Buy-side firms will clear eligible derivatives via FCMs instead of directly through the clearinghouses, which requires its own specific collateral management workflow. In a Q&A, State Street’s Neil Wright explains how the collateral management workflow is changing for investment managers as needed to support new demands from CCP clearing and rising collateral requirements under new financial regulations for bilateral contracts.
Q. Overall new requirements: What are the biggest changes to collateral management workflow buy-side firms have to contend with? For instance, the new requirement for the buy side (traditional asset managers at least) to pledge initial margin?
A. The biggest changes to the collateral management workflow center around the increased complexity, levels and frequency that collateral or margin needs to be posted. Many buy-side firms who do not post collateral today will be required (along with all market participants) to post collateral or margin on all bilateral and cleared derivatives transactions. For cleared derivatives, a daily posting of variation margin will be required and potentially, during periods of high volatility, intra-day margining may become a reality. For bilateral trades, mandated collateral is a new requirement. Additionally, proposed regulations specify both minimum levels of collateral and what constitutes eligible collateral, which many market commentators expect will lead to shortfalls of eligible collateral. This again will impact the overall collateral management workflow to consolidate all exposure requirements in order to make best use of available and eligible collateral and to minimize collateral transformation needs.
Q. What are the mechanics of how buy-side firms may utilize collateral upgrade or transformation services? What changes to their own internal workflow, such as liquidity management, need to take place to support use of this service?
A. It is anticipated that many market participants will not have sufficient eligible assets available to meet their margin or collateral requirements. A recent study commissioned by State Street found that 37 percent of firms surveyed did not believe they would have the high grade collateral required to trade swaps. To meet this shortfall, buy-side firms will look to their current providers to transform lower quality assets into eligible securities. This is akin to the Security Financing service currently provided by State Street. Buy-side firms are also increasingly looking for more analytics to assist in predicting their collateral or margin requirements to manage liquidity; buy-side firms need to anticipate their collateral needs with comprehensive “what if” analytics. This process should be the basis for “optimization,” to ensure best use of available assets, followed by financing or transformation to meet any shortfalls. It also should be mentioned that the regulations surrounding eligible collateral have not been finalized. There are calls for the regulators to expand eligible assets to include, for example, equities that are part of major indexes and other highly liquid assets.
Q. How are investment managers improving credit counterparty risk management procedures to better mitigate risk in the new market environment? Is real-time monitoring essential for the buy side?
A. Investment managers are increasingly managing the counterparty credit exposure in a number of ways, for example:
• Investment managers are carefully assessing their counterparty credit risk exposure and are increasingly requiring their dealer counterparties to post initial margin on bilateral trades.
• Requiring that all posted initial margin is held independently by third party custodians, such as State Street, under tri-party control agreements.
• Having all collateral tracked with real-time reporting of holding and settlements to provide a manager with complete transparency of contractual and actual collateral held.
A further issue that continues to get attention revolves around the February 7, 2012 rule by the Commodity Futures Trading Commission (CFTC) requiring a new margin segregation model for cleared swaps by Futures Commission Merchants (FCMs) and Derivatives Clearing Organizations (DCOs), known as LSOC; client funds are legally segregated but operationally comingled. This is different from the current segregation model for listed derivatives in which FCMs and DCOs may comingle customer funds. However, many buy-side firms have voiced concern with the LSOC model; although it purports to substantially eliminate “fellow customer” risk, it does not address the risk of loss by the FCMs or DCOs.
Q. Are there any other changes to the current collateral workflow that buy-side firms need to be aware of?
A. In addition to the changes mentioned above, there are two areas worth highlighting; reconciliation and electronic messaging:
• To ensure that collateral is posted in a timely manner and to avoid disputes in collateral calls, it is necessary to keep portfolios reconciled on a daily basis. State Street has deployed an industry leading tool to facilitate this daily reconciliation process on behalf of our Collateral Management clients.
• To further ensure that collateral calls are processed in a timely fashion and in response to requirements from the regulators, the industry is moving from the current practice of e-mailing collateral calls to electronic messaging. Coupled with the reconciliation process, this will lead to a more efficient process, shorten the time for the settlement of collateral and add more transparency.
Q. Looking Ahead: How can firms implement new operational changes amidst ongoing market changes impacting collateral management?
A. Buy side firms have to evaluate their collateral management needs, together with the cost of hiring the staff with the appropriate expertise. In addition, firms need to determine if they want to take on deploying the required technology or look to outsource this key function. The cost of “entry” is significant to build the necessary infrastructure and knowledge to support the collateral and margin requirements in today’s environment. By outsourcing this function to State Street, they benefit from the significant investments and our knowledge gathered that we have made in providing an industry leading service.
State Street offers execution and clearing services for listed derivatives across all major markets through its affiliates, State Street Global Markets, LLC and State Street Bank GmbH, London Branch.
State Street Global Markets, LLC is a futures commission merchant registered in the United States with the Commodity Futures Trading Commission and a member of the National Futures Association.
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