Collateral Management is the hottest topic in recent times.
My personal thoughts on this topic.
Dodd Frank Impact on Collateral Management
During the period of recession one of the things that keeps the Operational heads of capital market firms awake in the nights, is probability of a counterparty going bust. Prudent Collateral Management practices reduce the concern to some extent. On the face of it though it looks simple, the ever innovative OTC instruments and explosive volumes have made the tasks of the Collateral Managers extremely complex and important. The 2008 financial crisis triggered a renewed focus on collateral management for OTC derivatives. After the high profile credit failures, multiple regulations in different geographies have been focussing on Sound collateral management practices safe guarding client interests and client asset protection. The regulations have brought about a revolution in terms of overhauling the business dynamics. And the revolutions have made some sort of peace with the evolutions (More volume, complexity, depth and breadth of instruments) in the collateral management space. One of the prominent regulations is the Dodd Frank Act which focuses on mandating client central clearing, segregation & portability of client assets & positions.
Current Scenario
In a typical bilaterally executed collateralized trade the client often provides an “Independent Amount” or ‘’Initial Margin’’ of collateral at the inception of a trade (T+1), which the dealer holds for the life of the position. Often the corporate clients and other dealers are exempted from this mandate. The trade is marked to market daily. Depending on in /out of money each counterparty provides (required for out of money) additional collateral, with the change in value of the contract. There is always a Minimum transfer amount defined in the contract for each counterparty beyond which the margin is callable. Currently the dealers have the collaterals from the clients. They can utilize (Re-hypothecate) the collaterals for further gains. The present laws are not stringent enough to safe guard the client interests in case of dealer default.
The Mandates
Of all the regulations the Dodd Frank act has the major impact in OTC derivative Post Trade Processing space. One of the basic tenets of Dodd Frank regulation is Central Clearing, Client Asset Segregation and Portability.
Along side the regulations the industry body International Swaps & Derivatives Association (ISDA) has come up with numerous measures to improve efficiency in derivatives market processing with best practices in collateral management, portfolio reconciliation and margin management.
This section outlines the changes in business conduct and process level that need to be adapted and adopted due to the regulatory mandates and ISDA best practices
Regulatory
One of the basic tenets of Dodd Frank regulation is Central Clearing, Client Asset Segregation and Portability. The following diagram depicts the shift in the interactions amongst the players from the bilateral model to the central clearing model.
The central clearing model has a profound impact on the collateral management systems.
The basics being the narrowed range of eligible collaterals, frequency of Margin calls ownership of the collateral for pre and post default scenarios etc. The following table compares the Pre Dodd Frank and Post Dodd Frank scenarios along various Collateral Management business and functional parameters.
ISDA Best Practices:
The ISDA Collateral committee has been actively pursuing for smooth functioning of the collateralization process of OTC derivatives transactions through establishing standards and best practices, and collateral law reform efforts across the globe. Following are some of the published recommendations and best practices.
Best Practices for OTC Derivatives Collateral Management
A comprehensive document has been published detailing the recommended best practices for bilateral OTC collateral management, covering every step of the margin and collateral process from validation of external data upload to principles and timing around collateral settlement. Some of the key best practices are:
Electronic Communication of Margin Calls
A detailed recommendation for the use of data standards, frequency and methodologies behind the exchange of margin, collateral and substitutions messages with the intention of automating exchange of messages and replacing the current manual e-mails.
Portfolio Reconciliation Best Practices, Market Standards and Implementation Plan
Minimum data standards have been released and an implementation plan proposed for market participants to reconcile on a frequent basis (Monthly and weekly) all OTC portfolios over certain size. Automated reconciliation through an industry standard provider and adherence to at least the minimum mandatory fields for reconciliation are emphasized.
