How are investment managers improving collateral management processes three years after the Lehman Brothers default and one year after ISDA published its best practices ‘guide’ for the market? DerivSource’s Julia Schieffer talks to industry participants about their view on true market practice and concerns on managing margin within a central clearing environment.
A year ago, the International Swaps and Derivatives Association (ISDA) set the benchmark for best practices for collateral management with its “Best Practices for the OTC Derivatives Collateral Process” paper however, the buy side is still working out what market practice should look like for its sector, and especially within the scope of central counterparty (CCP) clearing of Over-the-Counter (OTC) derivatives.
The buy side, like all market participants, is focused on strengthening credit counterparty risk management practices amidst market volatility and especially after the default of Lehman Brothers nearly three years ago. In fact, this focus on risk within a newly re-instated investment operations committee at the Investment Management Association (IMA), the UK-based buy side trade association has prompted the committee to establish a working group to review market practices for collateral management for OTC derivatives within its members.
Specifically, this group is comparing the current collateral management practices of its members with those outlined in the ISDA best practices document for the purposes of ultimately creating its own outline of collateral management market practices, said David Broadway, senior technical advisor at the IMA and responsible for the investment operations committee.
“The group wanted to better understand if their internal operations concurred or didn’t with what others are doing,” said Broadway. “The outline is likely to show what firms are doing so others can see if it lines up with their own practices or if it proves they are doing something different.”
Publishing guidance papers is commonplace for the IMA, which has done previous reports on operational risk for instance, but members flagged collateral as a significant part of the current concern with risk management generally.
So far, the working group is finding that the ISDA best practices do generally reflect the market practices followed by the buy side.
Broadway said: “The ISDA best practices do appear to be largely workable, at least for the working group members. There are only two to three points where firms say they work differently and there are an additional 10 to 12 points where guidance is flexible but we’ve been able to pin down more specific practices within the group.”
He declined to specify which of the few points posed some diverging practices but noted 90% of the ISDA best practices are in line with what members are currently doing.
Once completed the IMA committee will publish an outline of the identified collateral management practices to be shared with other IMA committees before drawing conclusions. After completing the review of collateral practices for OTC derivatives, the committee aims to evaluate practices for other asset classes including repurchase agreements (repos), forward FX and possibly securities lending in the new future. The group is not looking at central clearing given the market uncertainty whilst the regulation is still being formalised, noted Broadway.
One of the major takeaways from the credit crisis of 2008 was that all market participants, but especially investment managers, needed to increase the frequency of margin calls from monthly or weekly to daily. However, a recent survey conducted by Algorithmics and Chromozome Consulting found that approximately 50% were not doing daily margin calls but weekly margin calls. This survey – “Collateral Management for the Buy Side: Emerging Challenges and Best Practices in a Changing Regulatory Environment,’ surveyed financial institutions in the fourth quarter of 2010.
The high number of firms not doing frequent margin calls was a ‘surprising’ finding given the focus on risk management and events of the last three years, said Neil Murphy, director collateral product management at Algorithmics.
About 40% of respondents said the failure to move to daily margin calls was the result of a lack of risk resources whilst others cited operational limitations. However, Murphy isn’t buying this excuse of lack of operational capacity for such a crucial task for risk management.
“So [firms] are trying to improve risk management but then choosing not to do something because [the firms] don’t have the capacity?” questions Murphy. “If you were to go to an investment bank you would see a lot of junior staff in the back office and there is not a huge cost to get staff to communicate with the brokers everyday to ask for the collateral.”
System limitations was another obstacle citied among survey respondents which was also an unexpected challenge because all the systems on the market can provide this daily or even intraday if required, said Murphy. “If you’ve got the system and infrastructure in place to do that weekly then there is no reason that it can’t be done daily,” he said.
Also, approximately 80% of the survey respondents said they use vendor systems or outsource collateral management to service providers so the true reason behind the system limitations excuse could be cost.
When firms outsource, obviously that cost is driven by the number of collateral relationships, credit support annexes (CSAs) or the number of margin calls, so investment managers could be opting to make margin calls only on a weekly basis (instead of daily) to avoid an increase in charges by their service providers, Murphy speculates. In short, cost of operations could be the true driver behind this system limitations comment.
Charges by services providers should not be prohibitive if the most appropriate fee structure is selected, argues Rajen Shah, global head, collateral management for Citi’s Securities & Fund Services.
“I think there are certainly ways in which a buy-side firm can negotiate the pricing so that its not dependent on activity per day and therefore [the clients] are not going to have that kind of issue from moving to weekly to daily margining,” he said.
In fact, most of Citi’s clients are doing daily margin calls.
“The general trend is to make the margin calls more frequent, but in most instances, we’ve seen [buy-side clients] are already doing them daily,” he said. However, ‘operational process is the challenge,’ which is why many buy-side firms tended not to do daily margining pre-Lehman Brothers’ default, he added.
A buy-side operations manager was also surprised by the low percentage of firms supporting daily movements reported in the survey, but he attributes this to operational capabilities of different types of firms.
