ISDA’s Collateral Management Best Practices Paper offers the industry a clear framework for processing of OTC derivatives collateral. Industry participants weigh in on the paper’s contents and what should be the next focus of market-wide initiatives to improve collateral management procedures in the medium term
The financial industry now has a comprehensive reference guide for OTC derivatives collateral management processes.
Recently the International Swaps & Derivatives Association (ISDA) published “Best Practices for the OTC Derivatives Collateral Process,” which provides a guide for current best practices for collateral management processes for trades collateralized on a bi-lateral basis. The paper is intended to help harmonize collateral management procedures across the industry and to facilitate better control and mitigation of risks.
To the sell side, this ISDA paper is a reaffirmation of current practices. To new OTC market entrants and to the buy side, this paper is a blueprint of standard practices to work towards. And for other industry participants, this paper presents an opportunity to focus on the next phase of industry initiatives in this space.
For the brokers and other sell-side firms, the content of the ISDA best practices document is no surprise, notes Joe Spiro, vice president, product management at The Bank of New York Mellon. “The paper is not intended to affect large-scale change as far as the big dealers are concerned because most of the [principles] haven’t come as a big surprise. The big 14 dealers are probably doing at least 90% of these processes already so the paper is largely a reaffirmation of current practices,” he said.
For the buy side however, these best practices represent different uses based on if an investment manager outsources this function or keeps it in-house, said Sean Sprackling, partner at Investment Solutions Consultants (ISC).
“To those that outsource [the ISDA paper] represents a benchmark against which to measure and monitor the performance of their service providers, whilst to those that run the function in-house, and especially to those with low but growing volumes of OTC derivatives, it represents a blueprint on how to set up and future proof their collateral management operations,” said Sprackling.
The best practices paper provides a comprehensive framework covering a wide range of collateral management activities including tri-party reconciliation, margin requirement calculations and interest processing. The ISDA Collateral Steering Committee, along with various related working groups, has been proactively improving collateral management practices by addressing inefficiencies revealed by the credit crisis. The best practices paper offers an overview of both the work completed and ongoing by the ISDA working groups. For this reason, many of the principles reference other ISDA initiatives and documents, such as the Dispute Resolution Procedure, that offer more detailed specifications and which the principles are largely based on.
Portfolio reconciliation is one of the most important principles included in the paper and was covered extensively.
“Portfolio reconciliation is an important principle because the best practices paper not only went into the format and frequency of reconciliation, but also stated that firms should have internal roles and responsibilities defined, and clear escalation processes identified for resolving the breaks and issues included in the reconciliation process,” said Spiro of BNY Mellon. “This is very helpful for firms to stay on top of disputed margin calls.”
Changes made to internal procedures to adhere to some of the best practices outlined for portfolio reconciliation will be required and may pose cultural challenges to some financial institutions.
Portfolio reconciliation best practices may be more challenging for firms to implement due to cultural obstacles including for instance, potential resistance from the front office team who has historically not been involved in collateral dispute, even when there are valuation or trade population differences, explains Scott Linden, managing director at The Bank of New York Mellon.
“Some of the largest derivatives dealers may not necessarily be following along with the new reconciliation best practices and that is where there can be some serious challenges,” said Linden. “Everyone needs to get onboard with the dispute resolution process otherwise the standard will be ineffectual,” he added.
Improving portfolio reconciliation is a top focus for buy-side firms, explains Sprackling.
He said: “The move to daily, proactive reconciliations post the credit crunch is ensuring that firms have certainty of their exposures and collateral balances,” Sprackling said. “Previously many firms would leave responsibility for oversight of valuations to the front office, but the best practices paper enshrines the need to separate this for the purpose of risk control and specialization.”
The requirement for a clear escalation procedure to speed up the dispute management process will pose challenges to some firms. “For the buy side this will require resources with a new skill set that are currently scarce in the market, and which applies whether or not the function is outsourced,” added Sprackling.
The ISDA best practices paper did not come without a couple surprises.
“The one aspect that was a little surprising to me, and pleasantly so, was the mention of settlement risk practice to keep the trades on the portfolio until settlement date,” said Spiro. “I know there are several major players that do not do this currently, so for ISDA to identify this as best practice is the right way to go from a risk perspective.”
If a firm takes a trade out of the collateral portfolio early (i.e. when the trade is terminated rather than settled), the firm will not be collateralized for that period, which means it will still have the risk exposure of non-delivery against the counterparty. So, from a risk management perspective it certainly makes sense to keep the trade on the portfolio until settlement date to best mitigate the counterparty credit risk, explains Spiro.
One area where the ISDA best practices paper does not go far enough is the standardization of data and file formats for the communication of broker data, said Mitch Schulman, ceo IntegriDATA, a collateral management solution vendor in NY.
