Collateral management has become increasingly complex with the introduction of new regulation and in particular the move to central clearing for standardised OTC derivatives. In a Q&A, Euroclear’s Cedric Gillerot, Director, Product Management and Collateral Management explains some of the collateral challenges market participants face and how a market utility can provide the mobility and control necessary to operate efficiently in this new environment.
Q. As we near the European Market Infrastructure Regulation (EMIR) deadline for mandated central clearing can you review briefly the significant challenges the market faces in the cleared environment?
There is no doubt that the market faces various challenges in the move to central counterparty (CCP) clearing; the operational change, margin requirements and even legal and documentation changes needed is monumental for CCPs, clearing members and buy-side firms although with varying degrees. There are two challenges of the new collateral paradigm that the Collateral Highway aims to address.
Firstly, financial regulation introduces greater complexity into the collateral management process overall and this impacts all market participants. Some of the processes can be harmonised from an industry perspective, however; there are divergences such as variations in offerings among the CCPs, clearing members and custodians. With greater complexity comes greater margin for error and costly problems.
Secondly, every market constituent has its own collateral management system, operational unit including valuation processes, eligibility checks, settlement process etc. Not only do the nuances within each collateral management process among individual firms complicate process further, but it also introduces significant redundancies throughout the process as procedures are repeated several times over and unnecessarily so.
The Collateral Highway as a neutral market infrastructure layer that sits in between market participants can help the industry avoid these redundancies but also simply the process of control and mobility of collateral through the processing chain and between buy-side firms, custodians and the counterparty to the trade.
Q. Another significant operational challenge in the CCP cleared environment is the requirement for asset segregation under EMIR. Can you outline some of the key requirements facing the industry starting with the different asset segregation models on offer?
As you’ve already stated, EMIR requires that CCPs offer market participants at least a choice between two client collateral segregation models – omnibus and individual. Some clearing houses are also gearing up to offer full physical segregation as well. Each different model comes with its own operational challenges and complexities, which requires support across the entire collateral management chain and from various participants including custodians and CCPs. At Euroclear, we are working closely with the market and all its constituents (CCPs, clearing members, buy-side and their custodians) to define and deliver solutions to address the operational issues that segregation models introduce and to provide greater control and efficiency in the movement, tracking and management of collateral throughout the entire processing chain.
For instance, the full physical segregation requires significantly more operational effort to support compared to other segregation models for both the CCPs and market participants. But whatever the segregation model, the key is to efficiently manage, monitor and track the flow of collateral across the entire processing chain. This means transferring as well as tracking the collateral from one party to the next to meet margin obligations in a timely manner.
On offer in the market is also the quad party arrangement, with four separate parties involved – the client, clearing member, CCP and collateral agent. Quad-party arrangements eliminate a step in the chain in that the clearing member is not an active part of the collateral settlement flow in the sense that the collateral moves directly from the buy-side and its custodians to the CCP.
We are discussing these different models with market participants in order to accommodate their various requirements and to achieve efficiencies in the mobility of collateral to support all models. In particular under a quad-party arrangement supporting individual segregation, the Collateral Highway can facilitate direct transfers of non-cash collateral of indirect clearing members (buy side firms) held at custodians to the CCP. Use of a quad-party arrangement and direct transfer to the CCP gives the buy-side firm more control over their non-cash assets used to meet margin obligations and can result overall is swifter movement of collateral and a simpler process for all parties.
Q. Tell me more about direct transfers. How this is different than how it works currently with clearing members and buy-side firms?
If the buy side client goes through the custodian to deliver its assets for margin obligations through a direct transfer towards the CCP, then it would have a slightly earlier buffer zone time and could not count on pre-funding from the clearing member – quad-party and direct transfers facilitate this movement from the buy-side client and custodian to the CCP.
Currently clearing members are tasked with bridging both the potential time gap and the potential credit gap if the asset manager’s margin obligation requires higher quality assets, which the firm does not have. To fill a time gap, the clearing member would step in to provide the eligible assets required to meet the obligation on behalf of the asset manager and in time to meet the deadline imposed by the CCP. To fill a credit gap, if only lower quality collateral is available then the clearing members still has to bridge the gap for meeting margin requirements, and possibly manage collateral swaps.
A full physical segregation model, whether or not under a quad-party arrangement, will be the most operationally challenging. This is because from a clearing member perspective, the ability to bridge the time and credit gaps historically has facilitated fluidity but these benefits disappear under the constraints of the model. The result from the buy-side view is that the right collateral may not be available when it has to meet the call from the CCP. Solutions such as Euroclear’s Collateral Highway have been developed to meet both sides’ requirements in the most effective way. Specifically this can be done via direct transfers whereby the assets need to meet margin obligations can be transferred directly from the buy-side firm’s account at a custodian to the CCP.
