Collaborating to conquer the OTC collateral challenge
For the OTC derivatives industry, joining forces is the only way to prepare for a rising tide of regulation. Only a combined industry initiative can drive the transformation in fluidity that will be needed when new regulations place collateral at the centre of every OTC derivatives trade. Unprecedented regulation is leading to unprecedented collaboration.
By Ted Leveroni, Chief Commercial Officer, DTCC-Euroclear Global Collateral Ltd.
For the past six years, derivatives brokers, asset managers and other market participants have heard repeated predictions of the operational obstacles associated with mounting regulation. But now the moment of reality is approaching.
The new OTC derivatives regulations are progressively being phased in. Notably, the BCBS/IOSCO margin requirements for non-centrally cleared derivatives will be gradually implemented from September 1, 2016 to September 1, 2020. They require most counterparties to post both initial margin (IM) and variation margin (VM). At the same time, mandatory clearing has already been introduced in the US, and will soon be extended to Europe and much of Asia.
Signaling the magnitude of the challenge, independent derivatives organisations are clubbing together to build industry solutions. Just as other industries are jointly engineering technologies in the face of economic and environmental challenges, so the big derivatives dealers are encouraging collaboration among industry infrastructures and technology providers.
One example of this is DTCC-Euroclear GlobalCollateral Limited (GlobalCollateral Ltd), the joint venture between DTCC and Euroclear that is pioneering efficient processing of OTC derivatives margining and financing.
Most industry participants are familiar with the scale of the operational challenge. In the OTC derivatives segment, the volume of margin calls is expected to jump by as much as 10 times, according to estimates, due to new regulatory-driven risk management practices. At the same time, the monitoring of the collateral covering margin requirements will become more complex. Indeed, regulations require that complex collateral eligibility criteria are monitored constantly, as well as haircuts and thresholds — on a bilateral and multilateral basis.
Existing operational processes and infrastructures are not fit for this new world. Many processes are still manual while infrastructures are fragmented. Without far greater automation and efficiency, trade fails, disputes and bottlenecks are likely to rise. No single firm can make the quantum leap required alone. Only by working together can industry participants achieve the degree of messaging standardisation, processing automation and inventory aggregation required.
This is the challenge that DTCC and Euroclear are seeking to solve through their joint venture. As an industry margin and collateral processing utility, GlobalCollateral Ltd brings together the best of each organisation’s infrastructures and technologies to offer the only open, global and complete solution to the challenges faced. Not only does GlobalCollateral Ltd standardise messaging and automate processing, but our infrastructure gives open access to collateral inventories at both parent organisations, as well as all custodians and CSDs. This means that assets can be settled no matter where they are held.
Anticipating the industry’s needs
GlobalCollateral Ltd has worked closely with the industry to understand its operational needs. On an ongoing basis, we canvass the views of our advisory groups, which include: 17 dealers, eight custodians, three CCPs and more than 30 buyside firms. They have given us keen insight into the challenges the industry faces, which we are building our platform to solve.
We have categorised the four areas in which the industry needs to upgrade its capabilities as: efficiency, mobility, visibility and security. These capabilities cover not only what is needed for mandatory clearing but also the BCBS/IOSCO margin requirements for non-centrally cleared derivatives. In broad terms, they centralise, standardise and optimise margin processing and settlement.
Our post-trade capabilities cover many of the key International Swaps and Derivatives Association’s (ISDA’s) recommended business and technology considerations. These are set out in its ‘Minimum Considerations for Uncleared Margin Future State Workflow’ paper, written by its working group dedicated to interpreting the BCBS/IOSCO margin requirements for non-centrally cleared derivatives.
The BCBS/IOSCO margin requirements oblige many firms to post IM and VM on OTC derivatives for the first time. They need to be able to automate collateral processing, streamlining asset allocation and substitution processes in order to meet the increase in volumes. Furthermore, platforms should be open architecture so that they can connect with messaging providers and custodians, and have automated settlement to reduce fails and enhance scalability.
Introducing efficiency, mobility, visibility and security
In order tosupport derivatives market participants, GlobalCollateral Ltd has determined it must deliver an automated, end-to-end electronic processing platform that will deliver a step change in efficiency when processing margin calls. We have brought together the capabilities of our parent organisations’ utilities with the standards and databases of third parties. These include AcadiaSoft and SWIFT, which together help to standardise settlement instructions and messaging. The result is an open, seamless, end-to-end margin processing hub for non-cleared derivatives.
ISDA’s paper addresses each of the business and technology requirements for becoming operationally prepared individually through its minimum considerations (MCs). For example, its MC 24 addresses instructing collateral movements and settlement. It recommends that ‘firms ensure they have the appropriate connectivity with custodians to meet the volume and timing of margin requirements’. In line with this, our utility provides the automated standing settlement instruction (SSI) enrichment to instruct collateral movements.
Monitoring and managing collateral eligibility is another critical area that must be automated if margin processing is to be executed at speed. ISDA’s MC 10 recommends that firms can execute CSAs, taking into account the terms documenting collateral eligibility that the counterparties privately negotiate. These terms govern issues such as credit quality, haircuts, concentration limits, minimum transfer amounts and wrong-way risk. Our platform centrally stores collateral profiles as agreed by counterparties in their CSA annexes, so that they can be readily applied.
For all parties to derivatives transactions, real time monitoring of margin calls and collateral settlement status is key. Collateral managers, risk managers and portfolio managers must be able to easily view everything in one place.
ISDA’s MC 25 shows the importance of visibility, stating that “at the close of each day, or as soon as possible thereafter, the third-party or tri-party system should provide, in a standardised electronic format, the information needed to effect a daily reconciliation of collateral balances”. It goes on to state that the format of the collateral balance file for reconciliation should be standardised across the industry to maximise efficiencies.
GlobalCollateral Ltd delivers a real time view of margin call and collateral settlement status, such as pending, settled and failed. We will also deliver exposure and collateral statements allowing firms to reconcile their collateral positions.
From a security perspective, the segregation of collateral assets, and the required control on these assets, potentially presents one of the new regulatory world’s greatest operational headaches. In a new two-way margin posting environment, ISDA recommends that counterparties “meet the segregation requirements under applicable law”. For example, US ‘40 Act Funds’ require that collateral does not go to the counterparty but is instead segregated with a custodian.
But custodians currently require signed faxes before they process release requests on the collateral — a manual process that would substantially hinder the necessary acceleration of collateral velocity, if only for the processing of collateral substitution operations. GlobalCollateral Ltd is developing a standard messaging format and operating model, facilitating the collateral release process.
Engineering an industry response
Meeting the BCBS/IOSCO margin requirements, as well as preparing for mandatory clearing, will take nothing less than a fundamental rearrangement of the OTC derivatives market’s operational infrastructure. Not only do firms have to move a lot more collateral more quickly, but in addition many more counterparties will have to be involved.
For OTC derivatives market participants, processing margins efficiently not only ensures regulatory compliance, but also protects competitiveness and frees management to focus on risk management.
In broad terms, our straight-through processing will reduce margin processing time and allow firms to handle more calls. Our automated collateral monitoring and optimisation capabilities will help to reduce risks while allowing firms to manage collateral more efficiently. The systems underlying these capabilities are robust, having been tested and widely deployed.
GlobalCollateral Ltd offers a scalable solution that meets the OTC derivatives market’s urgent operational needs and delivers a level of margin and collateral processing efficiency that will soon become essential. Without the collaboration of DTCC and Euroclear — as well as AcadiaSoft and SWIFT — it would not be possible. Ours is an industry response to an industry challenge.