at ICAP: RESET & ReMATCH

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Basis Risk Mitigation services

at ICAP: RESET & ReMATCH

Guy Rowcliffe

CEO RESET and BRM Group

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July 2012

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Definition of basis risk

• Basis Risk is defined by the Derivative Consulting Group Glossary as:

“The risk of loss arising from the difference between the economic or legal g g terms of two derivative transactions that are intended to hedge each other”

• Investorpedia.com explains this further:

“What Does Basis Risk Mean?

The risk that offsetting investments in a hedging strategy will not experience price changes in entirely opposite directions from each other This imperfect price changes in entirely opposite directions from each other. This imperfect correlation between the two investments creates the potential for excess gains or losses in a hedging strategy, thus adding risk to the position”

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Risk mitigation services at ICAP

• ICAP own and operate two industry leading basis risk mitigation

services: RESET and ReMATCH

• RESET reduces the basis risk from fixings on financial instruments such

as term rate fixing risk, FX non-deliverable forwards (NDF) fixing risk

and inflation fixing risk It also addresses structural imbalances within

and inflation fixing risk. It also addresses structural imbalances within

trading portfolios such as floating/floating basis

• ReMATCH rebalances the illiquid basis and market risks inherent in

many Credit Default Swap (CDS) portfolios

• Both technologies remove significant quantities of these second order

risks from the market and operate in ways distinctly different to voice

and electronic market places

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Understanding a leading risk

mitigation platform

To set the scene, it is best to take a look at perhaps the largest basis

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risk mitigation platform in the market today and answer the following

questions:

• What do RESET do?

• How do they do it?

• Why is it of value to their customers?

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Some key facts about RESET

• RESET transacts significant risk mitigating trade volumes and its use is

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widespread across the trader community:

$

– Total notional volumes traded since inception: $900+ trillion

375 client banks and 3 000+ individual users – 375 client banks and 3,000+ individual users

– 700 000 transactions last year or more than 2 500 per day – 700,000 transactions last year or more than 2,500 per day

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RESET risk mitigation

• RESET provide a service which focuses on risk mitigation in the interest

rate derivative market

• RESET enables banks and their traders to execute Forward Rate

Agreements (FRA’s) Single Period Swaps (SPS’s) and Non

Agreements (FRA s), Single Period Swaps (SPS s), and Non

Deliverable Forwards (NDF’s) to offset, remove or reduce the

outstanding reset (or fixing) risk from their trading portfolios

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Reset or fixing risk explained

• What is “reset” or “fixing” risk and where does it come from

• It is a 2

nd

_{order risk within interest rate derivative portfolios resulting}

from the structure of the instruments traded and a mismatch of

exposures over time

• It is an unwanted by-product of the core trading activity

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IRS floating rate cashflows

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IRS floating rate fixing

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IRS floating rate fixing

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How RESET operates

RESET Traders fill in Once filled Sophisticated RESET sends

sends a Portfolio spreadsheet on day of run their matching options, credit limits for counterparties in, it is emailed back to RESET trade results back to the trader and fi ti proprietary algorithm and multi year risk management expertise to all customers and position interests before a specified cut-off point confirmations go to back office 11

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How RESET operates in detail

• We provide a preset mid market curve (there is no bid/offer spread) with FRA prices for every day’s value out to approximately 1 year in the future

every day s value out to approximately 1 year in the future

• These are the prices at which all participants will trade if liquidity and individual matching criteria allow

• The curve is a snapshot of the market determined from a poll of market participants

• All potential participants receive the prices before executing any trades

• The service allows only market neutral transactions. Every buy must be offset by an equal and opposite amount of notional sell (just for different future value dates)

• Every trader can individually select from a number of standard matching criteria and restrictions that determine which combinations of offsetting trades can be done, from the full set of positions submitted to the service. Each selected criteria or restriction is

incorporated into the algorithmic solutionco po a ed o e a go c so u o

• The service is only run periodically (not daily or live). For example, in liquid currencies such as USD, it is run weekly every Monday

• Traders submit portfolios during the late afternoon and execution only occurs overnight, once all the data has been collected and the matching algorithm run on the full data set

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Why RESET is valuable to our

clients

• 1 basis point on $1m for 3 months is worth approx $25

• In a $400m deal that is a risk of $10,000 per basis point move in Euribor/Libor, every 3 months, for the few days between offsetting fixings

• Portfolio owners will have fixings of this type nearly EVERY SINGLE DAY

• Average daily Euribor/Libor volatility reached as high as 8-10 basis points during the credit crisis

• Removing offsetting positions removes exposure to this risk and is demonstrated graphically on the next slides

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Typical IRS portfolio fixing

exposures (client X)

