with its status What are the benefits of automated Matching and Confirmation? over a browser-based Internet screen. If the transaction fully matches, Deriv/SERV reports it as a confirmed match. If there are fields that do not Reduces Operational Risks associated with uncon- match, the system automatically reports them, firmed trades and related documentation, by quickly allowing customers to view discrepancies in real time identifying and resolving trading discrepancies. and submit new or enhanced data. Enhances Efficiency by centralizing, streamlining and Affirmation: Affirmation is used by buy-side firms, automating the processing of trade confirmations. primarily those with low volumes. Parties view trades “alleged” against them online and either Increases Accuracy through electronic matching, accept the trade details or suggest modifications. which reduces errors that can result from paper- When modifications are suggested, Deriv/SERV based and manual data exchange. automatically creates a new trade record, which Connectivity Options Dealers Dealers or Buy-side Firm s • Exception Processing • Exception Processing • Online Affirmation • Spreadsheet Upload Computer-toComputer Link Computer-toComputer Link both parties can compare against their original Who can I contact? records and continue to suggest modifications until the trade reaches “confirmed” status. For more information, please contact Deriv/SERV Relationship Management: Deriv/SERV uses Financial products Markup Language (FpMLTM) as its standard language. FpML E-mail: derivserv_rms@dtcc.com is a trademark of the International Swaps and New York: +1 212 855 2027 Derivatives Association. London: +44 (0) 20 7650 1410 Confirmation DTCC’s derivatives services are offered through DTCC Deriv/SERV LLC. 3/2008 The Depository Trust & Clearing Corporation DTCC Deriv/SERV Product Menu DTCC Deriv/SERV’s comprehensive automated matching and confirmation service allows market participants to process transactions in the three primary OTC derivatives asset classes – credit, equity and interest rates – with all major derivatives dealers on a single platform. Deriv/SERV accommodates a full selection of OTC derivative trade events including new trades, full or partial terminations, assignments, increases, amendments and exits. Equity Credit Single-Name Credit Default Swaps (CDS) Index and Share r Corporate r Sovereign r Options • North America • Australia • Americas • Europe • New Zealand • Europe • Japan • Emerging Europe LPN • Singapore • Australia • Asia (other) • New Zealand • Latin America • Japan • Japan • Europe • Emerging Europe • Singapore • Asia (other) • Latin America • Emerging Europe and Middle East • Western Europe (non-G10) • Asia Ex-Japan (AEJ) r Swaps • Americas • Japan • AEJ r Variance Swaps r CDS on Loans • Americas r CDS on Residential Mortgage-Backed Securities • Europe r CDS on Commercial Mortgage-Backed Securities • Japan Index • AEJ r CDX r iTraxx r Dividend Swaps • High-Grade • High-Grade • Europe • High-Yield • High-Yield • Emerging Market • Emerging Market r ABX (Asset Backed) r CMBX r LCDX (Loans) (Commercial Mortgage) Index Tranches r CDX r iTraxx r ABX r LCDX Interest Rates Coming Soon Single-Currency Fixed-Float Swaps Credit • Stub period at the start and/or the end • Options on CDS Single Name • Fixed-leg rolls can differ from floating-leg rolls • Options on Index • Adjusted or unadjusted calculation periods • LevX Index • Adjusted or unadjusted termination date • Bespoke Tranches • Allows for different fixing convention for 1st period • Supports ISDA Settlement Matrix, including override feature Equity • Dispersion Swaps and Options • Compounding • Portfolio Swaps • Averaging • Basket Swaps and Options • OIS • Corporate Actions • Regular cash flow schedules • Independent amounts can be specified Interest Rates • Advanced or delayed payments • Forward Rate Agreement • Fixed and/or float leg able to reference a bond • Caps • Fixable upfront or in arrears • Digital Caps • Floors Swap Options (Swaptions) on an underlying • Digital Floors Fixed-Float IRS • European style • Cash or physical settlement • Straddle as 1 deal or 2 Early Termination provisions • European, American or Bermuda style Single Additional Bullet Payment • Non-Deliverable Swaps Amortizing/Accreting Swaps Fixed Rate Schedules Cancellable/Callable Swaps DTCC’s derivatives services are offered through DTCC Deriv/SERV LLC. 3/2008 The Depository Trust & Clearing Corporation MCA-Xpress What is MCA-Xpress? What are the benefits of MCA-Xpress? MCA-Xpress is a service for OTC equity derivatives. Enhances efficiency by simplifying the process for MCA-Xpress allows parties to an OTC equity completing MCAs through online global negotiation of derivative transaction to negotiate and execute agreements and by maintaining documentation among ISDA®-published master confirmation agreements counterparties in a centralized, secure location. (MCAs) online and to maintain these and manually executed MCAs in a centralized location. Lowers costs involved in the labor-intensive, timeconsuming legal review and negotiation of voluminous MCAs are a key component of the legal documentation paper-driven documents related to multiple products, that creates legally binding trades between two regions and trading parties. parties of an OTC derivative transaction and are required prior to moving to an electronic confirmation Reduces operational risk by expediting the steps platform such as Deriv/SERV. involved in the MCA process, enabling quicker confirmation execution. Equity derivatives embody multiple combinations of product types and geographic regions, and their Increases controls by providing a single, secure complexity and lack of standardization have made location to view all executed MCAs. them challenging to automate. The resulting backlogs and associated risks are similar to those How does the service work? that characterized the OTC credit derivatives market several years ago. MCA-Xpress consolidates over 20 MCAs, including the ISDA® Equity MCA Protocol, into a user-friendly MCA-Xpress streamlines the negotiation and execu- matrix and provides parties with their own private, tion process by automating what has traditionally secure locations for managing their MCAs. been a manual and labor-intensive practice, fostering Counterparties select the dealer(s) with whom they market participants’ ability to move to an automated wish to commence negotiations, and then choose environment for processing OTC equity derivatives specific