ISDA’s Collateral Steering Committee proposed a Collateral Dispute Resolution Protocol last June with the aim of establishing a set of standard procedures for dealing with disputes over OTC derivative collateral calls. In a Q&A, Eddie Ridgway, MD at HSBC Global Banking & Markets and co-chair of the ISDA Collateral Infrastructure Working Group, explains how the enhancements in the protocol create a more structured, yet flexible dispute resolution process post financial crisis.
Why was the dispute collateral protocol developed by the ISDA Collateral Steering Group in 2009?
There are multiple reasons for the development of the dispute resolution protocol last year. The first reason is that there needed to be some enhancements to the existing language of the International Swaps & Derivatives Association’s (ISDA) Credit Support Annex (CSA) to be able to include more formality around the means of resolving collateral call disputes. Market practitioners identified specific areas that needed improvement and the ISDA Collateral Steering Committee, prompted by the ISDA Board, developed a set of enhancements to the existing procedures to create the structure required to reach resolution of collateral disputes in a more timely and efficient manner.
The periods of high volatility experienced during the credit crisis also further emphasized the need for new dispute resolution procedures. During the credit crisis, financial institutions had conflicting views on the value of a significant number of large, illiquid transactions. And often these disputes would cause larger collateral disputes across an entire portfolio, which threatened to grind the entire collateral process to a halt because a firm could dispute an entire collateral call even if there was disagreement over a single transaction. The proposed dispute resolution protocol provides the structure and documentation to allow for the exchange of collateral between parties on the agreed transactions despite disagreement over single transactions.
The need for more structure in resolving collateral disputes was clear after the amount of strain placed on Collateral Mgt. departments in the past couple of years. Market volatility was dramatically increasing the volume of collateral activity that had to be processed and the collateral departments also had to manage other tasks, such as internal reporting and external regulatory reporting as well. The industry recognized that a more structured dispute resolution procedure with more options available, would help the collateral teams better distribute the responsibility to other areas of the organization and thus lessen the burden on that specific team.
Also, the defaults of some financial institutions during the crisis revealed the potential opportunity for some firms to use the existing dispute resolution procedures almost to their advantage by disputing margin calls to extend the amount of time before the collateral called was actually exchanged. The new dispute resolution procedures clearly define that undisputed amounts of collateral should be exchanged between the parties despite any disputes over single transactions, which is a great new addition to the procedures. The industry also recognized that the time frame for dispute resolution needed to be shortened and resolution reached by a definitive point in time. This change is probably the most significant outcome of the credit crisis to influence new procedures for resolving disputed collateral calls.
How is the new protocol different from the current dispute resolution process? What are some of the specific changes?
The old process attempted to be very prescriptive but was actually very vague in many respects. So, by contrast, the new protocol offers a more controlled approach with more options firms can rely on to resolve disputes bilaterally.
The new protocol includes a well-defined, informal dispute resolution process that outlines a number of different methods that those firms can bilaterally agree to try to use to reach a resolution. For instance, parties have the option to make temporary adjustments to the way transactions are marked so an agreed common reference point can be used instead for resolving a dispute. The informal process even allows for a firm’s use of undefined dispute resolution procedures or the option to mutually agree to exit the position if the dispute cannot be resolved.
In addition to the informal process, the way the protocol is currently proposed allows for any party to unilaterally invoke the formal dispute resolution process. This change clearly comes out of lessons learned from the credit crisis in that if a financial institution has a great deal of concern about a particular counterparty and therefore wants to resolve a dispute as quickly as possible, the firm can invoke the formal dispute resolution process. This formal process is much more rigid in that it defines ways in which a dispute is resolved, and more importantly, it obligates firms to participate in the standard course of action. For example, the formal process clearly defines the required procedures for quote gathering to be adopted by both parties for the purposes of the resolution of a collateral dispute.
In short, the new protocol is practical, it provides informal guidelines but also includes a set structure that includes well-defined criteria, whilst also obligating firms to follow that much more formalized set of procedures.
