April 24, 2009 / 3:21 AM / 10 years ago

Trade mismatches raise derivative collateral disputes

BEIJING, April 24 (Reuters) - Disputes over the value, and sometimes the very existence, of some derivatives trades is adding to risks in the $450 trillion market and creating confusion over how much collateral needs to be paid to back the contracts, according to market participants.

Banks and asset managers post collateral against credit, interest-rate and other derivative contracts, with payments increasing or decreasing based on changes in the value of the underlying assets and in the credit ratings of trading counterparties.

In many cases, however, the amount of collateral needing to be paid is being contested due to disagreements over the market value of the assets the derivatives are based on, terms of the derivative contracts, and on occasion, whether or not the trades even exist.

There are too many disputes today that are too large and too long lived, said Michael Clarke, global head of collateral management and client valuations at UBS.

Clarke did not give specific examples, though noted in some instances rumours have circulated that amount of disputed collateral on certain days has been “significantly north of $1 billion”.

He was speaking at the annual general meeting of the derivatives trade association, the International Swaps and Derivatives Association (ISDA), in Beijing.

The use of collateral has increased as derivatives users seek more payments to back obligations. The payments reduce potential losses from the failure of a counterparty or from non payment of a contract.

A survey conducted by ISDA of banks, dealers and investors found that total collateral backing derivatives contracts jumped to around $4 trillion in 2008, from $2.1 trillion in 2007, as deteriorating asset quality and ratings downgrades of trading counterparties promoted higher payments.

Dealers now have to devote a higher percentage of their funds to collateral payments, said David Maloy, global head of collateral management at Credit Suisse, who was also speaking at the conference.

Collateral now represents around 15 to 20 percent of the daily liquidity of dealers, compared with former levels of between 4 to 7 percent, he said.

ISDA is developing standards that will be used to facilitate dispute resolution, with the hope it will reduce the number of outstanding disagreements.

“This is a really, really big issue,” Shaun Sheppard, executive director at Goldman Sachs, said at the conference.

Stress seen in August 2008 makes it “very clear that the existing mechanism is inadequate,” he said.

Greater use of so-called portfolio reconciliation services, which verifies terms of trades across counterparties to ensure there are no differences in the way contract terms have been recorded, is also key to reducing risks, market participants said.

Banks have been significantly more comfortable with counterparties when the exposures have been put through portfolio reconciliation, said UBS’ Clarke.

Reconciling trades to flag any mismatches in the way contracts were recorded may become a daily activity, Clarke said. (Beijing newsroom +8610 66271277; Editing by Jan Dahinten)

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