MCAs to negotiate. trades. Parties can also upload and reference MCAs executed outside MCA-Xpress, thereby Users of the service can also upload and/or provide providing a single global location to view all MCAs. information related to MCAs executed outside the service, helping create a complete recordkeeping matching and confirmation platform. Proprietary and audit trail. MCA-Xpress provides one location MCAs held by a firm can be added to MCA-Xpress for entering these legal agreements and gives by starting with an ISDA or industry-published individual firms the ability to see all documents template, adding other terms and then saving they have executed with their counterparties. the template for negotiation and execution with future counterparties. DTCC Deriv/SERV’s Operating Procedures include provisions for parties to agree that an MCA executed MCA-Xpress supports all ISDA-published MCAs, through the service shall constitute a legally including the Equity MCA Protocol (Q2’08), which acceptable method of qualifying their transactions. is designed to agree to default MCA terms and negotiate fewer terms. The service will continue to Once an MCA is complete between two counter- add MCAs as soon as published. parties, these firms can submit their OTC equity derivative transaction for electronic matching and Who can I contact? confirmation on services such as Deriv/SERV. For more information, contact Deriv/SERV MCA-Xpress is designed with an open architecture Relationship Management: that allows access to third-party service providers. If a party executes an MCA on MCA-Xpress, the firm E-mail: derivserv_rms@dtcc.com can also apply those execution dates to transactions New York: +1 212 855 2027 completed on paper or through another electronic London: +44 (0)20 7650 1410 DTCC’s derivatives services are offered through DTCC Deriv/SERV LLC. 3/2008 The Depository Trust & Clearing Corporation Novation Consent What is Novation Consent? Facilitates open access by providing interoperability with other platforms, including third-party service The Novation Consent service automates the request, providers for buy-side firms. approval and notification procedures among the three parties involved in an OTC credit derivative contract Enhances efficiency through a simple, one-touch assignment, as stipulated by the International Swaps assignment process. and Derivatives Association (ISDA®) in its Novation Protocol SM. Traditionally, these procedures have been Lowers the operational costs arising from labor- carried out via three-way email communications, intensive manual processing and allows staff to a manual, error-prone process not suitable for a focus on value-added responsibilities. high-volume market. How does the service work? Novation Consent allows participants to electronically request and obtain the approvals required by the Deriv/SERV’s Novation Consent service automates ISDA protocol when one party to a transaction the contract assignment procedures stipulated seeks to assign, or novate, its obligation to a new under ISDA’s Novation Protocol. firm. The service streamlines assignment processing by allowing firms to consolidate consents, retrieve When a party to an OTC derivative transaction wishes trade data from the Trade Information Warehouse, to exit that contract by assigning its position to then potentially submit an assignment to Deriv/SERV’s a third party, the exiting party (Transferor), in Matching and Confirmation service. accordance with the Novation Protocol, must notify the remaining counterparty (RP) and the entering Specific instruments that are covered by the party (Transferee) and seek permission for the Novation Consent service include all credit products assignment from the RP. currently supported by Deriv/SERV and the Trade Information Warehouse: single-reference-entity With Novation Consent, all three parties communicate credit default swaps (CDS)--including corporates, electronically on a common platform using point and sovereigns, loans, asset-backed and mortgage- click technology or FpMLTM-compliant messaging. backed instruments--indices and tranches. The Transferor initiates the process by creating a pending novation. If the contract to be novated What are the benefits of Novation Consent? resides in the Trade Information Warehouse, the Warehouse can automatically search its database and identify a list of possible trades, and the Reduces operational risks associated with uncon- Transferor selects the contract from the list. firmed assignments and resulting backlogs, by Alternatively, the Transferor can specify the trade enabling automated, three-way communication on reference identifier for the contract it is seeking to a single platform. novate. Once the appropriate contract is identified, the Transferor specifies novation details, such as Customers can access the Novation Consent service the names of the Remaining Party and Transferee, through a variety of interfaces. Connection via the novated contract amount, effective date, payment direct computer-to-computer real-time messaging amount and payment date. will be available to high-volume users. Lower-volume users can connect through a Web-browser interface. The Novation Consent platform then transmits the Internet connections are secured via a digital details electronically to the RP, which can accept certificate issued by DTCC Deriv/SERV and a high- or refuse the novation, and to the Transferee. security encryption connection. The pending novation then moves to Approved or Refused status. If the novation is approved, the Deriv/SERV uses Financial products Markup Transferor may request that the system auto- Language (FpMLTM) as its standard language. FpML generate an assignment record to be submitted is a trademark of the International Swaps and to the Trade Information Warehouse. Derivatives Association. Separately, the RP and the Transferee submit their Who can I contact? sides of the transaction to the Trade Information Warehouse. All three sides are then matched and For more information, contact Deriv/SERV confirmed by Deriv/SERV. Relationship Management: Novation Consent can also be used for contracts E-mail: derivserv_rms@dtcc.com that do not reside in the Warehouse. In those New York: +1 212 855 2027 cases, the system does not auto-generate London: +44 (0)20 7650 1410 assignment records for the Warehouse. DTCC’s derivatives services are offered through DTCC Deriv/SERV LLC. 3/2008

Counterparty Risk Seminar

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