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The importance of the bigger picture

Complying with regulatory deadlines shouldn't be the only driver for improvements in collateral management practices


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

Nothing concentrates the mind like a deadline, especially one set by a regulator that could prevent you from serving your clients if you miss it. But no matter how important, no single deadline can be treated in isolation - any regulatory deadline is just one representation of a longer process of change.


These are the precise problems being faced by buy- and sell-side firms ahead of the March 2017 deadline for compliance with new rules governing the exchange of Variation Margin (VM) by counterparties to bilateral OTC derivatives transactions. The new rules are not particularly complex, but they are part of a much bigger overhaul of the financial markets, which is placing collateral management – an under-resourced and often-ignored back-office process – right at the centre of operating models.


As such, firms have two key challenges in meeting the March deadline. First, the effort required by major swap dealers to comply with highly intricate new Initial Margin (IM) rules for bilateral OTC derivatives introduced in September means the remaining market participants which are affected are only now getting to grips with the documentation and operational implications of the VM deadline (of which the former is by far the most time-consuming in the short-term). Second, the workflow-related decisions that firms take in order to achieve compliance in March must be set in context of the need to reengineer collateral-related processes, perhaps on an enterprise-wide level. A misstep today could saddle a firm with crippling costs, risks and inefficiencies well into the future.


It’s likely that the documentation challenges will a key focus for bilateral OTC derivatives market participants in the coming months. Buy-side firms that have grown used to relaxed and flexible collateral terms from swap dealers will have to renegotiate credit support annexes (CSAs) – for each fund they run – in light of the new VM rules and a narrower approach to acceptable collateral, imposed on sell-side institutions by Basel III. Even with standardised documentation from the International Swaps and Derivatives Association (ISDA), there may be insufficient capacity to repaper all the existing agreements. In the extreme, firms that miss the deadline may have to temporarily withdraw from the market, compromising their ability to fulfil their fiduciary duties, in terms of stewardship of client assets.


But all the effort to sign off multiple new CSAs will be wasted if firms don’t put in place the building blocks needed to facilitate a more coherent and automated approach to collateral management when revamping processes to meet the March deadline’s operational requirements. As hinted above, it’s not just bilateral OTC derivatives rules that are increasing demand for collateral. Alongside new arrangements for centrally-cleared OTC derivatives trades, Basel III has increased sell-side appetite for high-quality liquid assets, while reducing liquidity levels and funding options, all of which places a higher premium on collateral access and mobility. PwC analysis from a white paper sponsored by GlobalCollateral found that every swap dealer will have to fund more than US$ 570 million annually, just to post IM against bilateral OTC derivatives exposures. Against this backdrop, every bilateral OTC derivatives market participant – no matter how small – is going to have to start making daily VM payments in T+1 settlement windows. To thrive beyond the March deadline, firms must adjust their operations ensure ongoing access to collateral in both the short and long term.


‘Operationalising’ the requirements for exchanging VM is a significant challenge with implications along the entire transaction chain. While a smaller firm might struggle to secure the resources to handle the upsurge in margin call volumes, larger firms may well be focused on the challenges upstream, which impact collateral management processes such as their ability to deliver timely valuations from the trade support team to collateral managers as settlement windows shorten under new rules. And although new services, technologies and utilities are being developed in collaboration with market participants, the upgrading of existing internal systems and platforms no small undertaking, nor is the testing of new processes and workflows across a highly heterogeneous derivatives market. In the short term, many problems can be ameliorated by directing resources to solve the problem. In the long term, adoption of standards and automation is the only path to sustainably reducing the costs and risks of establishing a collateral-focused operating model.


With the March 2017 deadline looming, it is important to plan for the short and the long term. The PwC white paper identified nine building blocks to achieve a comprehensive, joined-up approach – effectively Collateral Management 2.0 – based upon optimised economic allocation of collateral, enterprise-wide risk management, and an integrated operating model that is sufficiently flexible, scalable and collaborative to accommodate to future requirements. Few firms are in a position to build this model before the March deadline, but they can start to work towards it, laying the foundations for refining and optimising collateral management arrangements iteratively.


For example, the need to access and mobilise collateral for margin calls at a time of increasing overall demand is leading bilateral OTC derivatives market participants to establish acceptable collateral lists and apply haircuts based on schedules or internal models, while also intensifying efforts to monitor and remediate concentration and ‘wrong-way’ risk. Firms that tackle these challenges by simultaneously looking to reduce margin requirements through trade compression, implement firm-wide collateral inventory visibility and automate collateral allocation will not only meet regulatory objectives but also minimise operating and finding costs and enhancing collateral liquidity in the longer term.


Similar opportunities to meet tactical and strategic challenges in parallel can be identified across the nine underlying components of Collateral Management 2.0, some of which leverage both internal and external resources. To cite just one, the expected rise in margin and collateral disputes in line with higher volumes can be addressed by individual firms through higher levels of automation, with the costs mutualised by leveraging shared industry platforms which resolve disputes quickly and provide industry-level analytics to eliminate common causes over time.


As noted at the outset, while deadlines can concentrate the mind, the focus on compliance should not obscure the bigger picture. Deadlines should be seen as signposts on the path to a more efficient, holistic framework for servicing clients’ needs in the longer term. Changes to the structure of the financial markets and the availability of collateral – which will continue to evolve for the foreseeable future – require market participants to reassess and adjust their operating models. With average operating and infrastructure costs to support the collateral management needs expected to rise from US$7 million in 2015 to US$26 million in 2020 (PwC analysis for GlobalCollateral white paper ‘Collateral Management 2.0 – Preparing for OTC Derivatives Margin Regulation and Beyond’) bilateral OTC derivatives market participants should embark on that journey as soon as possible.



Ted Leveroni

Executive Director, Chief Commercial Officer

DTCC-Euroclear Global Collateral Ltd