Efficiencies for Over the Counter (OTC) derivatives have been driven by uncleared margin rules in recent years. The industry’s focus has rightly been on compliance with initial margin (IM) regulations waves 3, 4, and 5, but firms need to make sure these technology investments and operational improvements benefit their collateral management operations across the board. Amy Caruso, Director at DTCC and Chief Commercial Officer, DTCC-Euroclear Global Collateral Ltd, discusses the need to manage liquidity and capital, margin calls and substitutions and settlement confirmations more holistically using a single process for all types of derivatives trades.
The current industry focus on IM for 2019 and 2020 is absolutely necessary, but just as you need to look ahead of your car on the highway, you also need to have a view of the many lanes running parallel. There needs to be a focus on liquidity and capital management and how we can use straight-through processing (STP) efficiencies for additional derivatives’ collateral processing.
As more firms are looking at their hedging strategies and their use of capital with derivatives trading, they may be looking at Cleared Flow, Repos, To Be Announced (TBA) transactions andOTC Swaps and Forwards. They should also be looking at their operations holistically, including their STP for margin calls and substitutions, collateral settlement and data reporting needs and how these operational improvements can positively impact capital and liquidity needs.
Bringing increased STP to all margin processing – across market participants
Having one similar process for all types of margin calls and collateral settlements, including Exchange Traded Derivatives (ETDs), OTC Cleared, Repos, and TBAs beyond OTC swaps and forwards allows firms to have a holistic workflow and capital and liquidity management program. All collateralized processing should start and end with the same data points and have the same or very similar workflows. Increased regulatory requirements, such as FINRA 4210 for TBAs along with increased trading volumes in clearing, and margin and collateral demands impact the wholelandscape, not just uncleared swaps. Each type of market participant may have a different priority to seek out STP across their margin processing, but they all can benefit from STP:
Futures Commission Merchants (FCMs): STP is not just about operational efficiencies and reducing exception processing and fails that can be costly, but confirmation of settlements can improve regulatory compliance and funding needs. For example, to meet regulatory requirements, FCMs have to report to their regulators that they actually received client’s collateral by the end of day or they have to fund it on their clients’ behalf. Having confirmation of settlement intraday helps with the end-of-day reporting crunch that can lead to funding strains.
Buy-side firms: Orchestrating one similar collateral management and settlement process does not only improve operational efficiencies, but streamlining the process can improve financing and investment performance. Whether an investment strategy trades a futures contract, an OTC swap, a Repo, or a TBA, the margin call and collateral settlement process with position reporting should be the same or very similar to ensure effective counterparty risk and liquidity management.
Buy-side firms and Sell-side firms: We are seeing more and more resources coming together. Gone are the days that you had someone on a Repo desk who never spoke to someone trading Swaps, or you had one pool of collateral that was used for ETDs and another pool of collateral that was used for TBAs. Both buy-side and sell-side firms are constructing teams where data and resources come together to make the most profitable decision. STP and confirmation of settlement with standardized end-of-day reports can provide streamlined efficiency to aid in that decision.
Custodians:Whether a custodian is processing a settlement for an ETD margin call or an OTC margin call or any other collateral settlement, the process should be the same between the client and custodian; the communication of the settlement confirmation should be the same as well.
Collateral management STP reduces counterparty risk with substitutions
Counterparties need to know where their collateral is and how to efficiently process a substitution. This is the case whenever there is a downgrade of a counterparty and a firm needs to do a mass collateral substitution, if there is a quarterly roll of securities posted as collateral, or if there is an immediate need for a specific security to be replaced and recalled due to a liquidation.
With IM for Exchange Traded and OTC Cleared derivatives, substitutions processing can be a challenge. The FCM tries to get the collateral that has been posted back from the Central Counterparty Clearing House (CCP) and then pass it along to the end client in a timely fashion. In many cases the end client wants to receive the same collateral that they posted – not a similar security or cash in lieu of the security. Getting back that same security is very important for duration hedge matching purposes within some investment strategies.
Substitution processing for securities can add another layer of operational challenges when the FCM is reaching out to the CCP. DTCC-Euroclear Global Collateral’s (GlobalCollateral) Margin Transit Utility (MTU) will simplify this process. The MTU will send the substitution instructions to the FCM’s custodian and incorporates “smart substitution,” so the collateral doesn’t get recalled until the replaced item is received. This is an improvement on current processing, which is operationally intensive and requires calling back and forth, checking portals, or emailing the FCM or the custodian to confirm the replaced item has been received before the recall can be initiated.
One thing to note is that as interest rates rise, the use of cash for collateral is decreasing in areas where securities may be used. In Exchange Traded and OTC Cleared transactions, firms must post cash for Variation Margin (VM), but not for IM. Firms may decrease using as much cash for IM because they need to use it for VM and posting securities may be more effective per investment performance objectives. And with more securities being used, substitutions will increase.
This same streamlined substitution process can be of efficient use with OTC derivatives and TBAs, further ensuring that liquidity management is as efficient as possible across multiple product types.
MTU enables more holistic collateral processing
GlobalCollateral’s MTU enables firms to process collateral for multiple types of collateralized instruments, and not just OTC bilateral but TBAs, Repo, Interest payments and ETDs as well as OTC cleared. By having one similar process across multiple products, MTU can help reduce operational friction and improve capital and liquidity management – for a custodian, buy-side firm, dealer or FCM.