Legal Review, Analysis, and Improvements on Current Documentation
These recommendations are around the feasibility of standardising treatment of consent for substitution requests and development of standard amendment agreements that could accommodate treatment of segregated Independent Amount as a separate pool of collateral
Reducing Barriers to Use of a Third Party in IA Holding Arrangements
Recommend standard provisions that may be incorporated into documents for Third Party Custodian and Tri-Party Collateral Agent IA holding arrangements in order to facilitate negotiation and consistency of operation for participants who elect to use such arrangements.
Implementation of the Dispute Resolution Procedures
In 2009 the ISDA working groups produced a document with a formal procedure for margin dispute resolution, with a strict timetable of the steps required to investigate and agree margin / collateral.
3) Best Foot Forward:
The broker dealers need to invest on their collateral management functions looking holistically in the organizational context to have advanced features providing competitive differentiation in the market. This section outlines the 10 strategic techno functional book of work for OTC derivatives collateral management. The suggested initiatives are not in particular order of importance. The individual firm has to take decisions as per its own level of preparedness.
1) Integration with Intermediaries:
There are many intermediaries in the whole collateral management value chain offering services on reference data, information, margin intermediation, tri-party collateral mgmt, portfolio reconciliation etc. So a work-stream should be in place that will prepare and evaluate the long term strategy for external vendor integration on a continuous basis.
The first step would be assessing the CCPs and connecting to them to source the trade and margin details. This decision would definitely be influenced by the organizational approach to wards Industry utilities connectivity approach. One to One connectivity or through a Hub /Bus needs to be assessed. Apart from connectivity the collateral eligibilities for individual CCPs and the legalities need to be captured in the clearing brokers’ systems.
2) Reference Data Enhancements:
Accurate reference data drives up the efficiency and productivity in a period where there is increased need to interact with external entities. So initiatives should be undertaken to capture the following statics data requirements.
• CCP static data
• Instruments Supported ( including Unique Swap/product Identifiers)
• Collaterals Accepted per CCP
• Collateral Eligibility rules
• New legal and netting parameters (including Unique Counterparty identifiers)
• Support new Clearing House agreements and CSA parameters
• Contract assignment
3) Synchronization with Client Valuations:
There is a lot of overlap in collateral mgmt and client valuations functions in terms of the static data usage, Trade feeds, reporting and dispute management. So to ensure data consistency the feeds from various product specific booking & risk management systems should be same to both Collateral mgmt and client valuation systems. This would definitely reduce the possibility of a Margin call dispute arising due to valuations.
4) Margin Management:
The bilateral and centrally cleared trades pose different challenges for margin management. Though the bilateral process would continue unchanged, one major decision for the CCP cleared lot is to decide whether to simply accept the CCP Margin amounts or to calculate Initial Margin & Variation Margin requirements using proprietary models. Then the next decision is netting of the bilateral and cleared margin requirements across products subject to legal requirements.
The mandate for central clearing would increase the capital blockage for the buy side in the form of margins. Cross Asset Margining is a good form of optimization of the liquidity for them.
5) Consolidated Collateral View:
As a legacy process the collaterals pledged are being managed at different places under different legal arrangements by individual legal entities aligned with either geography or product lines. One of the requirements from the buy side has been for a consolidated view of collateral positions across legal entities, business line custodians and CCP eligibility. Because of new CCP collateral acceptability and stringent eligibility criteria there would be need of Collateral Transformation. So transparency on collateral holdings would be the need of the hour. Integration with Repo desk, Treasury dept and front office would enhance the collateral utilization. The clients now have the option to keep the initial margin amount with an independent custodian. In this light the custody models need to be relooked in terms of multiple connectivity setups, pulling of real-time collateral instructions / positions and fees / billing management etc.
6) CFTC /SEC Compliant Reporting:
Regulatory reporting is of great importance from a compliance and reputational risk point of view. The firms should be in a position to report according to the CFTC or SEC as appropriate. The clients would like to see their combined activities and exposures across trade types (bilateral & cleared) across products. So there is a need to collate all captured margin requirements and collateral agreed in relation to agreements containing trades other than OTC Derivatives. Tactically the aggregation can be performed at the client facing point of report delivery. But strategically the aggregation should be performed at the core processing level so that vital intelligence can be leveraged for funding purposes.
