The challenges of adjusting collateral management processes to support the new OTC derivatives market infrastructure highlights the importance of a integration between trading, and pre- and post-trade processes across asset classes, explains Chris Zingo, EVP & head of Global Sales, Calypso Technology. Comments from the recent DerivSource podcast.
Collateral management has always been the principal risk mitigation tool associated with OTC transaction and counterparty risk; however, the new regulation mandating central clearing with central counterparties (CCPs) will dramatically increase collateral requirements going forward, creating opportunities for some institutions and operational challenges for most.
The market projections for additional collateral associated with cleared transactions is $2 trillion to cover exposures, but assuming the trend towards clearing continues by 2019, it is estimated that 80% of the OTC market will be cleared, thus requiring $6 trillion of additional collateral.
The demand for collateral is going up, yet the eligibility of collateral is being squeezed, as the requirements imposed by the CCP are narrower than those of traditional bilateral agreements between two banks. Higher quality collateral is being held in margin accounts, which will impact the liquidity of underlying bonds or instruments used as collateral.
The liquidity issue potentially creates systemic risk. The principal requirement for the eligibility of collateral is whether there is sufficient liquidity. Going to the market to source bonds to cover liabilities can ultimately lead to losses.
The market is contending with this issue in a several ways: firstly the CCPs are exploring changes in their risk management policies and secondly, they are reviewing the concept of collateral transformation. Many clearing brokers, Future Commission Merchants (FCMs) and third party providers are looking for ways to support collateral transformation services in order to extend credit to their customer, by taking lower quality collateral and transforming it into greater collateral to cover the risks associated with CCP cleared transactions. Collateral transformation services generate profit and this is the way in which the market is contending with it.
The traditional risk mitigant of portfolio netting is another response being tested by the market. Netting exposures can lower overall risk profiles and margin requirements. The concept of cross margining and whether OTC transactions, cleared or non-cleared, can be integrated with futures exposures in order to lower overall risk and collateral posts is being considered by the industry generally.
These are the major issues discussed today, as a large number of providers in the market including clearing brokers, asset services, custodians or third party technology providers are looking for ways to support these dynamics.
In general, there are two main streams of how the market is responding to the collateral for clearing issue. On the one hand, CCPs are offering the market the benefits of cross margining as they trade futures contracts as well as clear OTC contracts. Alternatively, FCMs claim to offer broader visibility with their customer portfolios, offering them the opportunity of netting thereby reducing overall risk exposure and overall collateral required. FCMs are looking at ways to provide these services in order to capture more market share and mind share with their customers.
For the end user, there are many business and technological considerations. The derivatives front office needs to be able to quickly conduct pre-trade analysis to determine the most cost-efficient venue for clearing. It needs to be able to value both derivatives and cash products in order to benefit from any cross-margining or portfolio netting potential. At the same time, it needs to rapidly assess in-house collateral and determine if pledges are optimal, a task historically designated for the back office. Hence, many of the traditional back office functions require tighter integration front office activities. In summary, the challenges of collateral management created by the market structure changes highlights the importance of a derivatives operations that integrates trading with all the supporting pre- and post-trade processes across asset classes.
