Derivatives collateral management used to be a purely operational matter, but post-crisis regulation and sovereign downgrades have made it into a strategic priority for every bank.

For derivatives traders, collateral management was purely a matter for the back office. Until the financial crisis, that was. In practice, derivative markets survived the collapse of Lehman Brothers, and many of the safety mechanisms designed to manage the default of a major derivative counterparty worked successfully.

But some of Lehman’s clients found that sums owed to them on uncollateralised derivative transactions took months to recover through insolvency proceedings. And policy-makers perceived counterparty risk as a systemic threat worthy of legislation. Both the US Dodd-Frank Act and the EU’s Market Infrastructure Regulation aim to drive clearing for over-the-counter (OTC) derivative deals onto central clearing counterparties (CCPs).

Inevitably, central clearing houses will tend to have more standardised arrangements for posting collateral, rather than the individual credit support annexes signed between broker-dealers and each client. This means end-users or their bank intermediaries (or both) will need to maintain a larger pool of the most high-quality collateral that is universally acceptable. In its April 2012 Global Financial Stability Report, the International Monetary Fund (IMF) estimated that the increase in centrally cleared transactions would raise the requirement for cash or the safest bonds by $100bn to $200bn.

And just to compound the problem, the pool of potential top-rated collateral keeps getting smaller with each new sovereign credit downgrade in the eurozone. The IMF forecasts that the supply of assets considered safe might shrink by $9000bn by 2016, removing 16% of the total. Understandably, derivatives bankers feel a little under siege.

“Trading activity will probably shrink somewhat as regulations take hold, because there is not an infinite amount of collateral available. This is consistent with the current regulatory goal globally of addressing the 'too big to fail' scenario,” says Jim Malgieri, head of global collateral services at Bank of New York Mellon.

Client needs

Before pinning all the blame on policy-makers, it should be noted that the end-users themselves have also driven change in the clearing process, even if it means adding to their own cost base. This is especially true for the fiduciary fund management industry that had to cope with the fallout of frozen derivative trades with Lehman Brothers.

Trading activity will probably shrink somewhat as regulations take hold, because there is not an infinite amount of collateral available

Jim Malgieri

“The buy-side still wants to have a relationship with its prime brokers and other sell-side counterparties, but it also wants to make sure that it has a better understanding of the risks on topics such as full segregation of its collateral. This is more than a question of risk mitigation – in the case of a major broker-dealer default it could be a matter of business survival for the fund,” says Renaud Huck, head of UK institutional investor relations for Eurex exchange.

Henri Jeantet, chief executive of equities absolute return fund Syquant Capital and a former head of equity derivatives trading at Crédit Agricole until he founded the fund in 2005, points out that the European Undertakings for Collective Investment in Transferable Securities (Ucits) rules require all derivatives collateral to be posted in high-quality assets. Consequently, for Ucits-compliant funds, the differences in collateral posting between OTC and central clearing are minimal.

In addition, pure derivative strategies are far more lean in their cash usage than a fund holding conventional assets. One absolute return fund manager estimates that 96% of the fund’s money at any given time is held in government bonds or other cash-like assets, of which about 15% will be posted as collateral for outstanding derivative positions. Moreover, a significant part of the equity derivatives business is already centrally cleared, and in many cases traded via listed products – one banker estimates about 70% of equity option trades are now on-exchange.

Consequently, the main impact of new regulation is on credit default swaps and interest rate swaps (IRS) markets. The effect of this change is also greater because the client base tends to have less cash available for collateral, including pension funds that hold real assets and use derivatives for hedging assets and liabilities. And there will always be a proportion of OTC trades tailored to the specific needs of an end-user that CCPs will be unwilling to clear.

“Clearing houses do not necessarily need swap transactions to be entirely fungible with each other, but they do need trades to have economic characteristics for which there is enough liquidity in the risk transfer market, in order to manage the implications of a clearing member default. That presents challenges with options in particular,” says Richard Metcalfe, head of global policy at the International Swaps and Derivatives Association (ISDA).

Netting and fragmentation

The effects of central clearing can be mitigated by the extent to which counterparties can continue netting their trades to lower their margin needs, as they would do historically on bilateral OTC clearing. Some CCPs allow operational commingling of the positions of dealers and their clients even while keeping assets legally separate. This enables member banks to offer their clients some collateral optimisation on centrally cleared trades.

“It can happen that there is not total segregation of client and house positions, because in reality a client deficit at the CCP is covered by a house surplus,” says Romain Dumas, head of government repo and short-dated government bonds and bills trading at Credit Suisse in London.

The CCPs themselves have realised that the flexibility of their offering will be important in a competitive market. Eurex is launching a new risk methodology product called Prisma, which will be available across all the asset classes that the clearing house handles by mid-2013.

“This will allow margining across the whole of a client portfolio, and will enable the exchange-traded derivative and OTC positions to speak to each other for maximum capital efficiency,” says Mr Huck.

[Clearing houses] need trades to have economic characteristics for which there is enough liquidity in the risk transfer market, in order to manage the implications of a clearing member default

Richard Metcalfe

However, the cross-margining will only take place on positions within the same asset type, rather than allowing netting between equity, credit or rates derivatives as a bilateral clearer might offer to their clients. This is because the CCP would auction each asset class separately if it had to liquidate a portfolio in the event of a member default.

Moreover, end-users may be bamboozled by the need to use different CCPs depending on the memberships of their broker-dealers. A Bank for International Settlements (BIS) report in March 2012 considered the collateral implications of a number of scenarios, of which the optimum was for one CCP dedicated to each asset class.

