Act now before the nuisance
becomes a real headache!
OTC derivatives market participants are busily preparing for new rules governing initial and variation margin for bilateral transactions which will begin to be phased in from September 2016. There are many urgent tasks, but firms that overlook what is merely a ‘nuisance’ today could soon face a major headache.
Collateral settlement fails currently run at an industry average of 3% - according to recent research by PricewaterhouseCoopers (PwC)1–at these levels higher collateral transfers under the new margin rules will cause an exponential rise in the cost of remedying fails by buy-side and sell-side firms alike.
Exchange of initial and variation margin on a gross basis for bilateral OTC derivatives transactions requires significant process change, including adjustments to credit support annexes (CSAs). The incoming rules – which forbid netting between initial and variation margin – will make collateral movements more tightly regulated, more frequent (often daily), and closely monitored. At a time of scarcity, market participants must integrate collateral management processes into the transaction lifecycle from the outset, rather than an afterthought.
What might be the cost to market participants as the volume of collateral movements rise over the next five years, but fail rates stay the same? Based on current levels of STP and automation – unlikely to change given length of investment cycles and pressure on costs – PwC analysis estimates a 407% increase in the average annual operational cost of remedying bilateral OTC derivatives collateral settlement fails to US$3.6 million for each buy-side firm by 2020, while sell-side firms could experience a 377% hike in annual costs to US$2.4 million.
Because the cost of settlement fails is a function of the time taken to understand the cause and collaborate with counterparts and custodians to remedy the situation, PwC’s operating cost model focuses on the average amount of time spent remedying a fail per full-time employee (FTE) using current employee costs, fail rates and causes, and automation levels. A cost and time element was assigned to each activity in the remediation process, including escalation rates.
For buy-side firms, the predicted rise in operational costs for fixing collateral settlement fails translates into a six-fold increase in FTE headcount from four to 24 in five years (varying according to levels of STP and OTC derivatives usage). On the sell-side, growing collateral movements could increase FTEs from three to 16 to handle the concomitant increase in settlement fails. Lower costs compared to the buy-side reflect higher levels of STP internally and stronger leverage with custodians. Collateral settlement fail rates may increase under the new regulatory framework, at least in the short-term, as firms adjust to new margin rules across both centrally cleared and bilateral OTC derivatives trades. Moreover, the annual industry-wide unsupported exposure due to collateral settlement fails related to OTC derivatives is highly likely to increase from the US$26.7 billion recorded in the 2015 ISDA Margin Survey, using data from 42 large sell-side firms. Indeed, the present figure is already undoubtedly larger when factoring in buy-side firms and other sell-side firms not included in the ISDA survey. Rising operating costs may not be the only impact.
Especially in times of market stress, multiple collateral settlement fails or non-response to queries might suggest underlying problems. Even if not indicative of a failing counterparty, fails can still damage a firm’s reputation, making it hard to build relationships and win business. Replacing expected collateral in the event of a fail can be a significant funding cost, depending on liquidity levels and prevailing market conditions, with knock-on implications for other transactions. For banks, persistent unresolved fails could represent uncollateralised derivatives exposures, leading to extra capital charges under Basel III.
Regulators may respond to rising numbers of collateral settlement fails by imposing fines, as they have already threatened to do for ‘regular’ fails. To establish how to head off the costs and risks of collateral settlement fails, let’s first consider the main underlying causes: miscommunication, constrained technology, insufficient collateral, and counterparty insolvency (albeit perhaps not a business-as-usual event). The leading cause of collateral settlement fails is miscommunication, i.e. incomplete or incorrect data in the messages between counterparties, which the receiving counterpart may have insufficient time to identify and resolve prior to the settlement deadline, particularly if the movement is across borders, where different practices and cut-off times operate. 1 This fails rate, and other findings mentioned in this article, are published in a white paper prepared for DTCC-Euroclear GlobalCollateral Limited by PwC, which draws on interviews collateral settlement specialists on the buy- and sell-side, as well as technology providers, custodians, and outsourcing providers. Insufficient use of technology, such as fax-based delivery of instructions to a custodian – rather than using a standard message protocol – delays communication and increases error risk. Inability to perform intra-day reconciliation or inefficient record keeping (often due to batch processing) by the custodian can prevent efficient tracking of pledged / received collateral. Similarly, failure of a market participant’s own systems to identify pledged collateral also limits effective inventory management. Inability to post the required amount or type of collateral may result from a chain of fails, or poor visibility into the collateral pool, but can also be caused by concentration limits.
