Collateral management pressures ramp up in 2017
The over-the-counter (OTC) derivatives market is facing a period of unprecedented regulatory reform, with banks straining to conform to new clearing, transparency and margin standards. Undoubtedly the role of collateral management is increasing in importance with every new rule. The revised margin standards for OTC derivatives offer the chance for banks to review and evolve their collateral management function to create sophisticated collateral systems and robust operating models that not only meet regulatory requirements, but also leverage the opportunities that they present.
To me, to you – the two-way exchange of margin is now mandatory
Soon after the Dodd Frank and EMIR rules mandated the centralised clearing of certain OTC products, in September 2013 the Basel Committee on Banking Supervision (BCBS) and International Organisation of Securities Commissions (IOSCO) published a framework that dictated the global minimum margin standards for the OTC derivatives that remain uncleared.
This framework imposed the following key changes:
- The exchange of Variation Margin (VM) and two-way exchange of gross Initial Margin (IM) becomes mandatory, and must be calculated using standardised or approved models
- Eligible forms of collateral are restricted to only highly liquid assets
- IM should be held in way that ensures the margin collected is immediately available to the collecting party in the event default
- Settlement timings have been revised, with collection of collateral required within one business day following collateral calculation (or two if there is no requirement to collect IM)
These requirements have two main aims:
- Reduction of systemic risk by ensuring that collateral is available to offset losses caused by the default of a derivatives counterparty
- Promotion of central clearing by increasing the previously attractive low margin cost of uncleared derivatives
The first wave of implementation rocked the collateral boat
The BCBS-IOSCO rules apply globally but are being implemented by local regulators in phases. On 1st September 2016, the rules came into force for the highest volume swap dealers and major swap participants (that are not subject to supervision by the Prudential Regulators) in the United States, Canada and Japan.
The industry has seen banks that were in scope of the first wave of implementation face a number of challenges.
Firstly, firms needed to update collateral agreements (such as the Credit Support Annex) in a very short time frame to satisfy the contractual right to exchange both IM and VM. In most cases the repapering process had to be managed across multiple legal documentation systems, resulting in up to 200 new or amended agreements with each bank. This placed significant strain on legal teams and business signatories.
Secondly, firms had to determine the most suitable available Initial Margin Model and adopt this method into existing and, in many cases, new processes. In preparation for the regulation firms had to re-design, test and implement the ability to calculate, post and accept IM for all in-scope uncleared trades.
The biggest challenge concerned the role of custodians. In the US, IM must be segregated at a third-party custodian, subject to a custodial agreement. Due to the volume and operational complexities surrounding the segregation of IM, many of the largest custodians were not in a position to setup segregated accounts for their clients, which meant banks were unable to trade with up to half of their counterparties on day 1. This caused chaos in the market and highlighted the need for a holistic approach to regulatory implementations across the industry.
The long road to strategic collateral management
Given what was seen in the first wave of implementation, I believe it is critical that market participants consider, understand and align to the various rules and requirements imposed by the regulation to ensure that they are suitably prepared for the upcoming rules.
It’s clear to me that meeting the regulatory requirements will be an on-going journey.
In the short term, market participants falling in scope of the next wave should be preparing for day 1 by taking immediate steps to setup the appropriate working groups and governance structures to demonstrate compliance, perform an impact assessment to understand which parts of the regulation are most applicable to their organisation and analyse existing gaps in operational and technical capabilities.
In the long term, and for those organisations with more time to prepare, it would be advisable to consider:
- Investing in the infrastructure to develop sophisticated collateral systems with a high level of automation to identify, source, mobilise, post and report collateral
- Re-evaluating operating models to ensure robust collateral management process are in place to support the new collateral landscape and mitigate the challenges
In my opinion, if banks are able to manage change over a longer time-horizon, combining investment in infrastructure with a more robust approach to collateral management, they will be in the best position to comply with regulatory changes whilst operating as efficiently and economically as possible.