Brown Brother Harriman’s Stephen Bruel looks beyond the collateral craze to offer insight into how collateral management infrastructure needs to change so the buy side can thrive in the new OTC derivatives space.
HOW WE GOT HERE
The financial press has been discussing the many changes that collateral managers will face, using worrying phrases such as “collateral liquidity crunch” and “collateral scarcity”, and new terms such as “collateral transformation” and the “collateral upgrade trade.” This article provides context as to why these phrases are emerging, highlights key regulatory considerations for collateral managers, and discusses how industry collateral management infrastructure must change to accommodate the ever-changing derivatives environment.
The 2008 financial crisis and the role derivatives played in it compelled regulators to reexamine and reengineer the entire derivatives market structure. The disruption to the derivatives market is already underway, primarily as a consequence of behemoth regulations such as the Dodd-Frank Act (DFA), European Market Infrastructure Regulation (EMIR), Basel III and others. But new global regulations are not the only driver. Business practices are changing because of increasing pressure from stakeholders, such as boards of directors and institutional investors, for improved transparency, standardization and risk management.
An inherent part of bi-lateral swap transactions is the associated counterparty risk, and the means to collateralize that exposure will always be a paramount risk management function. Given that counterparty risk is tied to swap transactions, it is important that investment managers understand that this risk assumption can be mitigated – though not eliminated – through robust operations, sophisticated technology and a strong commitment to collateral management. While counterparty credit risk will remain a constant, how it is managed is in flux. Collateral management practices will increase in importance and must change to accommodate the emerging derivatives market structure. While the drivers and implications of change can be different for an asset manager as opposed to a diversified global bank[1], in either case, accommodating tomorrow’s collateral management environment requires a new strategy.
UNDERSTANDING DERIVATIVES COLLATERAL MANAGEMENT
In the new regulatory environment, the total cost of trading swaps, including the cost of collateral, will increase. Some asset managers may change their trading strategies to avoid the increasing collateral obligations. Others will look for ways to minimize those costs so that derivatives can remain a part of their portfolio. If derivatives remain, asset managers should think strategically about their collateral management practice and address key questions, such as:
– What are the goals of the front office and how must collateral management change to support those goals?
– What does an overhauled collateral management best practice look like, and how do I get there?
– How will my network of counterparties change?
– What are the potential netting opportunities I could have across counterparties and between listed and over-the-counter (OTC) products?
THE EVOLUTION OF COLLATERAL MANAGEMENT BEST PRACTICES: THE IMPACT OF CLEARING
Traditionally considered a middle-office function, derivatives collateral management helps protect an entity from counterparty risk by calculating counterparty exposures, and requesting or pledging collateral to cover open, unfunded economic exposures. The function is integral to swaps trading as swaps create counterparty credit exposure through the life of the trade.
In current industry practice, core collateral management is primarily an operational process comprised of a few steps. One particularly important regulatory change impacting collateral management practices is the mandate to centrally clear certain liquid and standardized swaps, which is something that many asset managers have not done before. While the new clearing requirements will reduce the number of bilaterally managed derivatives, the requirements could actually increase the complexity of managing collateral.
Broadly speaking, two types of derivatives existed before DFA and other such regulations. Those two types are:
- – listed and traded on an exchange, such as futures and options;
- – bi-lateral trades, executed OTC but not centrally cleared, including, but not limited to, swaps. [2]
Regulation adds a third classification, cleared swaps, which must be cleared by a central counterparty (CCP).
The daily margining requirement for cleared swaps will increase the volume of collateral movements. In addition, the stringent risk management practices of CCPs could increase the value of collateral that must be pledged, depending on netting opportunities. The forthcoming margin rules for uncleared swaps margining will also exacerbate the need for collateral.[3] The combination of these rules will increase the front office’s swap trading costs – by how much will partially be determined by the effectiveness of the collateral management program.
Another daunting issue is the changing definition of what is considered eligible collateral. Oftentimes, CCPs have greater restrictions on what can be pledged than what might exist under a credit support annex (CSA), and furthermore some counterparties are tightening eligibility requirements within the CSA.