There is every sign, however, that the opposite is set to happen, as new entrants in each asset class seek to grab a share of the business as it moves onto central clearing. For example, LCH.Clearnet previously dominated IRS clearing in Europe, but Eurex launched into this asset class in May 2012. And since CCPs are systemically important institutions, many jurisdictions appear keen to have a national champion clearing house of their own, entrenching the fragmentation of the sector.

“Futures commission merchants are better prepared to deal with this complexity, but it is likely to generate more confusion among buy-side clients, as well as increasing their technology costs. An efficient market usually brings about consolidation, which would drive more activity onto the CCPs,” says Mr Malgieri.

Mr Dumas believes the geographic proliferation of CCPs will also oblige broker-dealers to move towards narrower currency silos for the margin they accept from clients, to minimise their own exchange rate risks depending on the currencies required by the CCPs.

“It might still be possible for clients to use, for instance, Canadian and US dollars as margin fairly interchangeably. But it would be hard to imagine Eurex accepting a high proportion of dollar collateral, or the Chicago Mercantile Exchange accepting a lot of euros, so banks are likely to require their clients to keep separate dollar and euro collateral pools,” says one banker.

Outstanding marketable potential safe assets ($bn)

Optimising collateral use

All this is likely to make the process of collateral management not just complicated, but potentially an important competitive edge for players who can keep pace. The basic needs are simple – knowing what collateral is required for each transaction, and what pool of assets are available to meet those margin needs. But on a large and diverse book of business, the complexity can be considerable, says James Treseler, global head of equity finance at Société Générale Corporate & Investment Banking (SG CIB).

“You need to know your collateral schedules, what rate of collateral substitution is taking place, and what are the haircuts on the collateral provided. Understanding how all these mark-to-market elements will behave is a real challenge,” he says.

Increasingly, this business is being outsourced to specialist third-party securities services providers, with Bank of New York Mellon and JPMorgan the two dominant triparty banks. Jason Orben, Americas product executive for collateral management at JPMorgan Worldwide Securities Services, says identifying both the need and availability of collateral across a very large institution is a major first hurdle in itself.

“The first task is to improve the transparency of the institution. It is vital not to use high-grade collateral on bilaterally cleared transactions where the counterparty is flexible about the margin posted, and then find yourself short of high-grade assets for CCP-cleared trades,” he says.

One development that would ease the pressure on derivative users would be for the CCPs themselves to increase flexibility on collateral. Stuart Heath, head of Eurex’s UK office, says the exchange already accepts a broad range of securities, including equity, for its initial margin requirement, and recognises that accepting non-cash variation margin could be an important differentiator.

However, Mr Malgieri warns that CCPs themselves would face more operational risks if competitive pressures led them to broaden collateral eligibility too far toward lower-rated or less liquid assets. Even so, he anticipates some degree of collateral diversification, but points out that this adds to the complexity of the margining process.

“Where the requirement today is mostly for government bonds and cash, we might move to a situation where the norm would be for CCPs to accept other collateral types, such as high-grade corporate bonds. But market participants would then need to track the different haircuts on the corporate bonds, as well as how close they were to hitting acceptable limits for alternative collateral set by the CCPs,” he says.

Collateral transformation

There is a general feeling among bankers that another way exists to simplify the shift to central clearing. The process of finding suitable collateral – known as collateral transformation or upgrade trades – can be separated from the actual derivative transactions.

“It is more viable if all margining takes place in CCP-eligible collateral so that banks are not left with any asymmetric risks, and the transformation of non-eligible collateral can take place separately on some standard duration buckets from one day to three years. That avoids the bank having to price the daily mark-to-market of the derivative and the daily funding cost for the collateral transformation all in one trade,” says Mr Dumas.

He says the creation of a tradable secured Repo Overnight Index Average (Ronia) benchmark in the UK in 2011 further facilitated the development of a liquid collateral transformation market. To some extent, this is not an innovation, but the opportunity to expand something that has long existed – securities lending.

“Non-traditional securities repo is one of the fastest growing products in the secured lending space. I estimate that equity repo has reached €600bn to €700bn in Europe, and about a third of that in the US but growing rapidly. It has been helped by the ultra-low interest rates, because funds earn no more than single-digit returns without a haircut lending against treasuries, but can generate higher revenues with improved haircut on exotic collateral,” says Mr Treseler at SG CIB.

More noise in the pipeline?

Clearly, there is an opportunity for both dealers and triparty banks to tie together their derivatives offering with the exotic repo business. The only problem is that policy-makers have not finished their interventions just yet. The Financial Transaction Tax (FTT) proposed by the new French government specifically excludes securities lending and repo, but the draft proposal for a pan-European FTT by the European Commission did not provide for that exclusion.

“A 10 basis point tax on every asset recycling trade would destroy the economics for asset managers. Given that regulators themselves have encouraged the move to a world where funding transactions increasingly are secured as a way of reducing systemic risk, we would expect that they would not want to push the market too far back toward unsecured financing by driving up the cost of collateral,” says Eric Litvack, chief operating officer for global equity flow at SG CIB.

A further source of uncertainty comes from the EU’s bank resolution proposals, which ironically appear to cast doubt on a mechanism that helped the market manage the Lehman default. This is close-out netting, which allows a defaulted bank’s derivative counterparties to net all outstanding exposures and trade replacement costs, and use the collateral posted to cover any amounts owed by the defaulted bank. Only sums not covered by collateral end up in the general estate with other unsecured creditors.

“The EU has always had a slightly ambiguous attitude to derivative netting, as demonstrated by its requirement that banks should report gross rather than net exposures. But the fact is that close-out netting makes the market safer, and it worked well when Lehman Brothers defaulted. There were no knock-on defaults, and offsetting trades were crunched down efficiently despite the fall of a huge intermediary,” says the ISDA's Mr Metcalfe.


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