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Not a question of either / or

If you live by a river, you don’t worry overly about water storage. If the course of the river gets diverted, accessing and storing water quickly becomes a much bigger priority, requiring more careful monitoring and, perhaps, infrastructure investment.


By Ted Leveroni, Executive Director, Chief Commercial Officer, DTCC-Euroclear Global Collateral Ltd.

Over the past decade, collateral has gone from being a free-flowing and abundant commodity to a more scarce and valued resource. The story of its growing importance in the post-crisis financial markets is much more complex than the damming or diversion of a river, but it’s fair to describe the flow of collateral as critical to the functioning of today’s markets and to the success of market participants. The task faced by sell-side firms in particular is to restructure and coordinate existing and highly complex operating models in a way that reflects the new priorities and realities. Principal among these realities is the ongoing rollout of global regulatory change and the complexity of detailed implementations in the different jurisdictions, and a business environment that precludes large-scale investment and renders even cautious revenue forecasts uncertain. The combination of these factors is tempting many sell-side firms to make tactical decisions to achieve compliance in the hope of adjusting their operations gradually once regulatory deadlines have been met.


But there remains a real risk that tactical solutions will compromise future opportunities to optimise collateral management, leaving firms struggling under the weight of increased costs. Indeed, these costs could become unsustainable if not ameliorated by the appropriate long-term investments. According to assessments undertaken by PwC for a new paper sponsored by DTCC-Euroclear Global Collateral Ltd, swap dealers will need to post collateral worth US$ 570 million each per annum as initial margin for bilateral OTC interest rate derivatives trades, based on prevailing gross notional outstanding levels. Moreover, collateral operating and infrastructure costs could almost quadruple for sell-side over the next five years (from around US$7 million to almost US$27 million) depending on existing operations and exposures. The outlook might look challenging, but we believe that the tools, capabilities and skills are available for sell-side firms to meet the forthcoming challenge of securing sufficient access to collateral. We also believe that collective action is a critical component of any strategy to maintain the flow of collateral over the medium to long term.


The post-crisis regulatory environment has gradually ratcheted up the importance of collateral as part of efforts coordinated by the Financial Stability Board to reduce systemic risks. As individual jurisdictions have introduced rules to mandate collateralisation of exposures in the OTC markets, new capital rules under Basel III have had the effect of drying up liquidity, hiking funding costs and increasing the need to optimize balance sheets. As a result, sell-side firms are having to adjust to a secular change in the role of collateral, while simultaneously meeting multiple deadlines for compliance across markets and geographies. Much of the new regulatory framework is falling into place, but a possibly game-changing deadline lies just around the corner. While other margin rules have largely been phased in by institution type, March 2017 sees the global onset of variation margin (VM) rules for bilateral, non-cleared OTC derivatives for all counterparties, which will multiply the frequency, volume and range of counterparties involved in margin calls at a stroke. This kind of secular change both focuses attention on the tactical challenge of meeting specific requirements and underlines the extent of the changes required to existing operating models.


If we’re moving to an environment in which almost every trade has collateral implications, and the future supply of that collateral is subject to uncertainty, it makes sense to embed collateral management into every aspect of the trade lifecycle. In analysing what this ‘Collateral Management 2.0’ might look like, GlobalCollateral has identified nine areas in which process re-engineering is required to accommodate collateral requirements, from both a tactical and a strategic perspective.


For example, the expected increase in the number of margining counterparties (e.g. buy-side firms), higher volumes of margin calls (daily VM), application of low minimum transfer amounts and shorter margin call settlement windows (T+1) requires comprehensive automation of exposure calculation, collateral balance application, and issuance and matching of margin calls. In response to regulatory deadlines, most sell-side firms are already leveraging the International Swaps and Derivatives Association’s Standard Initial Margin Model, and implementing common workflows across front office, risk and collateral operations teams to increase efficiency and automation, often upgrading infrastructure to support T+1 settlement. But additional efforts are needed to enable electronic exchange of margin calls, facilitate communication about collateral to be posted and track settlement of collateral to deliver superior risk management and reduce operational costs by eliminating FTE-intensive manual functions.


By tackling upcoming compliance requirements in a way that supports the development of longer-term efficiencies and paves the way for a collateral-centric operating model, firms can meet regulatory deadlines while undermining those daunting predictions of spiralling collateral funding and operating costs.


A critical component of any firm’s approach is an analysis of progress by trade bodies, industry groups, utilities and service providers on solutions and initiatives that could supplement internal efforts. The scale and scope of changes required to sell-side firms’ existing operations in order to achieve Collateral Management 2.0 demand that they take a coordinated approach to the deployment of capabilities from third-party vendors and utilities as well as internal resources. As a provider of collateral management and margin transit utilities, GlobalCollateral (itself a joint venture between leading securities market infrastructure providers, DTCC and Euroclear) is playing its part in leveraging and repurposing existing platforms and services to improve collateral workflows. We believe that scalable, robust and open market infrastructure is required to support streamlined collateral processing and access to securities collateral on a global basis. Equally, we believe that other industry-level initiatives based on similar principles are needed across the collateral value chain to help sell-side firms meet their tactical and strategic objectives.

Post-crisis regulatory reform is not easily implemented, but its objectives are laudable and moreover necessary to long-term confidence in the financial markets. As such, regulators’ efforts to increase safety and security must be supported by appropriate adjustments to workflows and practices by market participants and infrastructure operators. In doing so, we should recognise that regulation, compliance and collateral workflow optimisation involve processes, which are refined incrementally over time – similar to the course of a river. In each case, the challenge is to build a framework or infrastructure of sufficiently flexible components to adapt to new circumstances.


Ted Leveroni

Executive Director, Chief Commercial Officer

DTCC-Euroclear Global Collateral Ltd