Following the 2007 financial market meltdown, one of the key G-20 reform measures was to have all standardized derivative contracts traded on exchanges, clear the trades through the Central Counter Party (CCP) and impose bilateral margin requirements for all non-centrally cleared derivatives. While the centrally cleared standardized derivatives trades are already backstopped by CCP-imposed margins, the new regulations of the Basel Committee on Banking Supervision (BCBS) and the International Organization of Securities Commission (IOSCO) for non-centrally cleared bilateral derivative trades extend margin requirements further to cover the entire derivative spectrum. These mandates seek to impart greater systemic stability, transparency and trust and will amplify demand for high-quality collateral to meet margin requirements.
The concluding instalment in our three-part series on collateral management examines the impact of new margin requirements on derivatives trades.
Margin Issues Are No Longer Marginal
The core regulatory-driven issues that will amplify collateral demand and spike the cost of derivatives trade are:
The introduction of threshold for initial margin: The initial margin (IM) must be posted for all non-centrally cleared bilateral derivatives trades, except for physically delivered and settled foreign exchange forwards and swaps. The introduction of the IM threshold of €50 million on a consolidated group-level basis is expected to soften margin demand.
Initial margin calculation: Firms have the choice to either use a standard margin schedule or an approved internal quantitative portfolio margin model to calculate their initial margin needs. The biggest concern, however, is the imminent variation between the approved models of counterparties, due to the complexity of the bilateral trade, analytics involved, variegated sources of data, leading to costly disputes and time-consuming arbitration. Though the International Swaps and Derivatives Association (ISDA) makes recommendations in its draft document to standardize IM calculation, even the most prescriptive guideline cannot prevent variation in outcomes.
Variation margin: It is necessary to fully collateralize the mark-to-market exposure of the non-centrally cleared derivatives that must be posted on the following basis—zero threshold, daily calls and minimum transfer amounts not to exceed €500,000.
Segregation and rehypothecation rule: This stipulates that while IM postings must be segregated and can be rehypothecated/used under conditions, VM postings can be rehypothecated/used without conditions.
Acceptable collateral: BCBS and IOSCO rules prefer a broad set of acceptable collateral with appropriate haircuts ranging from 0% (in the case of cash) to 15 % (in the case of equities). An additional 8% haircut is imposed when cash collateral posted in currencies differs from the underlying derivative obligations.
Margin Management Issues
Our analysis shows that firm-level structural challenges can inhibit an efficient and effective margining process (see Figures 1 and 2) and pose grave operational risks.
The common operational issues stifling optimal marginal process throughput are:
Lack of straight through processing (STP), the dominant presence of manual processes and paperwork and lack of an audit trail against records/transactions.
Firms' failure to post higher, collateral-heightening operational risks.
Traditional methods of "siloed" communication, time-consuming "sanity checks," manual touch points, "four-eye" approval processes and fragmented settlement procedures.
Labor-intensive processes, such as recordkeeping and reporting of collateral activities, positions and balances (owing to the absence of overnight, automated reconciliation of positions); regulatory reporting of margins/collateral.
Initial margin: Mutually negotiated between two counterparties as part of CSA (Credit Support Annex), exposing firms to counterparty risks.
Variation margin: Less daily variation margin calls due to threshold limits and consolidated margin calls have not stress-tested the party's liquidity capabilities.
Rewiring Collateral Management: A Blueprint
In our view, winning firms must build a strategic plan by the end of 2015 to comply with regulatory changes and use that time to rewire the collateral margin management process for the coming collateral era—a time when high-quality liquid assets will be expensive due to their anticipated demand. A strategic roadmap to counter regulatory and operational issues should encompass:
Building an effective collateral management ecosystem—an infrastructure that drives optimal collateral usage (for details, refer to our paper on collateral optimization (PDF)) and enables firms to decide to clear a trade centrally (or not) and to benefit from lower margin requirements.
Using electronic messaging platforms to improve the STP percentage–from pre-call to settlement.
Obtaining regulatory approvals to use internal margining models. In most cases, new margining models must be developed.
Optimizing netting and portfolio margining within asset classes to minimize margining requirements.
Performing a thorough collateral analysis at the trading desk to help ensure the effective pricing of counterparty credit risk.
Putting in place a robust margin-call management system and dispute-resolution process.
Developing an enterprise-wide view of the IM threshold across multiple legal entities of the holding firm.
Demonstrating efficient policies and processes that help ensure the segregation of collateral received and protection in the event of a bankruptcy.
Re-engineering legacy systems or building new ones that provide for margining effectiveness and efficiency such as:
- Cash flow netting of coupons, broker fees and clearinghouse fees.
- Adding an efficient haircut and eligibility management feature, with the ability to easily manage haircut and eligibility rules across agreements.
- A report that provides collateral eligibility information that can be used to calculate the amount of client-owned eligible collateral available for use per the firm's position book and underlying CSA.
- A mechanism for viewing enterprise-wide, available collateral positions online.