Euroclear’s Collateral Highway facilitates this transfer but also as a global hub offers additional services to help all parties involved to control the movement of assets to various CCPs. It is indeed not just about improving the speed and efficiency of the transfer of collateral initially but also the process of withdrawing collateral due to a change in exposure or conditions of the trade can be a very complex process. In this withdraw scenario both the counterparty and custodian must be involved in the process which further complicates the movement of the collateral as needed and makes the fluidity and velocity of the collateral movements difficult for the entire industry to handle.
Q. Can you explain in greater detail how the DTCC Euroclear Global Collateral joint venture can bridge those two gaps and address the different challenges market participants will encounter?
First let me provide some background. DTCC-Euroclear Global Collateral Ltd, which is a joint venture between DTCC and Euroclear, was formed last year to allow each other’s customers to access our collateral pools in the OTC derivatives space. Specifically, this joint venture brings to market the margin transit utility (MTU) and the collateral management utility (CMU), to collectively deliver more straight-through processing (STP) for the margin settlement through the use of the DTCC newly developed MTU and the CMU. The CMU is fully capitalizing on the existing Euroclear Collateral Highway infrastructure and it specifically addresses the allocation, the monitoring and the mobility of collateral globally.
Global Collateral joint venture will initially focus on the automatic transfer and segregation of collateral based on agreed margin calls for OTC derivatives. The aim of the utility is to centralise the management of the margin call itself and to process and settle the required collateral movements, while being agnostic of the location where the assets have to be delivered and settled. The utility will deliver an open model for both non-cleared and cleared business. Its focus is therefore not just on the clearinghouses but also on all other parties involved in the margin processing chain, including the custodians. One question that is being asked is whether it is possible for an open and utility model to manage collateral between two custodians? The custodians involved in the ultimate exchange of collateral may not have the same operational processes. The objective of the utility is to facilitate these transfers between custodians while allowing the custodian to maintain the relationship with its client. The end result is the process of moving collateral is harmonized and conducted in a seamless manner minimizing the risks of operational breaks in the midst of a transfer.
In terms of bridging the gaps, the utility offers the capability to use one centralized market infrastructure and to fasten the transfer at the right time and place. But again, this isn’t just about the transfer process because when margin is posted and the exposure or conditions change the withdrawal of collateral may be required and become a complex process. In this process both the counterparty and custodian must be involved in the process which further complicates the movement of the collateral as needed and makes the fluidity and velocity of the collateral movements difficult for the entire industry to handle.
Q. We’ve discussed how this works in a full segregation model but what about for the omnibus segregation model?
In practice, the operational set-up supporting the omnibus segregation will most often consist in a transfer of securities from the buy-side’s custodian to the clearing member and then from the clearing member to the CCP. In terms of collateral flow, there is an addition step, and asset class eligibility and traceability is key because if the client is giving one piece of assets to the chain, up to the CCP, it wants to be able to have substitution capability and therefore get a position back.
Considering the possibility of a default is challenging and it can be quite complex because you have to envisage a default of each counterparty within the chain, including portability. There are various scenarios to be assessed, and each and every party along the line must be aware of how it will work in practice, if the worst-case scenario happens.
This is an important point, because it goes back to the question of collateral monitoring and tracking, giving a full control on the collateral chain. That is where, typically, by nature of the business we can provide efficient solutions including to best manage a worst-case scenario, which is a default situation. It is mandatory to have a detailed discussion with each and every party as to the models they want to use and how this will be managed. Use of a market utility is useful in such assessments because it can provide additional controls around collateral flows, which in turn can assist in the assessment of how margin is allocated depending on default scenario.
Q. Looking ahead, how do you see the relationships between the different participants evolving for cleared derivatives?
Part of the challenge that the market is facing is the fact that the assets are held by buy-side clients on the books of the custodian but within the clearing model in Europe, the CCPs have to receive these assets within a securities settlement system. The key objective is to establish a model that offers more assets mobility and access to a wider pool of collateral that satisfies margining requirements. This means perhaps expanding the scope of collateral that can be used by buy-side clients through their custodians in order to meet the requirement from the CCP. This means not only connecting the custodian and the market infrastructure where the collateral will ultimately end up, but also reviewing the assets held in the pool maintained by the custodians and then conducting all relevant checks and monitoring when the collateral is transferred to the CCP.
A global utility, which is agnostic of the asset location, can play an important role because it will enable firms to expand the perimeter of the activities they manage and have greater control over the process. Through use of such an industry utility, market participants will have greater ability to keep up with growing margin requirements because they will have the control and mobility needed. And this streamlined process through a centralised utility can be utilised for cleared and uncleared derivatives collateral flow. It’s about more mobility and giving access to a wider pool of assets to satisfy margining regulation.
