List of Spreadsheets xix List of Appendices xxi Acknowledgements xxiii About the Author xxv Section 1 Basics 1 Introduction 3 2 Derivatives 5 2.1 Introduction 5 2.2 The Derivatives Market 6 2.2.1 Exchange-traded and OTC Derivatives 6 2.2.2 Clearing 8 2.2.

3 Market Overview 9 2.2.4 Market Participants and Collateralisation 11 2.2.5 Banks and End Users 14 2.2.6 ISDA Documentation 16 2.2.

7 Credit Derivatives 17 2.2.8 Financial Weapons of Mass Destruction 18 2.2.9 The Lehman Brothers Bankruptcy 19 2.3 Derivative Risks 20 2.3.1 Market Risk 21 2.

3.2 Credit Risk 21 2.3.3 Operational and Legal Risk 22 2.3.4 Liquidity Risk 22 2.3.5 Integration of Risk Types 23 2.

3.6 Counterparty Risk 23 2.4 Systemic Risk of Derivatives 24 2.4.1 Overview 24 2.4.2 Special Purpose Vehicles 24 2.4.

3 Derivatives Product Companies 25 2.4.4 Monolines and CDPCs 26 2.5 The Global Financial Crisis and Central Clearing of OTC Derivatives 28 2.5.1 OTC Derivatives and the Crisis 28 2.5.2 OTC Derivatives Clearing 29 2.

5.3 CCPs in the Global Financial Crisis 31 2.5.4 The Clearing Mandate 32 2.5.5 Bilateral Margin Requirements 33 2.5.6 CCPs in Context 34 2.

6 Derivatives Risk Modelling 36 2.6.1 Value-at-risk 36 2.6.2 Models 38 2.6.3 Correlation and Dependency 39 3 Counterparty Risk and Beyond 41 3.1 Counterparty Risk 41 3.

1.1 Counterparty Risk Versus Lending Risk 41 3.1.2 Settlement, Pre-settlement, and Margin Period of Risk 42 3.1.3 Mitigating Counterparty Risk 45 3.1.4 Product Type 46 3.

1.5 Credit Limits 48 3.1.6 Credit Value Adjustment 50 3.1.7 What Does CVA Represent? 51 3.1.8 Hedging Counterparty Risk and the CVA Desk 52 3.

2 Beyond Counterparty Risk 54 3.2.1 Overview 54 3.2.2 Economic Costs of a Derivative 54 3.2.3 xVA Terms 55 3.3 Components of xVA 57 3.

3.1 Overview 57 3.3.2 Valuation and Mark-to-market 57 3.3.3 Replacement Cost and Credit Exposure 58 3.3.4 Default Probability, Credit Migration, and Credit Spreads 59 3.

3.5 Recovery and Loss Given Default 60 3.3.6 Funding, Collateral, and Capital Costs 61 4 Regulation 63 4.1 Regulation and the Global Financial Crisis 63 4.2 Capital Requirements 64 4.2.1 Overview 64 4.

2.2 Capital Ratios 65 4.2.3 Risk Type 67 4.2.4 Market Risk Capital 68 4.2.5 CVA Capital 69 4.

2.6 CCR Capital 70 4.2.7 Leverage Ratio 70 4.2.8 Capital Floors 71 4.2.9 Large Exposure Framework 72 4.

2.10 Bank Stress Tests 73 4.2.11 Prudent Valuation 73 4.3 Liquidity 73 4.3.1 Overview 73 4.3.

2 High-quality Liquid Assets 74 4.3.3 Liquidity Coverage Ratio 75 4.3.4 Net Stable Funding Ratio 76 4.4 Clearing and Margining 77 4.4.1 Central Clearing 77 4.

4.2 Bilateral Margin Requirements 81 4.4.3 Exemptions 82 4.4.4 CCP Capital Requirements 84 5 What is xVA? 85 5.1 Overview 85 5.2 Analysis of xVA 86 5.

2.1 Definition 86 5.2.2 Components 86 5.2.3 Why Valuation Adjustments? 87 5.2.4 Mark-to-market and xVA as a Cost (and Benefit) 88 5.

2.5 xVAs by Transaction Type 90 5.2.6 Overlaps and Portfolio Effects 91 5.2.7 CVA is the Least Real Valuation Adjustment 92 5.3 Valuation 93 5.3.

1 Price and Value 93 5.3.2 xVA Markets 94 5.3.3 Accounting Standards 95 5.3.4 Accounting Trends 98 5.3.

5 Totem 99 5.3.6 Contractual Terms and Value 100 5.4 Pricing 100 5.4.1 Reality or Creating the Right Incentive? 100 5.4.2 Approach for Capital 101 5.

4.3 Approach to Regulatory Ratios 102 5.4.4 Lack of Arbitrage 104 5.4.5 Entry and Exit Pricing 105 5.4.6 xVA Quantification 106 5.

4.7 Special Cases 106 Section 2 Risk Mitigation 6 Netting, Close-Out, and Related Aspects 111 6.1 Overview 111 6.2 Cash Flow Netting 112 6.2.1 Payment Netting 112 6.2.2 Currency Netting and CLS 113 6.

2.3 Clearing Rings 114 6.2.4 Portfolio Compression 115 6.2.5 Compression Algorithm 118 6.2.6 Benefits of Cashflow Netting 120 6.

3 Value Netting 121 6.3.1 Overview 121 6.3.2 Close-out Netting 121 6.3.3 Payment Under Close-out 122 6.3.

4 Close-out and xVA 124 6.3.5 ISDA Definitions 125 6.3.6 Set-off 129 6.4 The Impact of Netting 130 6.4.1 Risk Reduction 130 6.