He said: “There is likely a significant disparity between the processing capabilities of large asset managers versus more boutique firms and the cost and resource required to perform daily collateral management is perhaps a stumbling block for some.”
Possibly the greater challenge is that the buy side needs to change its view of margin management.
“Lehman proved that this risk management and protection is important to the buy side as well (to manage exposures) so financial institutions should start to view daily margining as an important risk mitigation tool rather than a burden,” said Murphy.
Also, daily margining will become mandatory as the market moves to central clearing so the buy side will have to strengthen collateral management procedures to meet the new CCP standards.
“For firms doing [margining] weekly now, they will have the most to do [to prepare] as opposed to those firms doing margining daily already where the move to intraday will be a much smaller challenge,” said Murphy.
With increased CSA volumes and central clearing, collateral activity will grow significantly for investment managers so the buy side is looking to use a wide range of assets, such as equities, for meeting margin requirements with counterparties. In the Algorithmics/Chromozome survey 55 percent of respondents said they wanted to be able to see equities and other non-cash instruments become eligible for use as collateral.
“It is a logical request that the buy side want to use equities – how they are going to do that in the central clearing environment is a challenge because clearing will restrict the types of eligible collateral available to market participants,” said Murphy.
Jane Lowe, director, markets for the IMA is hopeful that legislation in Europe for the European Markets Infrastructure Regulation (EMIR) will widen the provision of collateral eligible for meeting central clearing margin requirements and the onus will be put on the clearinghouses to provide wider collateral solutions.
“I think we are completely at one with the regulators on wanting very high quality collateral, but we happen to think it should be much wider than just cash,” said Lowe.
The movement of cash and conversion of other types of collateral into cash creates other problems for the buy side and investors.
Lowe said: “Institutional investors often have large, directional trades and so they are going to have to put up a large amount of collateral. That’s fine, but [investors] don’t want to put up purely cash margin because that means they may have to sell more productive assets in order to raise the cash, or have to transform their assets through a bank which then raises all sorts of security issues.”
The ideal situation is for the CCPs to have arrangements in place to be able to handle collateral beyond cash, she added.
Collateral eligibility is one of the many moving parts to clearing conversation for investment managers and CCP support would be a cost-effective option, agrees the buy-side operations manager.
He said: “If collateral transformation is offered as a service it is important to understand the cost implications associated with this, broader collateral eligibility at CCP’s would remove much of the need for this service and any potential additional costs.“
In the case of a lack of support on the CCP end, many buy-side firms are looking to the general clearing members (GCMs) / futures commodities merchants (FCMs) and service providers to offer collateral transformation or collateral upgrade services to bridge the gap in assets available and assets eligible for central clearing.
Clearing is going to increase the amount of collateral some firms will have to post potentially by five fold and when 70 to 80% of collateral used to cover derivatives contracts is cash, some buy-side firms will have to utilise collateral optimisation services to meet these collateral obligations, said Shah.
In response, the buy side is focused on three areas of collateral optimisation: at the execution phase, what trade will get the firm the most margin relief; how to leverage the assets it already has through use of collateral asset servicer’s upgrade services; and how to achieve the maximum amount of netting possible, he said.
In addition to the cost of collateral, investment managers are concerned about the investment required to establish the infrastructure and technology needed to connect to the CCPs, and then support processing of these trades including managing the margin requirements and risk associated with this margin posted.
“All of that [infrastructure] adds up to a lot of cost. And especially when the buy-side client isn’t going to do the volume that, for example, a sell-side client, would,” said Shah. “ So, a lot of clients have concerns about the cost and asking how we [as service providers] can help them with more of a ‘pay as you go’ model around that cost.”
Investment managers are also concerned about the risk associated with posting margin to the selected GCMs/FCMs for use to cover centrally cleared transactions and are investigating collateral segregation structures at the CCP and service provider level, added Shah.
Segregation of assets is a ‘common concern’ with many buy-side participants and many want full segregation, said the buy-side operations manager.
“The CFTC proposed model of legally segregated, operationally co-mingled seems to provide a balanced solution between legal comfort and reasonable cost for managing,” he said.
Collateral eligibility, segregation and costs are the larger questions the buy side seeks clarification on ahead of moving to central clearing but the buy side needs to start preparing for central clearing and the impact this will have on collateral management processes. However, some firms are waiting for the rules toe finalised before they take action. Service providers are aware that firms adopting this ‘wait and see’ approach means that it is highly likely that there will be a long trail of clients requiring services at the same point in time and the providers won’t be able to cope, said Shah.
He said; “As a service provider, that’s what we fear most – that mad rush at the end, and that’s what we are trying to avoid.”
The degree of preparedness varies by firm, explains the buy-side operations manager.
“It is difficult to say when firms will start preparing if they haven’t already,” he said. “It’s apparent from recent press that large buy-side firms are already conducting transactions through the cleared model and it would certainly be prudent for others to consider doing so.”