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Same client X portfolio after a

RESET run

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Now moving to ReMATCH

ReMATCH was established by ICAP in 2009 to perform basis risk

mitigation for credit derivatives

• Credit derivatives market size in gross notional outstanding: $25 trillion (DTCC)

• Credit derivatives market size in net notional outstanding: $2.5 trillion (DTCC)

• However, there is a significant risk management challenge:

– Net Open Position (NOP) is a multiple of net notional outstanding

• NOP adds all net notionals per maturity date across the curveNOP adds all net notionals per maturity date across the curve

• Net notional risks change quarterly for individual market makers

• Managing micro curve risks is extremely difficult

• Exiting of odd-dates is often cost prohibitive

– Little liquidity

C h d t d fi

– Curves are hard to define

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ReMATCH

• ReMATCH offers a solution

ReMATCH offers a solution

• ReMATCH’s proprietary technology allows clients:

– Access to “pooled” liquidity on many maturity dates; allowing the opportunity to exit these ‘forward risks’

– Mid-market execution which removes prohibitive crossing of bid-offerMid market execution which removes prohibitive crossing of bid offer

– The ability to rebalance their portfolios utilising a range of powerful controls

– A discreet moment for the industry to access across-the-curve liquidity

• ReMATCH success in this area:

Over $600 billion in NOP reduced

– Over $600 billion in NOP reduced

– Deep penetration into the topical Western Sovereign and Emerging Market Sectors

– New solutions; Working with industry experts to development of a solution to mitigate additional second order risks; such as Quanto 17

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Portfolio risk mitigation methodology (generic)

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)

Client 1

Client 1 Client 2Client 2 Client 3Client 3 Client 4Client 4 Client 5Client 5 CLIENTS: CLIENTS: Risk Risk 3 KEY CLIENT 3 KEY CLIENT Curve Opinions

Curve Opinions Risk PortfoliosRisk Portfolios

Risk Constraints P&L Tolerance Risk Constraints P&L Tolerance 3 KEY CLIENT INPUTS: 3 KEY CLIENT INPUTS: Matching Algorithms Matching Algorithms Curve Normalization &

Smoothing

Curve Normalization & Smoothing PLATFORM ACTIONS: PLATFORM ACTIONS: Platform output: Bulk Trades Platform output: Bulk Trades

Trade Execution and Processing Trade Execution and Processing ALL AGREED:

ALL AGREED: Trade Execution and ProcessingTrade Execution and Processing ALL AGREED:

ALL AGREED:

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Characteristics of RESET and ReMATCH

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compared to ICAP’s voice and E-Platforms

Voice or Reset ReMatch

Platform type

E-Platform

Price determination Bid-offer Platform sets a mid market

price

Platform sets a mid market price

Feature

price price

Market type Continuous Regular scheduled (weekly

or less frequent)

Irregularly scheduled

Risk positioning Individual risk assuming Bulk risk mitigating Bulk risk mitigating

Risk inputp Individual trade interest Portfolio level risk interests Portfolio level risk interests

inc bid or offer

Execution model Trader driven execution Platform determined

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Platform determined ti

execution execution

Results Individual transaction Bulk runs of transactions Bulk runs of transactions

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Revenue models

• Generally they follow the same charging methodologies as the voice

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businesses and established norms for the products traded. So vary

from fractional percentages on notional amounts and linked to the tenor

of trades to fixed amounts per million traded

• Across both businesses and all products it is a varied value proposition.

Charges should be viewed in relation to the underlying volatility of the

risk they reduce and the liquidity of the relevant market

• The scale of charges goes from a significant discount to voice execution

where volumes are high, liquidity good, and underlying volatility low….to

a premium in the more illiquid, highly volatile markets where the risk

mitigating value is particularly high

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Performance and opportunity

• These basis risk mitigation technologies remove significant risk from the

financial system. An increasingly valuable capability in today’s regulatory and financial system. An increasingly valuable capability in today s regulatory and risk focussed environment

• RESET and ReMATCH showed a 13% increase in revenues last year despiteRESET and ReMATCH showed a 13% increase in revenues last year despite an economic backdrop of persistent, low and stable interest rates. This is a

fundamentally unattractive environment when you consider that LIBOR volatility should be the main demand driver for significant areas of the core businessg

• In the case of RESET expansion of services into additional markets and asset classes such as inflation, floating/floating basis and government bonds have , g g g been major steps towards leveraging both the core business model and the strength of the ICAP franchise. Additional opportunities and projects are in development

• In the case of ReMATCH direct potential within its original core area remains untapped whilst additional types of basis risk within the CDS space present significant opportunity. A “Quanto” service was launched last year to significant success and more recently an Indices product has been rolled out