The communication of bilateral margin calls is currently manual and therefore inefficient, error-prone and costly. In a Q&A, SWIFT’s Banu Apers explains how use of a standardised electronic messaging capability can reduce counterparty risk and brings a firm’s collateral management operation up to speed with market best practices.
Q. Why does the market need electronic messaging for margin call communication?
When we look at the current Over-the-Counter (OTC) derivatives market and the changing business dynamics, we come across two main themes: increased transparency and risk reduction. Financial institutions are geared towards achieving transparency and creating a controlled operational environment in line with the regulatory framework developing in Europe, UK and US.
Post-Financial Crisis
The financial crisis re-emphasised the importance of counterparty credit risk. The subsequent industry-led program of reform has addressed many of the shortcomings of the OTC market.
The current regulatory focus is standardisation of OTC derivatives and migration to central counterparty clearing (CCP). While this should increase transparency, reduce counterparty credit risk and allow better regulatory oversight, concerns remain over loss of flexibility, increased cost of financing positions, management of exposure across multiple systemically important venues and disruption over the transition period.
Despite the crisis, OTC derivatives are here to stay. The market is expecting to see a stable growth of OTC derivatives activity and most complex and bespoke contracts will continue to trade on a bilateral basis for the foreseeable future.
A Commitment to the Regulators & Part of the Roadmap
Taking into account these expectations, during the course of 2010 the International Swaps and Derivatives Association (ISDA) has been working very intensively and closely with market participants and industry associations to lay the foundation of a robust roadmap to strengthen the OTC derivatives market. In fact, last year, ISDA announced further industry commitments towards regulators, such as the Federal Reserve Bank (FED), in support of initiatives focused on central clearing, transparency, standardisation, operational efficiency, and bilateral collateral arrangements. Complementing their commitments to regulators, ISDA has also published a “ 2010 Roadmap for Collateral Management”. As part of the roadmap for improvements to the OTC collateral process, market practitioners have also committed to continuing the drive towards standardisation and electronic communication of margin calls. There is also a concerted effort amongst market practioners for better coordination across firms and vendors as a way to improve market efficiency and reduce systemic risk.
Reducing Operational Risk through Automation
Collateral management is a highly procedural activity which spreads across various functions and departments. It also involves various risks to firms accepting and monitoring of collateral as part of the transactions.
Currently sending e-mail messages, phones and faxes are the primary mechanism used to make margin call on OTC derivatives trades. However, business process based on these mediums to exchange information remains highly inefficient and prone to operational errors.
Market practitioners are not only looking to exchange margin information in a standardised approach but also electronically in a secured manner.
Expected key benefits from electronic margin call communication are enhanced and aligned operational environment, minimised risk, an improved overview of a margin call life cycle and management of counterparty exposure and collateral positions at any time during the event life cycle.
Q. Why has SWIFT got involved?
From our perspective, we consider standardisation and messaging as the core competencies of SWIFT. SWIFT offers messaging solutions in various business areas. If we look at the life cycle of a margin call, the final stage is the movement and the settlement of the bilaterally agreed collateral in the market place. SWIFT already has a prominent position in the settlement messaging space, therefore, it was a natural progression for us to move into margin call messaging.
SWIFT is owned by the banks and is therefore encouraged by financial institutions to bring standardisation and enable automation across various segments, including collateral management.
Beyond the marging call messages, SWIFT also offers a widely accepted tri-party collateral management messaging solution to service our customer’s needs in relation to their tri-party agents.
Complementary to our standards and messaging, SWIFT also offers a globally available secure network connecting more than 9,500 banking organisations, securities institutions and corporate customers.
Q. How does the SWIFT margin call messages work?
SWIFT’s bilateral collateral management messages are developed based on ISO 20022 methodology. The suite of messages is there to reflect the nature of a margin call communication bilaterally, which is different from a CCP or tri-party margining. The life cycle of a margin call incorporates a conversation like approach based on certain actions to be taken at certain times.
Our suite of messages incorporates standards starting from margin call request to agreement of underlying collateral. Through this approach we provide the flexibility to vendor solutions or in-house collateral management applications to maintain their own workflow and decision making process and enable them to link the message component at a stage relevant for their own operational flow.
In addition to margin call messages, SWIFT also provides messaging in complementary business activities such as substitution and interest payment processing and reporting as part of the complete bilateral collateral management messaging suite.
Q. What are the benefits of automating margin call communication?
Market practitioners are looking to standardise and automate any manual, repetitive tasks as much as possible in order to decrease the operation risk, manage counterparty risk at a better scale. Although the move towards CCP margining is there and will continue to grow, bilateral collateral management will not disappear in the foreseeable future. The volumes and the number of legal agreements signed between parties are increasing every year at double digits so the demand for automation and STP is increasing. During the 2008 global financial crisis, the industry experienced the sudden impact of the market volatility in the collateral management space. At that time collateral management went from a routine middle office task to centre stage as a key tool to mitigate counterpart, credit and operational risk. Lessons have been learned and now the industry is working together to set the best practices and solutions to ring fence the operational environment for collateral management.
Market practitioners are looking ways to monitor their activity and position as much as possible, at any time during the life cycle of a margining.
Q. What’s next for this evolving space?
The regulatory space is rapidly evolving and as of end of Q2 2011, we should start to see more implementation and adoption of various solutions enabling increased transparency and automation, which will ultimately lead to risk reduction in this space.
The pain point and focus right now is clearly on OTC derivatives, but as we address those issues, we see the industry looking to expand into other asset classes such as securities lending and repurchase agreements (repo).
Moreover, while a lot of the focus seems to be on bilateral process, there is also a growing demand for the standardisation of CCP margining in different asset classes. From a SWIFT perspective and to meet the changing the requirement of different models, SWIFT is also launching complementary messaging solution in the space of CCP margining. Our objective is to provide a suite of messaging solutions tailored to the business needs of different models such as bilateral, tri-party and central clearing.
With regards to collateral management, SWIFT will continue to evolve and incorporate the market requirements. We will continue to work with industry bodies and regulators closely to reflect and to respond to their needs in this space. As an industry cooperative, we are in a great position to work with the community to help set the best practices and guidelines around messaging standards.