7) Trade Portfolio Reconciliation:
To reduce the number of disputes the firms need to proactively and defensively reconcile exposure trades to identify potential mis-matches outside of agreeable thresholds. To make the process more efficient adoption of the ISDA defined mandatory and optional field attributes is required. On a tactical basis there should be provision of manually uploading the trade portfolios to the (Portfolio reconciliation provides like Tri-optima, Markit etc.). On a long term basis the firms should be prepared for STP by adopting industry wide adopted messaging formats.
8) Integrated Dispute Management:
The firms need to enhance their dispute resolution service to not only include OTC reconciliations, but also, OTC trade confirmation management, sourcing from the client middle office, interpretation, upload into the Portfolio reconciliation provider and comparison with the counterparty for reporting back to the client’s middle office.
9) Integrated Query Management Platform:
An enhanced Query Management Platform is a client service differentiator. The Query Management Platform should be able to provide the clients transparent status updates for every query raised by them. It’s imperative to develop an operationally controlled solution that is consistent across legal entities and regions adopting the ‘follow the sun’ model.
10) Integration with Front Office:
To improve straight through processing the front office should be the single source of Reference Data, Market data and Transaction data and Collateralization data. The collateralization cost efficiency should be integrated with the Pricing model to ensure proper risk management for bilateral and cleared trades. The collateral transformation would impact the pricing model for the clearing clients.
4) Conclusion
The time has come to bring Collateral Mgmt function from a siloed credit function to a client service differentiator function. So the firms need to realign their people, processes, and IT systems and data management practices to achieve an optimal operating model. This mandates Integration with CCPs, new business partnerships with the custodians, Cross asset margining, collateral transformation, alignment with client valuations functions. These key features which are mostly connectivity, data and analytics driven capabilities pose higher
My personal thoughts on this topic.
Dodd Frank Impact on Collateral Management
During the period of recession one of the things that keeps the Operational heads of capital market firms awake in the nights, is probability of a counterparty going bust. Prudent Collateral Management practices reduce the concern to some extent. On the face of it though it looks simple, the ever innovative OTC instruments and explosive volumes have made the tasks of the Collateral Managers extremely complex and important. The 2008 financial crisis triggered a renewed focus on collateral management for OTC derivatives. After the high profile credit failures, multiple regulations in different geographies have been focussing on Sound collateral management practices safe guarding client interests and client asset protection. The regulations have brought about a revolution in terms of overhauling the business dynamics. And the revolutions have made some sort of peace with the evolutions (More volume, complexity, depth and breadth of instruments) in the collateral management space. One of the prominent regulations is the Dodd Frank Act which focuses on mandating client central clearing, segregation & portability of client assets & positions.
Current Scenario
In a typical bilaterally executed collateralized trade the client often provides an “Independent Amount” or ‘’Initial Margin’’ of collateral at the inception of a trade (T+1), which the dealer holds for the life of the position. Often the corporate clients and other dealers are exempted from this mandate. The trade is marked to market daily. Depending on in /out of money each counterparty provides (required for out of money) additional collateral, with the change in value of the contract. There is always a Minimum transfer amount defined in the contract for each counterparty beyond which the margin is callable. Currently the dealers have the collaterals from the clients. They can utilize (Re-hypothecate) the collaterals for further gains. The present laws are not stringent enough to safe guard the client interests in case of dealer default.
The Mandates
Of all the regulations the Dodd Frank act has the major impact in OTC derivative Post Trade Processing space. One of the basic tenets of Dodd Frank regulation is Central Clearing, Client Asset Segregation and Portability.
Along side the regulations the industry body International Swaps & Derivatives Association (ISDA) has come up with numerous measures to improve efficiency in derivatives market processing with best practices in collateral management, portfolio reconciliation and margin management.
