The collateral conundrum: burden or opportunity?
10 June 2014
For those that have yet to decide on a comprehensive strategy, the risks are becoming even greater for operating with a substandard non-optimal system, says David Field of Rule Financial
Image: Shutterstock
The passing of the European Market Infrastructure Regulation (EMIR) 12 February trade reporting deadline was perhaps not as smooth as many market participants would have liked, but it may have provided invaluable lessons ahead of the impending collateral reporting deadline this August. Different firms’ self-assessments range from confident claims of complete preparedness to those who are yet to mobilise, leaving the majority somewhere in between, aware of the implications of not complying but uncertain of how best to transform their current systems.
The current pace of regulatory change can seem overwhelming to those trading derivatives and the move to centrally clearing some OTC products has raised a number of new challenges around the collateral management process that firms must wrestle with.
Traditionally, collateral management was a credit mitigation process run by operations, margining was less frequent and collateral processing was largely supported via spreadsheets. This article will consider the impact of changing approaches to collateral usage, as firms must define their target operating models and leverage available technological benefits, most notably software as a service (SaaS). Regardless of whether you see opportunities or challenges in this changing landscape, proactive collateral management and optimisation will be a competitive differentiator, a method of reducing costs and performance drag.
The possibility of a collateral crunch in the coming years will depend largely on supply and demand, but at this early stage the data suggests that there will be sufficient collateral in the market. The main challenge lies in creating a market infrastructure that gets the right collateral to the right place at the right time, which is a highly complex task.
Under normal market conditions, an estimated $2 trillion of additional collateral is likely to be required. However, in less certain times, say during a major default, volatility could cause collateral demand to jump as high as $11 trillion. Bilateral counterparties will require more initial margin as counterparty ratings drop and central counterparty (CCP) value at risk (VaR) models generate higher PFEs (potential future exposure). Variation margin requirements will also increase as a consequence of market volatility.
While a collateral crunch may not occur, a client onboarding crunch for clearing services and collateral technology could result in real problems, particularly for the buy side as it rushes to meet the requirements.
Managing risk
The benefits of strong collateral management capabilities are numerous but the adoption of new practices should also be viewed as an exercise in risk mitigation. In the situation of a counterparty default or market crisis, the collateral system must provide a clear view of all margin calls and pledges to every CCP and bilateral counterparty in one place. In addition, the visibility of allocated and unencumbered collateral across all funds (own, outsourced and third party), dynamic management of margin calls, substitution and pledging, and the ability to meet sudden variation margin calls quickly with eligible collateral should all be provided.
Delivering all of this while minimising headcount costs and performance drag by allocating cheapest to deliver (eligible) assets and using collateral transformation services efficiently, gives some idea of the challenges ahead.
In our opinion, an automated solution from one of the main technology vendors is likely to be needed. Should another Lehman Brothers occur or even worse, a CCP fail, then the cost of a leading edge collateral management system will be money well spent. Moreover, firms may also want to verify CCP/broker margin calls by replicating the CCP’s initial margin calculations. This will help when forecasting collateral requirements on a forward-looking basis, thus creating the valuable time needed to source suitable collateral at a reasonable cost.
Stress testing the collateral portfolio can also be a valuable exercise, enabling risk managers to analyse the effect on collateral requirements and funding costs in scenarios such as a self-downgrade or major market movement.
The new collateral function
and processes
Previously, margining was relatively simple with portfolio managers seeking alpha through cash instruments and hedging with derivatives. Typically, firms would post collateral in cash and manage margin with spreadsheets. The buy side, for example, posted one-way independent amounts to counterparties that were marked-to-market on a relatively infrequent basis.
In the post-crisis landscape as collateral demands grow, funds may no longer hold enough cash to meet the increase in margin requirements. This will result in a drive towards non-cash collateral to reduce the impact on fund performance. Non-cash collateral requires more intensive processing, leading to a step change in complexity for the buy side. Inventory management therefore becomes a core function and firms will need a clear view of inventory by fund in order to source collateral for initial and variation margin in an efficient way.
Secondly, a margining engine is essential for processing more frequent calls in an automated way with minimal strain on operations or headcount. A third key component is management of eligibility, concentration, haircut and reference data schedules and ensuring that the firm remains compliant with its mandate and risk guidelines. Finally, the use of margin messaging tools and reconciliation solutions would improve straight through processing and reduce operational risk.
Selecting your CCPs, clearing brokers and FCMs
Settling on the most appropriate CCP, clearing brokers and futures commission merchants (FCMs) can be one of the most time-consuming aspects of moving to a cleared environment. The majority of firms will connect to at least two clearing brokers and CCPs in order to diversify risk. However, this will result in a need for connectivity to many different venues, potentially fragmented order flow and reduced netting benefits. This increased complexity results in more margin calls, more widely dispersed collateral (thus reducing concentration risk), but at the expense of increased operational risk.
