Jez Bezant explains the importance of collateral management
A couple of years ago I was explaining to one of our fund managers how the components required in the OTC process fit together. Why, you may ask? I’ll tell you later. As you can imagine, I had their full attention as I described the activities and stages within the investment team, but the further we got from the sharp end the more cloudy the eyes. Then I got to collateral. ‘Collateral?’ they said, ‘What has that got to do with me, why do I care?’
Now I had a choice; either explain what is a very important yet operational part of the process to a front office manager, or opt for an easier life and move on. Not being one to give up, I dug in.
‘Collateral’, I explained, ‘is the bit where if your trade is going in your favour your counterparty puts money, or stock, into your collateral account. That way you reduce your credit exposure to your counterparty. It works the other way too of course.’ Faced still with a vacant, yet expectant look, I carried on. ‘it is important for you to know this’, I said, still trying to convince them, ‘because if we don’t get this set up correctly it will affect your ability to trade by limiting how many positions you can have open with a counterparty. Bing! That was it. Suddenly, I had found the sweet spot and the light went on. Vaguely threatening to restrict a fund managers’ ability to trade is like a red rag to a bull. Quite right too! I wouldn’t want anyone to do that to me.
So why did I go there with the fund manager? There were two reasons. Firstly collateral comes from the fund. At the time, we were planning to dramatically increase our trading in OTCs. This would create more demand on the fund for collateral, but also, should the trades go the other way, a surplus of cash or stock. What I didn’t want was the fund manager to trade this collateral.
Secondly, we were planning to completely overhaul our collateral agreements. Striking a tougher line with a zero threshold (the value below which collateral does not need to be moved) was then quite different from our existing agreements and, it seemed, market convention. I fully expected calls to come in from our counterparties and wanted to ensure the desk responded accordingly.
When we started I hadn’t quite realised how overlooked and ignored it had been. Many of the older agreements we have seen have been enlightening. For example, some were one-sided, and not in our favour. Others had such high thresholds that collateral would never move due to the notional value of the trade; others had no collateral terms at all. I strongly suspect this was due to the difficulties in running collateral accounts.
Perhaps also, there was the belief that such trades would be uncommon and therefore credit exposure not a big issue in the grand scheme of things. But times have changed and volumes have increased. If you are considering or have high volumes there are many things to sort out. But an important and time consuming step is to check your collateral arrangements. The details can be found in the credit support annex or deed; part of the ISDA documentation. Get an expert too.