This section outlines the changes in business conduct and process level that need to be adapted and adopted due to the regulatory mandates and ISDA best practices
Regulatory
One of the basic tenets of Dodd Frank regulation is Central Clearing, Client Asset Segregation and Portability. The following diagram depicts the shift in the interactions amongst the players from the bilateral model to the central clearing model.
The central clearing model has a profound impact on the collateral management systems.
The basics being the narrowed range of eligible collaterals, frequency of Margin calls ownership of the collateral for pre and post default scenarios etc. The following table compares the Pre Dodd Frank and Post Dodd Frank scenarios along various Collateral Management business and functional parameters.
ISDA Best Practices:
The ISDA Collateral committee has been actively pursuing for smooth functioning of the collateralization process of OTC derivatives transactions through establishing standards and best practices, and collateral law reform efforts across the globe. Following are some of the published recommendations and best practices.
Best Practices for OTC Derivatives Collateral Management
A comprehensive document has been published detailing the recommended best practices for bilateral OTC collateral management, covering every step of the margin and collateral process from validation of external data upload to principles and timing around collateral settlement. Some of the key best practices are:
Electronic Communication of Margin Calls
A detailed recommendation for the use of data standards, frequency and methodologies behind the exchange of margin, collateral and substitutions messages with the intention of automating exchange of messages and replacing the current manual e-mails.
Portfolio Reconciliation Best Practices, Market Standards and Implementation Plan
Minimum data standards have been released and an implementation plan proposed for market participants to reconcile on a frequent basis (Monthly and weekly) all OTC portfolios over certain size. Automated reconciliation through an industry standard provider and adherence to at least the minimum mandatory fields for reconciliation are emphasized.
Legal Review, Analysis, and Improvements on Current Documentation
These recommendations are around the feasibility of standardising treatment of consent for substitution requests and development of standard amendment agreements that could accommodate treatment of segregated Independent Amount as a separate pool of collateral
Reducing Barriers to Use of a Third Party in IA Holding Arrangements
Recommend standard provisions that may be incorporated into documents for Third Party Custodian and Tri-Party Collateral Agent IA holding arrangements in order to facilitate negotiation and consistency of operation for participants who elect to use such arrangements.
Implementation of the Dispute Resolution Procedures
In 2009 the ISDA working groups produced a document with a formal procedure for margin dispute resolution, with a strict timetable of the steps required to investigate and agree margin / collateral.
3) Best Foot Forward:
The broker dealers need to invest on their collateral management functions looking holistically in the organizational context to have advanced features providing competitive differentiation in the market. This section outlines the 10 strategic techno functional book of work for OTC derivatives collateral management. The suggested initiatives are not in particular order of importance. The individual firm has to take decisions as per its own level of preparedness.
1) Integration with Intermediaries:
There are many intermediaries in the whole collateral management value chain offering services on reference data, information, margin intermediation, tri-party collateral mgmt, portfolio reconciliation etc. So a work-stream should be in place that will prepare and evaluate the long term strategy for external vendor integration on a continuous basis.
The first step would be assessing the CCPs and connecting to them to source the trade and margin details. This decision would definitely be influenced by the organizational approach to wards Industry utilities connectivity approach. One to One connectivity or through a Hub /Bus needs to be assessed. Apart from connectivity the collateral eligibilities for individual CCPs and the legalities need to be captured in the clearing brokers’ systems.
2) Reference Data Enhancements:
Accurate reference data drives up the efficiency and productivity in a period where there is increased need to interact with external entities. So initiatives should be undertaken to capture the following statics data requirements.
