Collateral management information is becoming increasingly part of the investment decision process as traders and risk managers demand more collateral information for determining the cost efficiency of a trade. Investit’s Sarah-Jane Dennis explains how the demand for collateral management information is impacting operational teams at buy-side institutions and she offers a check list for how these teams can become operationally ready for this new information demand.
Q. Apart from the operational changes that collateral management teams need to put in place for central counterparty clearing what other changes should they expect?
Collateral management teams need to brace themselves for being pulled into the organisational spotlight again as when Lehman Brother’s collapsed in September 2008. Although, unlike that event, which eventually faded the spotlight away, the European Market Infrastructure Regulation (EMIR) and Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) are firmly fixing the spotlight in place, bringing collateral management information very much in to the investment decision process.
Specifically it will be the traders and risk management teams with the most active interest in information which can only be provided by collateral management teams and their supporting systems.
The traders will want information to help them determine the cost efficiency of a trade, a calculation that will include the cost of providing collateral. They will want a support service from their collateral management team, advising on the available options and associated costs of each. It is a real possibility that circumstances may be such that the cost of an OTC derivative contract is simply too high to justify it being agreed.
The risk management teams will be focusing on counterparty risk and operational risk. Counterparty risk needs to continue to track exposure to counterparties where there are bilateral agreements and add in to their views exposure to the Clearing Members (CMs) and the central counterparties (CCPs).
Operational risk teams will be involved, not only by the significant re-modelling of the operations for OTC derivatives, but also to update the Own Risk and Solvency Assessment (ORSA) reviews (particularly relevant for insurance firms meeting Solvency II).
Q. It sounds like a lot of pressure on the collateral management team to provide information, will the collateral management team be able to provide it?
Collateral management is certainly increasing in complexity in terms of the number of participants, the types of payment required and additional services being delivered, all of which need to be monitored. Remembering of course that collateral management is not just about the trade, it’s also about the day-to-day management of all of the positions and monitoring collateral levels.
Obviously specific functionality within the collateral management system is needed to impose some form of control over all of the information. There will be a lot of reliance upon the CM to provide much of the data but there are aspects, such as which assets are available for transformation, that the collateral management team will maintain control over.
Q. If you were heading up a collateral management team what would you be doing to check your readiness?
Six key process and procedure type things would be:
Education: Ensure that everyone really understands the services being provided by each CM and CCP. This sounds really silly but we all know that when you have the front office asking you specific details you have to be confident that you understand all the moving parts – especially to start with when there will have to be some explanation to the investment decision makers about the ins and outs of the options available and associated restrictions.
Legal agreements: Ensure it is possible to readily see the status of all of the legal agreements that are being put in place CMs and CCPs, and the status of the updates to the Credit Support Annexes (CSAs) for counterparties that will be involved in bilateral agreements.
Relationship management: Review the relationship with each CM and CCP to ensure that it is being closely managed by the right people, as for any outsourced service. The relationship with the CMs is of primary importance because this is where the collateral transformation and credit line services are likely to reside, each one incurring costs that have to be understood, within predefined parameters and reported back to the front office and risk teams.
Processes and procedures: Obviously there will have been a lot of time and effort put in to the processes and procedures surrounding the new operational model so it is worth checking what is happening for the processes and procedures around bilateral agreements.
Disaster Recovery (DR) planning: The processes and procedures should be tested to see how they perform in the event of a CM or CCP being unavailable. Scenarios should include technical issues that lock out access for an hour, at key points in the day, for a day etc. The failure/collapse of a CM should also be considered.
DR planning: The disaster may well be that the information needed cannot be provided to anyone because of an issue on the asset manager’s side of things, let alone the traders and risk management teams. The processes and procedures should provide the structure as to what to do in such a situation; this is when good working relationships with the CMs and CCPs will really pay off.
Q. From a technical point of view what would be included on a check list of what investment managers should have in terms of functionality internally or via services from their clearing members?
Of course, the sort of things I would be looking for include functionality around the CM and CCP. Ultimately the asset manager needs to know exactly what is held at the various CMs and CCPs for both trading purposes and risk management purposes.
Therefore my questions would be around whether the collateral management system/service:
Supports multiple Clearing Members? Even if an asset manager intends to push all of their centrally cleared OTC derivatives through one primary CM, there will need to be a secondary CM as a fall back. Therefore even the most vanilla set up should include two CMs.
The requirements around CMs include the ability to set up standing data for each CM, enforce any restrictions for the use of a CM, charges, track collateral activity for each CM and support reporting at CM level as well as at a rolled-up top level for the consolidated picture.
Supports multiple CCPs? Although the interaction with the CCP will be via the CM, legal agreements need to be in place for each of the CCPs used. Therefore the system needs to be able to show which of the CCPs each contract has been cleared through for counterparty exposure calculations, hold static data (such as charges) for the CCP etc.
Track over-collateralised positions at the CM? CMs will invariably end up holding excess collateral which is protected by the OTC Addendum to the Clearing Agreement Terms of Business. This represents exposure to the CM and needs to be reportable to the risk team to contribute to counterparty exposure totals. It also provides some ‘ready’ collateral for new contracts so the traders will want to be able to see this information too.
Monitor the use of credit lines provided by the CM? Credit lines may well be used to cover intra-day calls from the CCP. These lines will incur charges so the collateral management team will need to be able to have enough information to know that the credit lines have been used appropriately. i.e. if there is an over-collateralised position then the credit lines should not be the first port of call for the CM.
Q. Clearly there is a lot to think about. What advice would you give collateral management teams at buy-side institutions?
Really all of this can be boiled down to operational teams looking at their service level agreements (SLA) with their CMs and ensuring that they have the mechanisms in place to monitor the information necessary to manage their relations with each of those CMs.
Collateral management teams need to draw on their experience of relationship management that they have developed with supporting bilateral agreements. The change of focus will be that they have to manage the relationship to a SLA rather than a CSA and there are differences.