ENHANCING THE FRONT OFFICE
The three drivers impacting collateral management are higher volume[4] of collateral movements, increased value[5] of collateral required, and more restricted eligible collateral. More assets need to be earmarked to cover the new collateral requirements, limiting the front office’s ability to use these assets to generate portfolio returns. Good collateral could become scarce, and there will be competing priorities for the use of collateral within a firm. Collateral transformation is one potential solution, though not appropriate for all. Firms must consider collateral as a valuable resource, and therefore must view their collateral management practice not simply as a series of operational steps but rather as a discipline that maximizes collateral efficiency to reduce the impact of collateral on portfolio performance.
The pace and intensity of the industry’s change is highlighted in the diagram “Increasing Complexity: Collateral Management Requirements Build Over Time”. Challenges in collateral management are not going away. They are building in a cumulative manner. The gap between what could pass for a viable collateral management infrastructure prior to the crisis and today is noticeable, but could be closed with some improvements. The gap between what is viable today and what will be required for collateral management in the future is far more significant. Not only are there more challenges, but also the complexity of these challenges is increasing. When a firm moves from one phase to another depends on factors such as trading strategies and legal jurisdiction, however the need to evolve collateral management practices is universal.
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Collateral has historically not tended to be a limiting factor in the front office’s trading decisions, but that will now change, increasing the need for transparency into the key collateral analyses, metrics and processes, and requiring increased communications between the collateral management team and the front office.
STEPS TO COLLATERAL MANAGEMENT BEST PRACTICES
To bridge the gap, some of the key steps to develop new collateral management best practices include:
- – Improve eligible collateral inventory management tracking
- – Institute sophisticated collateral optimization tools to ensure the most efficient collateral usage
- – Identify opportunities for netting across counterparties and asset classes
- – Develop tools to analyze collateral implications before a trade is executed so that the optimal execution path is followed
- – Explore the need for collateral transformation services
- – Build capacity to increase the frequency of collateral substitutions without straining operational resources
- – Minimize operational pain points (e.g. settlement fails)
A combination of the above actions should alleviate collateral pressures faced by the front office. There are several paths asset managers can take to adapt their infrastructure for the industry’s new collateral management model. Certain managers may opt to mange this function in-house. Others may have a desire to outsource the collateral management function to a provider that has made the investments, lived the market’s evolution, and consequently has deep knowledge about the new practices impacting asset managers.
PROSPERING IN THE NEW ENVIRONMENT
Risk assumption is a necessary part of the financial industry, and robust risk management is a necessary pre-condition to that risk assumption. Regulators are concerned with excess risk-taking, as demonstrated by their reaction to the 2008 financial crisis. The resulting action has been to introduce new business practices into the market, such as the mandate that swaps be cleared. Some asset managers have never cleared a swap nor managed the associated collateral. These new, unfamiliar requirements are worrisome for many; however, there are mechanisms to assuage those fears.
The collateral management industry is in the midst of its most significant transformation. There has been much attention to this fact, causing great uncertainty. While the industry changes are dramatic and regulatory priorities can shift, making the right investments and adhering to new best practices can alleviate those concerns and limit the angst. Though there is choice in how asset managers undertake implementing a collateral management solution, one that has the flexibility and robustness to thrive in the new environment is not an option, rather a strategic imperative.
[1] For example, the Liquidity Coverage Ratio requirement that banks hold 30 days worth of high quality liquid assets (HQLA) presents collateral management challenges for banks that are different from those for asset managers.
[2] The terms under which collateral is exchanged in a bi-lateral swap are mostly governed by a credit support annex (CSA) that is negotiated bi-laterally between the two counterparties.
[3] BCBS IOSCO Consultation paper dated September, 2013: https://www.bis.org/publ/bcbs261.pdf
[4] The DTCC suggests a potential 1,000% increase in collateral calls: http://www.dtcc.com/~/media/Files/Downloads/WhitePapers/CollateralMGMT_WhitePaper.ashx
[5] Between $600 billion and $10 trillion – http://www.ft.com/intl/cms/s/0/e7737740-6f85-11e2-b906-00144feab49a.html#axzz2K3ksXEGk Article Title: “Crunch feared if collateral rules enforced” 5 February 2014. Atkins, R.
The views expressed are as of 18 March 18, 2014 and are a general guide to the views of Brown Brothers Harriman (“BBH”). The opinions expressed are a reflection of BBH’s best judgment at the time. BBH is not affiliated with derivsource.com and does not monitor or maintain any of the information available on their site nor represent or guarantee that such web sites are accurate or complete, and they should not be relied upon as such.