How are firms preparing for the use of the new dispute resolution procedures?
Dispute resolution is complex. It requires changes to many business components including portfolio reconciliation, legal rights and documentation.
All of the G14 and several of the large buy-side institutions have already put a tremendous amount of effort and investment into the portfolio reconciliation operation. Specifically, the signatories of the Fed letters have made commitments to the regulators to achieve certain milestones within portfolio reconciliation, including doing daily reconciliation and to reach resolution on unmatched transactions by a certain date.
HSBC is one such Fed Letter signatory, and we put together a sizeable team in an offshore location to be able to perform nothing else but portfolio reconciliation on a daily basis. Our firm has also engaged with a vendor to be able to obtain the infrastructure to support this portfolio reconciliation operation and future growth in the area. This has been a fairly significant investment and most of the other large institutions have done the same. The portfolio reconciliation needs to have robust infrastructure and dedicated resources to both complete the process efficiently and in compliance with the new market standards.
Implementation of new dispute resolution procedures also requires the involvement of other departments within an organization, such as product control, trading desks and the finance department, which have certain responsibilities to provide quotes to the collateral management team, for instance. So, firms have to line up all of those other groups outside of the collateral management team to educate them about the proposal and work out how procedures internally will be adjusted to satisfy the requirements associated with the new practices and procedures.
There is a fair amount of work on the legal side required to analyze the proposed dispute resolution protocol and its’ language, to review how the new terms might change the rights under the new documentation and finally, how existing procedures might need adjusting to satisfy new protocol requirements. Most firms are engaged with internal legal departments or external legal counsel to review the language of the new protocol and its effects on the firm.
In addition to the legal and structural changes, financial institutions are participating in the drafting of the protocol itself and working in various industry groups to put this together. Participation in the pilot also calls for a set of dedicated resources that can provide feedback to working groups.
Will use of the new dispute resolution protocol affect how the collateral management team works with other areas of the organization?
While most firms have a procedure in place around the way the collateral management department interacts with other areas of the organization such as trading desks or the finance department, the management of these internal relationships has sometimes been challenging in recent history.
Some participants in our working group have expressed the need to add a more formalized structure to this internal correspondence to actually obligate other areas of a firm to deliver items, such as a reference quote on a transaction or independent valuation, within a specified period of time. This gives the collateral management department the ability to work in a more structured manner with other parts of the organization where in the past, interaction and exchanges were informal and more ad hoc, but now the protocol will include clear obligations and time frames which all departments will be aware of.
What is the next step for adoption of the dispute resolution protocol?
The second trial period for the protocol was due to end June 15th, however there have been some issues raised around the formal dispute resolution process which requires further review and amendment to the language of the protocol as it is currently proposed. Once the review is complete and the newly amended language is officially agreed upon, another pilot based on the new amendments will take place. This entire course of action will take us to the end of 2010, at which point a decision will be made whether or not to move forward or revisit issues as necessary.
It is important to recognize that this a complicated initiative and one with many moving parts. There is the portfolio reconciliation component, both the informal and formal dispute resolution processes, and the amendment of legal documentation.
Given the complexity, it is important the enhancements are reviewed through the pilots so any possible issues are dealt with appropriately and so we have a clear understanding if what is suggested in the protocol is both feasible and practical for implementation. For this reason, I don’t believe there is a definitive date for implementation until we get through the outstanding issues that we are dealing with now.
Although the initiative is clearly driven by the ISDA working group and its many participants, in order for the protocol to be successful it has to be widely adopted by industry participants. The new dispute resolution protocol does not necessarily have to be mandated by regulators to be formally adopted, but it has to be agreed between market participants to be the procedures used to resolve collateral call disputes. The ISDA Collateral Steering Committee is actively discussing how the protocol will be taken forward so stay tuned.
Readers of this article may also wish to visit www.isda.org where the documents outlined in this article are publicly available. |
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