This latter cause may increase if regulators seek to reduce the risk of counterparties becoming over-exposed to particular assets. In the context of a broader appraisal of front-to-back-office operations, OTC derivatives market participants can adopt a number of best practices – along with advances in technology – to increase operational efficiency, reduce counterparty risk, and limit collateral settlement fails. Some gains can be made internally, through greater departmental collaboration on trading documentation, notably the terms of CSAs, as well as a more holistic approach to data management, perhaps to store trade-related data in an enterprise-wide repository or enhance visibility of collateral inventory, preferably in real time, to satisfy margin calls with the optimal collateral.
Such measures may require considerable coordination, and may be pursued after remaining vestiges of manual processes are minimised. Spreadsheet-based margin calculation exposes firms to greater risk of uncollateralised exposures, while manual processes generally hamper efforts to track disputes or monitor exposures. Similarly, use of industry standard margin messaging can limit recourse to faxbased communication. Standard messaging platforms can be further leveraged to efficient settlement as collateral movements increase in volume and complexity. Automated enrichment of SSIs (standard settlement instructions) and account information through a global database is critical in an increasingly interconnected environment. Utilities focused on the enrichment and maintenance of SSI data already deliver lower fail rates.
In addition, compression of collateral payments can reduce the overall number of transfers, while technology-based advances can support more complete record-keeping and more timely monitoring. For a long time, market participants have chosen to live with the back-office inefficiencies that cause collateral settlement fails. But as their occurrence increases in line with the growth of collateral transfers necessitated by the new regulatory requirements for bilateral OTC derivatives, the time has come for action, to protect firms against not only higher costs, but damage to their reputation with regulators and counterparts. The costs and risks to individual firms may be higher or lower to the scenarios outlined above, but all firms should evaluate which measures might be suited to their own situation. However, when looking at best practices to leverage, firms should also remember that their fails rate depends heavily on their counterparts.
In such an interconnected industry, firms are only as strong as their weakest link. To avoid both higher cost and greater regulatory sanction therefore, there is a strong case for utilising shared solutions for non-competitive functions that promote operational efficiencies, industry standardisation, and mutualisation of costs.
For information on how DTCC- Euroclear GlobalCollateral Ltd can help your firm prepare for the regulatory changes and streamline margin and collateral processing, contact:
Chief Commercial Officer
DTCC-Euroclear Global Collateral Ltd.
Director Sales and Relationship Management
As noted in the article, the main causes of collateral settlement fails – miscommunication, constrained technology, insufficient collateral, counterparty insolvency – can be addressed largely via more automated and standardized information flows within and between counterparties. Global- Collateral’s utility-based solutions will tackle these underlying causes of fails as follows:
Miscommunication – DTCC-Euroclear Global Collateral Ltd. generates an automated settlement instruction using the collateral call agreed between the counterparties, including details of the security and the amount, thus eliminating manual error in the instruction sent to the custodian. Further, the instruction is informed by reference data from a central database, rather than internally maintained sources.
Constrained technology – Disconnects between systems and use of semi-manual processes, e.g. faxes, are ill-equipped for higher volumes of collateral transfers, but GlobalCollateral’s Margin Transit Utility (MTU) offers market participants an automated and scalable environment enabling STP throughout the entire lifecycle of a margin call.
Insufficient collateral – By providing users with up-to-date (essentially real time) views into all settled collateral balances, GlobalCollateral offsets the risk that a collateral settlement fail will leave the intended recipient short of assets which it has already promised to another counterparty (e.g. a margin call).
Counterparty insolvency – It used to be said that you only know your exposure to a counterparty after it goes bust. Not anymore. GlobalCollateral provides up-to-the-minute collateral settlement positions so counterparties know immediately whether they have received all the collateral due from an insolvent party, as well as the status of any their collateral held by the counterparty at the point of insolvency. Moreover, monitoring fail rates and comparing settlement times with other counterparties may forewarn that a counterparty is struggling to meet its obligations.