Data management is a “monumental challenge” for investment management firms when dealing with collateral management because of the high data intensity of the process, combined with the use of non-standard file formats and complex processes that require use of this data.
The lack of standardization of broker files was a top pain point among buy-side firms who participated in a recent IntegriDATA survey of current practices for processing OTC derivatives collateral.
The IntegriDATA survey, which reviewed operations managers and C-level executives at investment management firms, found that 56% of survey participants complained of broker files being not leverageable for automated data extraction, 52% complained of non-standard broker file formats and 64% noted a lack of industry standard for financial instrument IDs for matching as a pain point.
Schulman said: “The ISDA Best Practices touches on this [lack of standardization of data], but not at the level of specificity and urgency that is required. It urges individual buy-side firms to push for standards, when in fact it should be calling for the entire industry to come together on this critical point.” This means the third party software vendors must step up the data manipulation functionality in their offerings.”
Electronic messaging for collateral calls will also require much more industry coordination in the coming months before this can become industry best practice.
“There’s a lot of merit to the concept and it’s been surprising to me that there hasn’t been more of movement within a quicker timeframe, “ said Linden of BNY Mellon.
ISDA published “Standards for the Electronic Exchange of OTC Derivative Margin Calls” last November which covers the details of the electronic communication of collateral calls including specifications on frequency and content. However, the industry must first agree on some fundamentals before electronic messaging will gain the traction required to succeed.
“They key to achieving the benefits of electronic messaging is transparency around platforms and standards,” said Nick Newport, director at InteDelta. There has been much discussion in the collateral management space as to what the appropriate infrastructure needed to support electronic messaging.
Newport said: “Multiple vendors have entered the market space aiming to fill different parts of the electronic messaging needs of the industry. Debates have been taking place over the use of multi-lateral platforms versus bi-lateral solutions and how the various available technologies will fit together. This has caused confusion for many collateral managers, and has led many to taking a ‘wait-and-see’ approach,” said Newport.
To be successful, the industry needs to clarify how messaging solutions can work together and achieve system interoperability, said Newport. For many firms, electronic messaging is a high priority going forward because these firms are eager to automate communication of collateral calls, which is an integral part of the end-to-end collateral management process, he added.
Linden is hopeful electronic messaging will take shape soon.
“Within the next two years, the electronic messaging initiative should be beyond a few dealers conducting a pilot to where electronic messaging is more entrenched in the day-to-day activities within all major dealers and largest buy-side institutions,” Linden explains. “I don’t think this is an aspirational goal given it’s been a few years since [electronic messaging solutions] have been in development.”
For many investment managers with collateral management functions in-house, the focus today is on automation and improving controls and efficiency. Many firms have much to do to achieve this.
Of the buy-side firms surveyed by IntegriDATA, 40% admitted to not performing certain key control processes such as reconciliation and verifying margin. To IntegriDATA this figure was astonishing after all these firms have been through with the Lehman Brothers debacle, said Schulman.
“The bottom line is, no matter which way you cut it, automation is seriously lacking (primarily due to source data limitations) and these key control processes are most likely propped up by highly skilled knowledge workers,” he said. “In addition, these firms face a potential risk in the case of a loss or absence of key staffers that hold these processes together on a daily basis.”
The buy side is more immediately focused on ensuring that their collateral management processes are “well defined, optimal and fit-for purpose,” said Sprackling. Specifically, buy-side firms are improving processes to allow for daily reconciliation and the monitoring of uncollateralized exposures in a frequent and accurate manner.
Many investment managers are also looking to improve their counterparty risk measurement and monitoring capabilities and collateral management is central to their investigations they try to define how their operations will manage both bilateral collateral management and central clearing via central counterparties clearing facilities (CCPs), noted Sprackling.
Sprackling said: “The focus that is now on collateral management has shone a light on an area that was often ignored by much of the buy side, and has highlighted what an important part of risk management the function is. As a corollary to this, however, it has shown many firms that they did not have the requisite knowledge to keep on top of market practices and the rapidly changing environment, and I see an increasing amount of firms looking to outsource their operations and rely on the providers to provide this skill set for them. “
Consequently, the third party service providers are responding to the buy-side’s growing demand for more services and functionality by upgrading their systems and product offerings accordingly.
“We are improving our solution to offer more customized reporting because reporting is key for an outsource provider,” said Linden who noted BNY Mellon is currently enhancing its client-facing Web portal. “From our perspective, this is an example of what we feel is best practice for service providers,” he said.
* ISDA Dispute Resolution Procedure was published in November 2009 and the updated draft is due this Fall 2010.
* This is the first of a series on Collateral Management published exclusively by DerivSource. If you wish us to cover a specific aspect of collateral management or counterparty risk mitigation practices, please feel free to get in touch at email@example.com