Collateral takes centre stages
As the industry continues its frantic preparation for the impending overhaul of the OTC derivatives market, very few of the regulatory changes will have as much impact as the added collateral burden.
Through the European market infrastructure regulation and provisions of the US Dodd-Frank Act, large swathes of the OTC derivatives market will be traded on exchange-like platforms and cleared through central counterparties (CCPs). The instruments that are likely to fall under the clearing obligation in the first instance are credit default swaps, interest rate swaps and non-deliverable forwards.
In terms of collateral, the new rules – which will start coming into effect from early this year – will have a number of implications.
The first is the need to post initial margin. Traditionally, under bilateral deals the buy-side rarely pays initial margin and typically posts variation margin to reflect the change in exposure that occurs over the life of the contract.
However, worthy of note is that initial margin has been on the radar of market participants since the collapse of Lehman Brothers in Q3 2008 – which was counterparty to 900,000 swaps transactions at the time.
The frequency of variation margin will also be increased from weekly to daily, and potentially even intraday.
The exchange of collateral for cleared swaps will also be indisputable in the new world, a change from the current bilateral process whereby investment banks determine a value for a position which is then verified by the buy-side counterparty.
“If there are any disputes, the classic model is to exchange the non-disputed amount and continue the debate over the remainder,” says Sarah-Jane Dennis, consultant at buy-side advisory firm Investit. “This is somewhat of an administrative burden, but follows pre-defined rules that give institutional investors some flexibility.”
Moreover, any instruments that cannot be standardised – and therefore valued accurately by CCPs – will be subject to even higher margin obligations to reflect their bespoke nature and the added risk they carry.
Asset of choice
Cash has been the favoured type of collateral for institutional investors and will also be preferred by CCPs that will want to minimise as far as possible the systematic risk they pose from standing in the middle of multiple swaps transactions. But it will not be optimal to use cash in every case and, at the time of going to press, CCPs were in the process of determining the collateral they are willing to accept. This is likely to include sovereign bonds at the very least, but there is also a push to consider other high-quality assets.
For non-cleared swaps, regulators are thought to be considering the use of high quality corporate or covered bonds of different tenors, gold and equities that are part of major indices. “The overall collateral demand for non-cleared swaps could potentially be very large – particularly as the current proposed draft margin rules would require margin to be collected with limited portfolio benefits and paid and collected by both parties,” notes Yves Dermaux, managing director, markets prime finance, Deutsche Bank.
With so many demanding changes, the effective management of collateral is now top of mind for market participants. “With a shortage likely to continue in the medium-term, optimising collateral will be critical to firms that want to continue to trade OTC derivatives as part of their hedging strategies,” says Ted Leveroni, executive director, strategy at post-trade processing firm Omgeo. “The dangerous alternative is that without being able to meet the collateral requirements of central clearing, firms may turn to inferior hedging tools, which could nullify one of the objectives of the regulatory reform programme – the mitigation of counterparty risk.”
Bringing it together
Custodians and banks are beginning to respond with services that help firms manage their collateral inventory, optimise its use across different business functions and substitute assets held on a firm’s balance sheet into eligible collateral. “Collateral optimisation, through intelligent inventory management and collateral transformation, are key areas of focus for the entire capital markets industry,” says Saheed Awan, global head of collateral management services at Euroclear. “To date, investment banks have done the most to change their operating models for collateral management. Rather than developing these capabilities internally, many of the G-14 investment banks rely on their depositories (CSDs), which hold a substantial portion of their assets, to consolidate the inventories that these investment banks hold with agent banks into a single collateral pool.”
In July, Euroclear announced a partnership with BNP Paribas to create what they call the Collateral Highway, allowing customers to move securities from wherever they are held to serve as collateral that can be held against bilaterally-cleared OTC derivative trades and exposures within CCPs, among other uses.
“The next steps will be encouraging other agent banks and CSDs to join our Collateral Highway, with the aim of first building a firm-wide view of its global inventory,” says Awan. “Second, clients will be able to pool their assets as collateral for optimal allocation to meet CCP and other obligations, including of course central banks and bilateral counterparties.” Awan adds that the international CSD, Euroclear Bank, has several CCPs connected and ready to receive collateral from the Collateral Highway.
Collateral solutions in other areas are also beginning to take shape. J.P. Morgan allows its clients to deposit excess collateral in a subsidiary to ease the reconciliation burden associated with meeting margin calls. BNY Mellon is introducing a service that gives its customers a view of their collateralised status in real-time via an interactive dashboard.
Effective management of collateral also presents a revenue opportunity, particularly for buy-side firms that have a surplus of what regulators and CCPs deem to be high-quality collateral assets, such as top rated government bonds.
Clearing members are likely to be most in need of transformation services given that they are likely to be responsible for meeting collateral calls on behalf of their buy-side and corporate clients.
“The collection of variation margin will be more onerous, with intraday calls expected at least seven times a day,” says Dennis. “The technology needed to meet these calls is rarely found on the buy-side. The clearing member is therefore likely to act as a buffer between the CCP and the buy-side firm by offering a funding line, for a fee, as one option for a stopgap.” However, there remains some uncertainty over whether this model will be favoured by the market, with CCPs in the process of deciding the best model for accepting collateral in a timely way.
Furthermore, while this does present new revenue opportunities for some buy-side firms, the need for such a service will be dependent on what the asset clearers and regulators accept as collateral. “If the main collateral takers end up selecting a broad range of collateral and accept the type of securities commonly held by different market participants, the need for transformation will diminish,” says David Little, director, strategy and business development, Calypso, provider of a front-to-back office solution for derivatives and treasury products.
But Awan at Euroclear points out that, aside from new OTC derivatives rules, banks will also need to adhere to liquidity coverage ratios required under Basel III, the latest set of guidelines to ensure banks are adequately capitalised. “Banks will need access to high-quality assets like cash and government bonds to cover short-term funding requirements under Basel III,” he says. “They will need the ability to pledge securities as collateral with trading counterparties for reasons other than OTC derivatives reforms.”
While some industry observers have expressed concern at the potential for a new type of systemic risk to emerge through the growth of collateral transformation services, regulators appear to be gaining comfort with the practice. Having consulted the market on the use of collateral swaps since July 2011, the UK’s Financial Services Authority (FSA) released final guidance earlier this year that accepted the benefits of such trades.
“We recognise that these transactions enable the temporary transfer of liquid assets to firms that need them, whilst at the same time providing the lending firm with secured exposures and potentially an enhanced yield,” wrote Paul Sharma, director of policy at the FSA. “We see a role for these transactions on a sensible scale, provided the risks are properly identified and managed by both parties.”