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Pushing through the pain barrier

Collaboration, consolidation and optimisation will prove abiding themes as firms get to grips with new initial and variation margin rules for the non-cleared OTC derivatives transactions.


By Mark Jennis, Executive Chairman, DTCC-Euroclear Global Collateral Ltd.

When we go through a painful and testing experience, the short-term suffering is easier to bear if we can convince ourselves of the long-term benefits. Students revising night after night for an exam may be comforted by the knowledge that their revision technique is improving and the expectation that success will boost their future career prospects.


The major swap dealers that implemented multiple new processes this year to meet the September deadline set by US and Japanese regulators for the exchange of Initial Margin (IM) between counterparties to non-cleared OTC derivatives transactions certainly bear some scars. At the recent Euroclear Collateral Conference in Brussels, one senior executive from a global bank described the experience of meeting the compliance deadline as “a bloody nightmare”.


A combination of new calculation processes, complex documentation requirements and new operational requirements - not to mention late clarification on permissible models by the US regulator - caused more than a few late nights, even though this first wave of IM compliance impacted only a relatively small, homogeneous group of well-resourced sell-side institutions with high levels of skill and experience.


Like the first exam of the season, this was just one deadline of many for the OTC derivatives market. In January, those tier one swap dealers will also have to comply with similar IM requirements in Europe, before helping counterparts and clients through their own IM deadlines in three successive waves (unlike the first, these are expected to be synchronised across Europe, Japan and the US). There is also the small matter of the global introduction of Variation Margin (VM) exchange rules for all non-cleared OTC derivatives market participants in March 2017, not to mention the subsequent introduction of IM rules in other G-20 jurisdictions.


Although it undoubtedly took swap dealers’ resources and focus away from working with clients to prepare for the impending VM rules, the intensity of the effort required to meet the IM deadline has lent those firms some useful perspective that will help them and other OTC derivatives users to handle the oncoming deadline crush and adjust to the emerging new operating environment.


The challenges are different of course - IM requires new models and calculations, while VM is more about managing compliance costs through process efficiency and coordination - but much remains in common. We see three key takeaways. First, cost-effective, capital-efficient exchange of IM and VM requires a high degree of internal coordination across asset classes, desks and departments and throughout the transaction chain. Second, the testing of new processes and operations is extremely labour-intensive and time-consuming, even for firms that are highly automated. This means early coordination on common standards and protocols with suppliers, market infrastructures and customers should be prioritised. Third, the short-term, manual fixes that are an inevitable element of meeting compliance deadlines should wherever possible be informed by the subsequent need to automate, refine and optimise, in order to establish an operating model that reflects the central importance of collateral management.


Broadly speaking, the lesson of the first wave of deadlines for new non-cleared OTC derivatives transactions is one that emphasises consolidation of internal capabilities, collaboration with industry partners and optimisation as the new environment matures. Greater velocity and visibility of collateral movements will be critical to successful participation in the OTC derivatives markets (and indeed others) in a low margin, capital-constrained world. This requires a change of model and mindset. Why? Because this new emphasis on collateral efficiency requires a degree of cooperation between multiple internal and external counterparties that has rarely been part of the traditional financial markets ethos.


What are we talking about in practice? The ability to forecast, calculate and meet collateral obligations related to non-cleared OTC derivatives transactions, and delivering on these in the most capital-efficient manner, entails a step change in process efficiency in a series of related functions. Indeed, a recent PwC report commissioned by DTCC-Euroclear Global Collateral Ltd (GlobalCollateral) identified nine areas of focus across front- and back-office operations:

To select just one of the nine, real-time access to high-quality reference data is a vital support to frictionless and frequency exchange of collateral for margin purposes across jurisdictions, instruments and counterparties. Straight-through processing of collateral-related tasks such as valuation, margin calculation, dispute management and settlement rely on efficient sourcing, distribution and management of a diverse range of reference data. Much can be achieved by firms’ own data enhancement and centralisation efforts, but they should also look to leverage industry infrastructures such as trade repositories and other emerging utilities, as well as actively participating in the development and adoption of initiatives to standardise data and message formats. Such a collaborative approach not only reduces exceptions (which could prove a heavy burden if current rates are maintained at higher volumes) and lowers staffing costs, but paves the way for future efficiencies as collateral processes for derivatives and other markets are further refined and optimised.


For each firm, the preferred approach to improving collateral processes across these nine areas will be informed by unique circumstances and priorities. But any operational reconfiguration undertaken in light of incoming IM/VM rules will need to utilise a range of internal and external capabilities, including greater use of outsourcing and utility solutions. Regardless of the individual paths taken, collaboration, consolidation and optimisation will prove abiding themes.


At one level, the industry faces a common challenge, in terms of the new regulatory framework, which is best tackled by recognising and building upon today’s increasingly inter-dependent ecosystem, then competing on the basis of shared, collaborative platforms that support the regulators’ goal of robust financial markets. At another, regulatory requirements and shifting liquidity conditions are encouraging firms to take a more consolidated approach to collateral management. By centralising and coordinating collateral capabilities, firms will achieve the visibility and control to make their assets work harder, which will have benefits beyond IM/VM compliance, especially if staff are equipped with the tools and skills required to operate effectively in the emerging new landscape. But collateral management strategies will need to be flexible enough to accommodate iterative change, with market practice optimised over time as regulatory and market conditions dictate. As well as the rolling IM/VM deadlines, Basel III’s new rules are staggered, while other reforms also have the potential to impact liquidity, meaning even the most forward-thinking of OTC derivatives market participants will be unable to rest on their laurels for long.


Speaking to major swap dealers at recent conferences and one to one, I increasingly find this message is hitting home. Whether because of the sheer scale of the impact of regulatory reforms, or because they are being asked to change ahead of other market participants, top tier firms realise that efficient use of capital depends on a clear understanding of collateral implications of OTC derivatives transactions. Moreover, this understanding can best be achieved through the establishment of an interoperable collateral management framework based on common standards and connectivity to overcome the heterogeneous nature of the market. While other OTC derivatives market participants will face different challenges - perhaps due to size or business model - similar conclusions can be drawn: start early; work closely with partners (internal and external); and keep in view the long-term strategy even when tacking the short-term problems. Over time, I am convinced the pain will be worthwhile.




Mark Jennis

Executive Chairman

DTCC-Euroclear Global Collateral Ltd