4.2 The Impact of Netting 131 6.4.3 Multilateral Netting and Bifurcation 132 6.4.4 Netting Impact on Other Creditors 135 7 Margin (Collateral) and Settlement 137 7.1 Termination and Reset Features 137 7.1.

1 Break Clauses 137 7.1.2 Resettable Transactions 140 7.2 Basics of Margin/Collateral 141 7.2.1 Terminology 141 7.2.2 Rationale 142 7.

2.3 Variation Margin and Initial Margin 144 7.2.4 Method of Transfer and Remuneration 145 7.2.5 Rehypothecation and Segregation 147 7.2.6 Settle to Market 150 7.

2.7 Valuation Agent, Disputes, and Reconciliations 151 7.3 Margin Terms 152 7.3.1 The Credit Support Annex 152 7.3.2 Types of CSA 153 7.3.

3 Margin Call Frequency 154 7.3.4 Threshold, Initial Margin, and the Minimum Transfer Amount 155 7.3.5 Margin Types and Haircuts 157 7.3.6 Credit Support Amount Calculations 161 7.3.

7 Impact of Margin on Exposure 163 7.3.8 Traditional Margin Practices in Bilateral and Centrally-cleared Markets 165 7.4 Bilateral Margin Requirements 166 7.4.1 General Requirements 166 7.4.2 Phase-in and Coverage 168 7.

4.3 Initial Margin and Haircut Calculations 169 7.4.4 Eligible Assets and Haircuts 171 7.4.5 Implementation and Impact of the Requirements 172 7.5 Impact of Margin 173 7.5.

1 Impact on Other Creditors 173 7.5.2 Market Risk and Margin Period of Risk 174 7.5.3 Liquidity, FX, and Wrong-way Risks 178 7.5.4 Legal and Operational Risks 179 7.6 Margin and Funding 180 7.

6.1 Overview 180 7.6.2 Margin and Funding Liquidity Risk 181 8 Central Clearing 185 8.1 Evolution of Central Clearing 185 8.1.1 Exchange Trading 185 8.1.

2 Evolution of Complete Clearing 186 8.1.3 What is a CCP? 187 8.2 Mechanics of Central Clearing 189 8.2.1 Landscape 189 8.2.2 Novation 191 8.

2.3 Multilateral Offset and Compression 192 8.2.4 Margin and Default Funds 194 8.2.5 Clearing Relationships 195 8.3 CCP Risk Management 197 8.3.

1 Overview and Membership Requirements 197 8.3.2 Margin 198 8.3.3 Default Scenarios and Margin Period of Risk 199 8.3.4 The Loss Waterfall 202 8.3.

5 Comparing Bilateral and Central Clearing 204 8.4 Initial Margin and Default Funds 205 8.4.1 Coverage of Initial Margin and Default Funds 205 8.4.2 Default Fund Versus Initial Margin 206 8.4.3 Default Fund Coverage 207 8.

5 Impact of Central Clearing 209 8.5.1 Advantages and Disadvantages of Central Clearing 209 8.5.2 Will Mandatory Clearing Kill Credit Value Adjustment? 210 9 Initial Margin Methodologies 213 9.1 Role of Initial Margin 213 9.1.1 Purpose 213 9.

1.2 Margin Period of Risk 215 9.1.3 Coverage: Quantitative and Qualitative 217 9.1.4 Haircuts 218 9.1.5 Linkage to Credit Quality 218 9.

1.6 Cross-margining 220 9.2 Initial Margin Approaches 222 9.2.1 Simple Approaches 222 9.2.2 SPAN® 223 9.2.

3 Value-at-risk and Expected Shortfall 227 9.3 Historical Simulation 229 9.3.1 Overview 229 9.3.2 Look-back Period 230 9.3.3 Relative and Absolute Returns 231 9.

3.4 Volatility Scaling 233 9.3.5 Procyclicality 234 9.3.6 Current CCP Methodologies 239 9.3.7 Computational Considerations 241 9.

4 Bilateral Margin and SIMM 242 9.4.1 Overview 242 9.4.2 Standard Schedules 244 9.4.3 Variance-covariance Approaches 245 9.4.

4 The ISDA SIMM 249 9.4.5 Implementation of Bilateral Margin Requirements 252 10 The Impact and Risk of Clearing and Margining 255 10.1 Risks of Central Clearing 256 10.1.1 Historical CCP Problems 256 10.1.2 The 1987 Stock Market Crash 258 10.

1.3 The 2018 Nasdaq Case 259 10.1.4 Risks Faced by CCPs 260 10.1.5 Risks Caused by CCPs 261 10.2 Analysis of a CCP Loss Structure 262 10.2.

1 Review of the Loss Waterfall 262 10.2.2 Impact of Default Fund Exposure 264 10.2.3 The Prisoner''s Dilemma and AIPs 265 10.2.4 Other Loss Allocation Methods 267 10.3 Impact of Margin 271 10.

3.1 Background and Historical Examples 271 10.3.2 Variation Margin 273 10.3.3 Initial Margin 275 10.3.4 Cost and xVA 276 10.

3.5 Seniority 277 10.3.6 Bilateral and Cleared Markets 277 Section 3 Building Blocks 11 Future Value and Exposure 283 11.1 Credit Exposure 283 11.1.1 Positive and Negative Exposure 283 11.1.

2 Definition of Value 284 11.1.3 Current and Potential Future Exposure 285 11.1.4 Nature of Exposure 286 11.1.5 Metrics 288 11.2 Drivers of Exposure 292 11.

2.1 Future Uncertainty 292 11.2.2 Cash Flow Frequency 293 11.2.3 Curve Shape.