LO 26.5: Explain the process for the reconciliation o f collateral disputes.

LO 26.5: Explain the process for the reconciliation o f collateral disputes.
To mitigate risk, it is generally preferred to include the maximum number of trades in collateral agreements. However, if even a single trade cannot be properly valued, it can complicate collateral calls and may lead to collateral disputes. If trades include potentially problematic assets, it may be optimal to only focus on a subset of trades that make up the majority of credit exposure and leave out asset classes that are hard to value either due to complexity (e.g., exotic options) or illiquidity (e.g., credit derivatives). Global considerations are also important, especially as counterparties trade with each other over many time zones and geographical locations. It may be optimal to handle trades separately with regions that are problematic and make up only a small portion of trades. Finally, if an entity expects one of its counterparties to have difficulty valuing certain trades or assets, it may be preferred to leave those trades uncollateralized rather than face potential and frequent disputes. Given that collateral agreements typically require that undisputed amounts be transferred immediately, it is generally advantageous to collateralize the majority of products.
If disputes do arise, they can relate to the trade population, trade valuation, netting rules, market data and market closing time, and valuing collateral that was previously posted. If the disputed amount or valuation difference is small, counterparties may simply split the difference. If the disputes involve larger differences, the exposure will remain uncollateralized until the dispute is resolved. Disputes include the following steps: (1) the disputing party notifies the counterparty of its intent to dispute the exposure by the end
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Topic 26 Cross Reference to GARP Assigned Reading – Gregory, Chapter 6
of the day following the collateral call; (2) all undisputed amounts are transferred, and the reason for the dispute is identified; and (3) for unresolved disputes, the parties will request quotes from several market makers (usually four) for the MtM value.
Reconciling trades minimizes the chance of disputes. Parties may also find it beneficial to perform dummy (practice) reconciliations prior to trading and periodic reconciliations during trading (weekly or monthly) to preempt future disputes.
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