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Article: Collateral Management Infrastructure: 10 Reasons You Need to Invest

06 April 2015 | Ted Allen
   

So many activities which used to be outside the view of regulators now fall squarely under a supervisory search light, that firms have to continue to invest in their systems, people and procedures to stay still. Something simple like portfolio reconciliation used to be a sideshow, but is now required and monitored with capital charges hitting miscreants. With further regulation coming down the pipe in the form of Leverage Ratio, rules governing margin on bilateral (non-cleared) OTC business and others, firms must think ahead and have budget available to adapt to these new rules.

The Drivers for Change

I’ve picked ten major reasons to consider your investment budget in collateral management, some which are causing an impact now, and some which could be major drivers of change in the near future. I would be interested to hear from readers which of these they regard are the most pressing needs for their firms, get in touch after you’ve read these through.

1. Blurred Lines: With the arrival of hybrid swap futures from CME and Eurex, and possibly more to come – you may find your software unable to manage the risk on those products. From a trading point of view these are futures, but the underlying risk is an OTC Rate Swap. If your front office aren’t already trading these, they may do soon, as the margin requirement on the underlying IRS is calculated using a one or two day holding period, rather than five at most CCPs.

2. Cross-margining: Eurex and CME both offer an approach to picking futures positions which reduce the Initial Margin requirement on your cleared OTC swap portfolio. The effect of this is to transfer futures into the OTC swaps margin calculator and default management process, leaving your futures back office without any need to reconcile the margin on those positions.

3. Call frequency: Given the regulatory focus on clearing and margining, many firms are finding themselves having to support daily margin calls, something new for smaller firms. This means the collateral management teams must be capable of updating portfolios, agreements, trade valuations, asset valuations and custody holdings every night.

4. Variation Margin per currency: For cleared business, and for some un-cleared business, the variation margin needs to be calculated, called and funded in the underlying currency of the portfolio. Clearing houses only work this way, and for the alignment of funding costs, some bilateral business is moving this way, for instance ISDA proposed the wholemarket move to this model, but regulatory events have overtaken that initiative.

5. Asset Hubs and Highways: Both Clearstream and Euroclear have global projects to remove barriers to using assets in local custodians and other countries, by using a legal framework to enable assets to be actively used in a global market. Buy-side firms will want support for this flexibility allowing them to pledge a wider range of assets against your margin
calls upon them.
 
6. Triparty: Once collateral flexibility is enabled, how does your platform select and allocate available assets against exposures? Clearstream and Euroclear both offer a Tri-Party services where they automatically apply your eligibility rules and your exposure figures to select and allocate counterparty as sets. For some firms this provides a framework for managing assets
that is visible and secure, and will want your firm to support such a service.
 
7. Cost reduction: With the increased complexity of multiple CCPs, multiple clearing relationships and multiple SEFs, managing the costs of collateral become more
complex and more visible. Collateral is no longer a back-office settlement function, but a recognised part of the economics of trading, albeit indirect. Firms who can analyse the relationships between eligible assets, multiple routing paths across clearing, and find the optimum cost / benefit sweet spot are going to win in the long run. Tools to run what-if scenarios across these permutations which are linked to margin calculation engines coupled with inventory management views will provide the decision support necessary to stay on top of this complex landscape.
 
8. Organisational change: With the blurring referred to above – does it make sense to run multiple collateral teams each looking at vertical business silos such as OTC, Exchange Traded, Repo, Stock Loan and Prime Brokerage? Modern platforms provide the support for these trade flows, and also the margin calculations, enabling firms to optimise their organisation structure to meet the needs of these business lines and avoid duplication of people and systems.
 
9. Collateral trading: The collateral held by your firm will come with some restrictions on re-hypothecation but will provide unencumbered assets for you to trade with. Your platform needs a close relationship with your treasury or Repo desk, who will be both a provider of assets to meet incoming margin calls, but also active traders of long assets to balance the funding side of the pool. Clearly it is vital that a firm predicts their margin funding needs in advance and anticipates their needs, thereby leaving a surplus for trading, and making profit.

10. Bilateral margin rules: This topic alone justifies a review of your collateral management platform, and will be the next major change for many users of OTC products. Regulations in the US and EU are targeting December 1st 2015 for firms to begin applying a new model of Initial and Variation Margin to un-cleared OTC portfolios. The rules exist in draft form but in summary require VM per currency, daily margin calls, IM by asset class, a VaR or schedule based approach to IM, splitting of your existing CSAs and potentially back-loading of trades into your new CSAs post- Dec 1st.

 
Where to Start?
Firms who trade in multiple asset classes need to think cross-asset and plan for fewer more integrated platforms, with real time capability. The alternative is to pile increasingly complex requirements on dis-integrated people and systems, building cost into the business and losing flexibility. The blurring of the boundary between OTC and ETD products means the front off ice will soon require support for cross-margining, as CCPs are pushing the dramatic margin reductions to justify the approach. In the third part of this series, I will look at the operational challenges for CM, and look at where common requirements suggest a new cross-asset approach.

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