• CCP static data
• Instruments Supported ( including Unique Swap/product Identifiers)
• Collaterals Accepted per CCP
• Collateral Eligibility rules
• New legal and netting parameters (including Unique Counterparty identifiers)
• Support new Clearing House agreements and CSA parameters
• Contract assignment
3) Synchronization with Client Valuations:
There is a lot of overlap in collateral mgmt and client valuations functions in terms of the static data usage, Trade feeds, reporting and dispute management. So to ensure data consistency the feeds from various product specific booking & risk management systems should be same to both Collateral mgmt and client valuation systems. This would definitely reduce the possibility of a Margin call dispute arising due to valuations.
4) Margin Management:
The bilateral and centrally cleared trades pose different challenges for margin management. Though the bilateral process would continue unchanged, one major decision for the CCP cleared lot is to decide whether to simply accept the CCP Margin amounts or to calculate Initial Margin & Variation Margin requirements using proprietary models. Then the next decision is netting of the bilateral and cleared margin requirements across products subject to legal requirements.
The mandate for central clearing would increase the capital blockage for the buy side in the form of margins. Cross Asset Margining is a good form of optimization of the liquidity for them.
5) Consolidated Collateral View:
As a legacy process the collaterals pledged are being managed at different places under different legal arrangements by individual legal entities aligned with either geography or product lines. One of the requirements from the buy side has been for a consolidated view of collateral positions across legal entities, business line custodians and CCP eligibility. Because of new CCP collateral acceptability and stringent eligibility criteria there would be need of Collateral Transformation. So transparency on collateral holdings would be the need of the hour. Integration with Repo desk, Treasury dept and front office would enhance the collateral utilization. The clients now have the option to keep the initial margin amount with an independent custodian. In this light the custody models need to be relooked in terms of multiple connectivity setups, pulling of real-time collateral instructions / positions and fees / billing management etc.
6) CFTC /SEC Compliant Reporting:
Regulatory reporting is of great importance from a compliance and reputational risk point of view. The firms should be in a position to report according to the CFTC or SEC as appropriate. The clients would like to see their combined activities and exposures across trade types (bilateral & cleared) across products. So there is a need to collate all captured margin requirements and collateral agreed in relation to agreements containing trades other than OTC Derivatives. Tactically the aggregation can be performed at the client facing point of report delivery. But strategically the aggregation should be performed at the core processing level so that vital intelligence can be leveraged for funding purposes.
7) Trade Portfolio Reconciliation:
To reduce the number of disputes the firms need to proactively and defensively reconcile exposure trades to identify potential mis-matches outside of agreeable thresholds. To make the process more efficient adoption of the ISDA defined mandatory and optional field attributes is required. On a tactical basis there should be provision of manually uploading the trade portfolios to the (Portfolio reconciliation provides like Tri-optima, Markit etc.). On a long term basis the firms should be prepared for STP by adopting industry wide adopted messaging formats.
8) Integrated Dispute Management:
The firms need to enhance their dispute resolution service to not only include OTC reconciliations, but also, OTC trade confirmation management, sourcing from the client middle office, interpretation, upload into the Portfolio reconciliation provider and comparison with the counterparty for reporting back to the client’s middle office.
9) Integrated Query Management Platform:
An enhanced Query Management Platform is a client service differentiator. The Query Management Platform should be able to provide the clients transparent status updates for every query raised by them. It’s imperative to develop an operationally controlled solution that is consistent across legal entities and regions adopting the ‘follow the sun’ model.
10) Integration with Front Office:
To improve straight through processing the front office should be the single source of Reference Data, Market data and Transaction data and Collateralization data. The collateralization cost efficiency should be integrated with the Pricing model to ensure proper risk management for bilateral and cleared trades. The collateral transformation would impact the pricing model for the clearing clients.
4) Conclusion
The time has come to bring Collateral Mgmt function from a siloed credit function to a client service differentiator function. So the firms need to realign their people, processes, and IT systems and data management practices to achieve an optimal operating model. This mandates Integration with CCPs, new business partnerships with the custodians, Cross asset margining, collateral transformation, alignment with client valuations functions. These key features which are mostly connectivity, data and analytics driven capabilities pose higher