Firms must consider portability agreements that allow them to port positions and collateral over to another broker/FCM in the event of a default. Therefore, when assessing a CCP and performing due diligence, firms need to consider a wide range of both quantitative and qualitative factors including: margining methodologies, the credit quality of the CCP’s clearing members, default and resolution procedures, and transparency of the CCP’s risk management procedures.
It is also worth considering the likelihood of a central bank backstop, although as yet few central banks have explicitly agreed to backstop a CCP. This, and a lack of transparency around risk management methodologies, makes it hard to compare like-for-like when evaluating one CCP against another.
What has helped is that technology providers are constantly innovating in the area of CCP optimisation, simplifying previously complex calculations that consider the CCP’s initial margin methodology, collateral eligibility criteria and netting options.
Sourcing and transforming collateral
The extent of the growing demand for high-quality assets remains uncertain but the effects of central clearing, two-way exchange of margin for bilateral trades and Basel III liquidity coverage ratios will all add to it. Movement of collateral around the financial system may also slow due to reduced rehypothecation and CCP account segregation. However, new supply of high quality collateral assets coming back into the market through the winding down of quantitative easing in the UK and the tapering of the US Federal Reserve system support may balance this.
Holding cash for CCP variation margin calls is likely to be expensive, creating a drag on fund performance. There are indications that leading FCMs will soon be charging 50 basis points for lodging cash collateral. Where some lead, others will follow, especially as some markets move into negative interest rate territory. Conversely, many funds will not be holding enough high-quality liquid assets to meet CCP margin calls.
The widely accepted solution lies in the collateral transformation trade that upgrades lower quality assets into CCP eligible collateral via the securities lending or repo markets. A broker can take non-CCP eligible collateral assets from the buy-side firm and then upgrade them for CCP eligible securities in the securities finance markets, charging an upgrade fee to do so.
Matching the maturity of collateral with the derivative portfolios it is underpinning is a key consideration and there are potential maturity mismatches in collateral upgrades. Short-term repo markets can of course provide a source of collateral when clearing a long dated swap at a CCP, but this can expose the derivatives end user to rollover risk. Collateral transformation may also be prohibitively expensive for many on the buy side, and sell-side firms are facing balance sheet constraints in the new regulatory environment.
As ever, in solving the collateral conundrum, there is no substitute for mobilising as soon as possible. For those that have yet to decide on a comprehensive collateral management strategy, the risks are becoming even greater for operating with a substandard non-optimal system, incurring high costs associated with non-compliance and inefficient tactical solutions.
The current pace of regulatory change can seem overwhelming to those trading derivatives and the move to centrally clearing some OTC products has raised a number of new challenges around the collateral management process that firms must wrestle with.
Traditionally, collateral management was a credit mitigation process run by operations, margining was less frequent and collateral processing was largely supported via spreadsheets. This article will consider the impact of changing approaches to collateral usage, as firms must define their target operating models and leverage available technological benefits, most notably software as a service (SaaS). Regardless of whether you see opportunities or challenges in this changing landscape, proactive collateral management and optimisation will be a competitive differentiator, a method of reducing costs and performance drag.
The possibility of a collateral crunch in the coming years will depend largely on supply and demand, but at this early stage the data suggests that there will be sufficient collateral in the market. The main challenge lies in creating a market infrastructure that gets the right collateral to the right place at the right time, which is a highly complex task.
Under normal market conditions, an estimated $2 trillion of additional collateral is likely to be required. However, in less certain times, say during a major default, volatility could cause collateral demand to jump as high as $11 trillion. Bilateral counterparties will require more initial margin as counterparty ratings drop and central counterparty (CCP) value at risk (VaR) models generate higher PFEs (potential future exposure). Variation margin requirements will also increase as a consequence of market volatility.
While a collateral crunch may not occur, a client onboarding crunch for clearing services and collateral technology could result in real problems, particularly for the buy side as it rushes to meet the requirements.
Managing risk
The benefits of strong collateral management capabilities are numerous but the adoption of new practices should also be viewed as an exercise in risk mitigation. In the situation of a counterparty default or market crisis, the collateral system must provide a clear view of all margin calls and pledges to every CCP and bilateral counterparty in one place. In addition, the visibility of allocated and unencumbered collateral across all funds (own, outsourced and third party), dynamic management of margin calls, substitution and pledging, and the ability to meet sudden variation margin calls quickly with eligible collateral should all be provided.
Delivering all of this while minimising headcount costs and performance drag by allocating cheapest to deliver (eligible) assets and using collateral transformation services efficiently, gives some idea of the challenges ahead.
