Sarah-Jane Dennis of Investit tells us how…
"In our experience over half of investment management firms using OTC derivatives do not yet have a policy guiding their collateral management operation."
For many buy-side firms the process of negotiating International Swaps and Derivatives Association documentation is cumbersome and slow. By implementing the right type of collateral management policy a firm can speed up this negotiation process and reduce operational risk.
The legal and documentation teams of the top ten investment banks are inundated with requests from the buy-side to put ISDA documentation in place for their funds. This can run into the thousands at any one time, so maintaining momentum is crucial to buy-side firms. In addition, each OTC derivative contract is, by nature, unique. Running through a lengthy internal agreement process for each instrument is yet another delay.Delays in putting ISDA documentation in place can mean delays in trading for the fund, which can mean missed opportunities in the market – and can prove costly.
So, how do investment managers make the ISDA negotiation process more efficient?
A collateral management policy will speed up ISDA negotiation and reduce misunderstanding between the counterparties – reducing operational risk and improving efficiency. But what does such a collateral management policy look like?
What is collateral management?
Collateral is a form of security, transferred in physical assets or cash, that is offered against a loan or other form of debt. In the case of an OTC derivative contract, collateral is moved between two counterparties as the exposure varies, depending on market movements in the underlying assets or rates in the contract.
There are a number of elements that affect collateral management operations at investment management firms. At the center of these elements are the ISDA Credit Support Annex (CSA) documents. ISDA CSAs dictate the basis on which collateral assets are exchanged, how often they are exchanged and the returns that might be generated on the collateral held. Our research shows a typical investment management firm might now have more than 100 ISDA CSAs across a dozen brokers for 50 mandates. Many investment management firms have issues with ISDA negotiation, such as the time taken to put ISDA CSAs in place and a lack of understanding by broker legal teams of buy-side fund structures. So, effective and efficient negotiation of ISDA documentation, to ensure the right levels of collateral management are in place, needs a combination of the skills and coordination of a dedicated person and the input and cooperation of the managers of the front, middle and back office.
Developing a collateral policy for OTC derivatives would shorten the preparation phase of negotiation and also ensure the firm has a wider understanding of the effect of counterparty credit exposure on funds, and the effect of operational processing on the firm, before executing ISDA documents. In our experience over half of investment management firms using OTC derivatives do not yet have a policy guiding their collateral management operation.
The collateral policy
What should a collateral management policy include? We asked our investment management clients to provide some best practice below and have outlined their responses.
The document should contain clear statements on who owns the policy document and under what authority it operates. It can include how often and under what circumstances it is reviewed and updated (i.e. for new instruments, new guidelines, new procedures, new systems) and who is responsible for updating/owning sections within the document and what parts of the process during negotiation. Documenting the negotiation process and attendant roles and responsibilities will ensure all departments will save time and effort during negotiation.
There should be a section of the collateral policy that puts forward guidelines for the take on of new business and that clearly indicate what criteria have to be met and who is involved in the sign-off process, i.e. the portfolio manager, client account manager, sales, collateral management head, operations head, etc. There might be metrics included which indicate thresholds of support in the collateral management team beyond which more resources will be required. For new instruments a defined new instrument review process needs to be referenced – part of which is the review of the policy document. This section will help manage expectations in the front office and promote more accurate planning of expected volume increases. In terms of the negotiating process, it may influence whether or not any work is carried out on new ISDA agreements and therefore save time.
Counterparty credit guidelines
There needs to be some indication or guidance on what the global counterparty credit limits are and specifically indicative values or ranges of value for such items as cross default thresholds. Different departments in different institutions influence these – some have employed a specialist credit officer, some combine the role with an all-encompassing risk manager and others still rely on the compliance department. These guidelines will be key to ensuring a fund is not exposed, through aggregated threshold amounts in multiple CSAs, to more counterparty credit exposure than is mandated or (if the market has moved in the other direction) to more debt than it can meet with available assets under management.
Reuse of collateral
Firms may want to consider rehypothecation as part of this section of the policy. When collateral is received the collateral taker, as owner, can do what is best for the client that is holding the collateral. Therefore, the collateral can be sold, used to meet incoming collateral calls or reinvested with another desk internally, for example the securities lending department.
Communication with counterparties
Very often the interface between counterparty and investment management firm is the sales trader and the portfolio manager. Therefore, any policy on communication needs to include a consultation with the portfolio manager to ascertain the extent they want to be involved – and at what points in the process.
Clear operating procedures
This should include either as an appendix or referenced to another document the process flows for managing collateral on a day-to-day basis. The policy document should contain the timings of certain key processes and flows of data and would include when all calls must be made, when valuations will be received, when disputes must be settled, when reconciliation files need to be sent or received and the reconciliation process completed.
Frequency of marking to market
The frequency, along with the source for mark-to-market prices and values needs to be established at policy level with consultation with the portfolio manager and the head of the operations/pricing department.
Common areas of disputes between counterparties might be:
Exposure valuation. Disputes are generally settled informally by:
– Including a mutually agreed tolerance level in the CSA.
– Agreeing to ‘split the difference’ of the disputed amount and delivering only the undisputed amount as required by the CSA.
Both parties agreeing to the undisputed amount only. The portfolios are then re-valued the following day in order to compare prices. If the difference is consistent then a suitable tolerance can be agreed.
In this instance the need to bring the front office into the dispute might not be required. However, if price differences are consistent and large then the portfolio manager (and traders) need to be consulted as soon as possible, as they will know the market better than anyone and be able to shed light on pricing anomalies.
Collateral valuation. Disputes are rare and only usually occur when exotic securities, such as CDOs with low liquidity, are involved. If pricing problems persist then the collateral taker usually requests to substitute the disputed collateral.
ISDA negotiation. For commercial points, i.e. the cross default clause, as a rule of thumb once the firm’s ISDA negotiator/coordinator has taken up the disputed point internally (with credit, operations, collateral manager and legal) and found an impasse, then this is the time to bring it to the attention of the front office for their opinion and possible escalation. It might be that the point in question can be resolved internally or it is not important to them (the front office) and they are happy to concede in order to win a different disputed point with the broker.
Guidelines for CSA parameters
This section in particular will help establish a standard for ISDA documentation and become a key reference document for all departments. Areas for inclusion here are:
Preferred levels of minimum transfer amount and thresholds. These could be sub-divided by client grouping, for example OEICS, unit trusts, institutional fund, etc
Tolerance levels for pricing and valuation differences.
Types of collateral – particularly when taking collateral versus giving.
Netting with same counterparty and within the same fund/client.
Returns on collateral held and the reference rates.
Procedures for departing from policy
This last section is important, as all departments must know to whom they can appeal to in order to change or make exceptions to the contents of the policy. There must be a process for a temporary adjustment (including who would authorize this) and for then returning to the point and reviewing the policy in light of the change. Often when these points occur it is because the market is changing rapidly or there has been a launch of several investment products simultaneously (i.e. Liability Driven Investing). Either of these situations will require some remedial review work on the policy document.
In summary, an effective collateral management policy will allow an investment management firm to streamline the internal approval process while cutting down the time taken to agree ISDA CSA terms with the counterparty. And reducing the time taken, will allow portfolio managers can implement desired investment strategies more quickly. In a time when investment management firms consider to struggle with operational headaches caused by OTC derivatives processing, anything to smoothen the processing of OTC derivatives is an opportunity to improve a firm’s overall efficiency.
*Sarah-Jane Dennis is a consultant at Investit, a London-based investment management consultancy.