THE BIG SQUEEZE.

A new dawn of central clearing is almost upon us but sourcing the right collateral may be tricky. Lynn Strongin Dodds reports

Ever since Dodd Frank, the European Market Infrastructure Regulation (EMIR) and Basel III hit the financial scene, collateral management has become a key buzzword. Navigating the new centrally cleared landscape is no easy task especially as the ink is not yet dry on the final versions. The impact will vary according to which camp industry players sit in but balancing the new regulatory minefield while trying to generate growth will prove challenging for all.

For the buyside, firms will not only have to post higher initial margins for all over the counter transactions to clearinghouses but the collateral used will be restricted to conservative assets such as cash or government bonds. In the pre-Lehman world, OTC contracts were typically bilateral agreements between parties with established relationships and they rarely had to deal with initial or variation margin – the amount of collateral required to cover changes in an instrument’s value. Fund managers relied on Excel spread sheets and legacy systems to manage, but in the new regulatory dawn they will have to post both margin, choose clearing members and negotiate new legal documents.

One of the biggest concerns is that there will be a shortage of eligible collateral to meet the growing demand. It is also difficult to put a number on the costs of the additional margining that will be required as there are many estimates being bandied about in the marketplace. They range from the International Monetary Fund forecasts of $2 trillion to $4 trillion, to industry trade group International Swaps and Derivatives Association’s which puts the margining of non-centrally-cleared derivatives at between $15.7 trillion and $29.9 trillion. Meanwhile the Bank of England’s figure stands between $200 bn and $800 bn.

Industry players attribute the discrepancies to the assumptions that are factored into the equations. Numbers can be skewed if FX and forwards are excluded or if netting is taken into account. For example, the ISDA report assumed no netting, while the Bank of England supposed netting benefits across cleared and uncleared interest rate trades of 95–99%.

The other unknown is the expense involved in overcoming these new hurdles. Not only will institutional investors have to optimise and transform unacceptable assets into eligible collateral but they could also face a drop in the netting options they can pursue since a single clearinghouse may not be able to initially clear all products traded by the client. “The buyside is facing more and more collateral needs on the back of Dodd Frank and EMIR and they are looking towards their service providers for product solutions to turn non eligible to eligible collateral,” says David Raccat, head of global markets for market and financing services, BNP Paribas Securities Services. “Although it is not completely clear when the implementation dates will be, there is no doubt it will create additional costs for the buyside.”

Ted Allen, vice president, collateral management at SunGard’s capital markets business, adds, “What we are seeing is financial institutions are making more effort to better understand the costs and collateral requirements pre-deal. This means calculating the margin impact of the transactions at different central counterparties and looking at collateral optimisation which is to reduce the total cost of collateral of the firm as a whole.”

Global banks as well as custodians have also adopted a more inclusive approach and can offer clients a comprehensive view of positions, where the collateral is being held and availability of assets across the firm. Sophisticated processes and systems have also been developed to optimise as well as transform assets with many pulling together services under one roof. For example, J.P. Morgan has merged its global clearing, collateral management and agency execution businesses into a new integrated offering while BNY Mellon recently launched its global collateral service which brings together the firm’s global capabilities in segregating, allocating, financing and transforming collateral.

Market participants are re-evaluating the way they conduct collateral management today,” says Tom Riesack managing principal at of Capco. “They realise that a siloed approach won’t work in the future and that it is essential to use what is available in the best possible way. This requires a holistic, company-wide view on collateral management as close to real-time as possible. The sellside is ahead while the buyside is still trying to get to grips and catch up with the regulatory impact.”

Despite their lead, banks and brokerage houses still have their work cut out for them, according to a recent survey by SunGard and IntelDelta, which canvassed 100 market participants including banks, asset managers and clearinghouses. To date, most banks have built their cleared OTC collateral management capabilities out of their existing bilateral function. This is mainly due to the inherent flexibility required by an OTC derivatives platform to be able to handle a wide variety of products and agreements. However, very few respondents – only 10% – felt that their systems and processes were fully complete in their ability to support the combined cleared/non-cleared model for processing collateral.

Breaking it down into specifics, the sellside is falling short on the full automation front as well as their collateral optimisation capabilities which are one of the keys if they want to capture new revenue streams. The study shows that only 21% of respondents felt that they were fairly advanced or better in this space. In fact, it is one of the areas in which banks may look to build or buy a new technology component rather than simply build on existing platforms.

While few doubt that the sellside will step up to the servicing and technological plate, the bigger question perhaps is whether their buyside counterparts will continue to trade derivatives at the same levels. A new study conducted by Tabb Group which polled 31 hedge as well as traditional funds, bank and insurance companies, showed that to date, the impending regulation has had little impact on notional volumes with 88% of the firms noting the size of their swaps books were flat to up over the previous year. However, up to 14% of fund managers have changed their trading patterns, with some withdrawing from the so-called exotic products because many of those contracts are ineligible for central clearing.

“I think what we will see is that the buyside will look at the potential costs and weigh those against whether trading OTC derivatives achieves a fund’s strategic goals,” says Fergus Pery, director and global product head for OpenCollateral in Citi’s Securities and Fund Services. “Some may find other routes while others especially those with liability driven strategies will continue to use them.”

For those that do want to continue to be active users of OTC derivatives, they should conduct a review of their strategies to establish what cleared contracts will be used, according to Jonathan Philp, a specialist in OTC clearing and collateral management at the business and IT consultancy Rule Financial. Buyside firms should also model the initial margin requirements of their portfolios and determine whether they are using the most cost-effective services. In some cases, using an outsourced collateral management service provider or moving towards a tri-party collateral management service which could bring real efficiencies in sourcing and deploying CCP-eligible collateral.