There are still too many moving parts but in the next two years or so OTC regulation will be a firm fixture on the landscape. Lynn Strongin Dodds explains why buy-side firms need to stop procrastinating and pick up the collateral gauntlet.
The pieces of the derivatives regulation jigsaw in Europe are almost complete although there are still some loose ends to tie up. FX derivatives, margins for un-cleared derivatives and moving deadlines all need to be nailed down. It may be tempting to wait for more clarity, but one thing is certain – the clock will not be turned back – and buy-side firms are advised to start their collateral engines now.
As Richard Young, head of regulatory affairs at Swift said, “The regulations are not all in place but we know the broad direction of travel. At the end of the day, margin requirements are going to increase for Over-the-Counter (OTC) trades, and the complexity associated with the necessary collateral movements will grow. I think it would be wrong to wait for everything to be finalised. Firms will need to become more efficient in the way they manage their collateral sooner rather than later.”
Mahesh Muthu, US-based associate principal at operational outsourcing specialist eClerx adds, “There is a big gap between what the industry is hoping and the initial guidance from the regulators. The larger banks and buy-side institutions have the scale to put together collateral management and optimisation systems but that is not the case with small to mid-sized companies. They are doing high level planning and although the minutiae may change, initial and variation margin are here to stay. The challenge is to be able to be nimble enough to hit moving requirements, and potentially deadlines.”
Fergus Pery, EMEA head of OpenCollateral at Citi echoes these sentiments. “Buy-side firms in Europe may now have more time – probably until mid-2016 – before they have to start clearing prescribed OTC derivatives but I think they should start getting ready earlier. They will not only want to test the pipes and processes but also to take advantage of the better pricing that may occur before their implementation deadline.”
Asset managers were only recently given more breathing space – 18 months – to implement OTC clearing after the final edict is issued by the European Securities and Markets Authority (ESMA) slated for the end of the year. By contrast, their sell-side counterparts or those who already clear interest rate or credit derivative swaps at an approved clearing house will only have six months to leap into action. US buy-side groups, on the other hand, just had 180 days to start clearing after equivalent rules under Dodd-Frank came into effect at the close of 2013.
The International Swaps and Derivatives Association (ISDA) is also asking the Basel Committee on Banking Supervision (BCBS) and the International Organisation of Securities Commissions (IOSCO) for more leeway on its proposals for initial and variation margin for un-cleared derivatives. Although the aim of the BCBS IOSCO framework is to steer participants towards central clearing while imposing strict conditions on the re-hypothecation of initial margin collateral, ISDA estimates that un-cleared contracts will still account for a sizeable chunk – about $127 trn worth of the global $600 trn OTC derivatives market.
The trade body, which is asking for a two-year extension, believes that the December 2015 will be too tight. Its research from 2012 shows that in the best-case scenario, the introduction of bilateral margining globally would drain $800 bn in liquid assets from the system and that market participants will need the additional time not only to get their collateral and risk management houses in order but also to sign new legal agreements with clients and in some countries, alter their asset custody arrangements.
In addition and equally as important, ISDA is pushing for a level playing field among countries. It would like to see all of Europe as well as Japan and the US to be at the starting gate at the same time with a more coordinated set of rules to avoid regulatory arbitrage. For example, the US has taken umbrage with some of the European Supervisory Authorities’ (ESAs) recommendations, most notably the potential risk that the “FX Haircut” and concentration limits could present.
Different interpretations of rules are also hindering progress on the FX derivative front. To date, there is a lack of consensus over whether or not FX forward contracts, which are typically entered into for commercial purposes, should be classified as derivatives. There are also divisions over what constitutes an FX spot trade, which is used to purchase a currency for immediate delivery, and an FX forward contract, employed to exchange currencies at a future date at a pre-determined price.
These fault lines were exposed in the run-up to the first European trade reporting hurdle in February. After much debate and discussion, it was agreed that the decision would be delayed and made under MiFID in 2017. This would give ESMA plenty of time to canvass industry contenders and consult with regulators to reach some kind of consensus over terminology. It is uncertain though whether those countries that currently use a “commercial purpose” test to determine whether an FX forward contract is or is not a derivative will change their regulatory guidance or approach in advance of any formal harmonising measures emanating from the Commission within three years’ time.
It is not surprising perhaps that given the backdrop financial institutions, are at various levels of preparedness. A recent study conducted by consultancy Rule Financial and software group 4sight showed that very few – only 4% – of the 25 buy and sell-side firms questioned had fully picked up the collateral mantle although around 46% though were in the process of implementing their target operating model while 27% had just defined their archetype. Only 23% were still at the drawing board.
“I think different firms are at different stages but brokers are spending a huge amount of money assessing and re-engineering their collateral management processes,” says Ted Leveroni, executive director of strategy and buy side relations at DTCC. “They are also looking to see where they can share processes and leverage industry utilities to find community-based solutions. The buy side are preparing but with less urgency and scale in part because the implementation date for most investment managers is further out. There is also a large number of asset managers who have never had to deal with collateral management so there will be a steep learning curve.”
The operational and technological challenges should not be underestimated. As the Rule Financial study points out, the level of complexity has jumped significantly. Buy-side firms will not only have to trade via multiple clearing brokers but also clear trades through numerous central counterparties. Moreover, many will be posting initial margin for the first time and will have to learn a completely new set of collateral ropes as well as come to grips with the different and nuanced segregation models at the different central counterparties (CCPs).
There are five basic models in Europe on offer including fully segregated, individual and omnibus accounts. The latter come in two varieties – one where the margins are computed and transferred net and the other where it is calculated gross. Clients can also select between receiving the exact asset or the value of the asset back in case of a clearing member or CCP going under. It is far easier in the US where there is only one structure to contend with – a legally segregated but operationally co-mingled account.
Two of the biggest challenges, according to Pery, are risk and operational risk management. “On the risk side, it means choosing the proper segregation model, which vary across the different clearinghouses and clearing members. On the operational front, it is important that investors have sufficiently robust systems to handle and deliver margins on based various models, as well as comply with the different regulations.”
One result is that brokers, custodians and CCPs will have to prove their mettle. Those that do will have the edge. “The buy side had been focused on meeting the trade reporting requirements and now what we are seeing is that they are moving onto the next step – the central clearing model,” says John van Verre, head of global custody and treasury services at HSBC Securities Services. “The main topics of discussion today are around the appointment of a clearing broker and a collateral management service provider. Buy-side firms also want to be sure that their clearing broker is using a CCP they are comfortable with. From the collateral manager, they want to know whether they can support all the necessary processes in an efficient and cost effective way. It starts with the traditional valuation and reconciliation services to meeting the different margin calls and expands to mobilising, optimising and transforming the collateral and the reporting.”
Mike Landolfi, managing director of BNY Mellon’s global collateral services business also believes “financial institutions who can provide a clear view of what needs to be collateralised, how to collateralise it, where their collateral is, and how to efficiently deploy that collateral through optimisation and transformation will have the advantage. Many sell-side firms already have these processes in place and while it will be a challenge to build out these capabilities particularly for the bilateral space, it should also be seen as an opportunity.”