In our opinion, an automated solution from one of the main technology vendors is likely to be needed. Should another Lehman Brothers occur or even worse, a CCP fail, then the cost of a leading edge collateral management system will be money well spent. Moreover, firms may also want to verify CCP/broker margin calls by replicating the CCP’s initial margin calculations. This will help when forecasting collateral requirements on a forward-looking basis, thus creating the valuable time needed to source suitable collateral at a reasonable cost.
Stress testing the collateral portfolio can also be a valuable exercise, enabling risk managers to analyse the effect on collateral requirements and funding costs in scenarios such as a self-downgrade or major market movement.
The new collateral function
and processes
Previously, margining was relatively simple with portfolio managers seeking alpha through cash instruments and hedging with derivatives. Typically, firms would post collateral in cash and manage margin with spreadsheets. The buy side, for example, posted one-way independent amounts to counterparties that were marked-to-market on a relatively infrequent basis.
In the post-crisis landscape as collateral demands grow, funds may no longer hold enough cash to meet the increase in margin requirements. This will result in a drive towards non-cash collateral to reduce the impact on fund performance. Non-cash collateral requires more intensive processing, leading to a step change in complexity for the buy side. Inventory management therefore becomes a core function and firms will need a clear view of inventory by fund in order to source collateral for initial and variation margin in an efficient way.
Secondly, a margining engine is essential for processing more frequent calls in an automated way with minimal strain on operations or headcount. A third key component is management of eligibility, concentration, haircut and reference data schedules and ensuring that the firm remains compliant with its mandate and risk guidelines. Finally, the use of margin messaging tools and reconciliation solutions would improve straight through processing and reduce operational risk.
Selecting your CCPs, clearing brokers and FCMs
Settling on the most appropriate CCP, clearing brokers and futures commission merchants (FCMs) can be one of the most time-consuming aspects of moving to a cleared environment. The majority of firms will connect to at least two clearing brokers and CCPs in order to diversify risk. However, this will result in a need for connectivity to many different venues, potentially fragmented order flow and reduced netting benefits. This increased complexity results in more margin calls, more widely dispersed collateral (thus reducing concentration risk), but at the expense of increased operational risk.
Firms must consider portability agreements that allow them to port positions and collateral over to another broker/FCM in the event of a default. Therefore, when assessing a CCP and performing due diligence, firms need to consider a wide range of both quantitative and qualitative factors including: margining methodologies, the credit quality of the CCP’s clearing members, default and resolution procedures, and transparency of the CCP’s risk management procedures.
It is also worth considering the likelihood of a central bank backstop, although as yet few central banks have explicitly agreed to backstop a CCP. This, and a lack of transparency around risk management methodologies, makes it hard to compare like-for-like when evaluating one CCP against another.
What has helped is that technology providers are constantly innovating in the area of CCP optimisation, simplifying previously complex calculations that consider the CCP’s initial margin methodology, collateral eligibility criteria and netting options.
Sourcing and transforming collateral
The extent of the growing demand for high-quality assets remains uncertain but the effects of central clearing, two-way exchange of margin for bilateral trades and Basel III liquidity coverage ratios will all add to it. Movement of collateral around the financial system may also slow due to reduced rehypothecation and CCP account segregation. However, new supply of high quality collateral assets coming back into the market through the winding down of quantitative easing in the UK and the tapering of the US Federal Reserve system support may balance this.
Holding cash for CCP variation margin calls is likely to be expensive, creating a drag on fund performance. There are indications that leading FCMs will soon be charging 50 basis points for lodging cash collateral. Where some lead, others will follow, especially as some markets move into negative interest rate territory. Conversely, many funds will not be holding enough high-quality liquid assets to meet CCP margin calls.
The widely accepted solution lies in the collateral transformation trade that upgrades lower quality assets into CCP eligible collateral via the securities lending or repo markets. A broker can take non-CCP eligible collateral assets from the buy-side firm and then upgrade them for CCP eligible securities in the securities finance markets, charging an upgrade fee to do so.
Matching the maturity of collateral with the derivative portfolios it is underpinning is a key consideration and there are potential maturity mismatches in collateral upgrades. Short-term repo markets can of course provide a source of collateral when clearing a long dated swap at a CCP, but this can expose the derivatives end user to rollover risk. Collateral transformation may also be prohibitively expensive for many on the buy side, and sell-side firms are facing balance sheet constraints in the new regulatory environment.
As ever, in solving the collateral conundrum, there is no substitute for mobilising as soon as possible. For those that have yet to decide on a comprehensive collateral management strategy, the risks are becoming even greater for operating with a substandard non-optimal system, incurring high costs associated with non-compliance and inefficient tactical solutions.
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