It turns out that it is far easier to enact regulatory reform than to implement it. In September 2009 G20 leaders agreed that all standardised over-the-counter (OTC) derivatives contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties (CCPs). The G20 also stated that OTC derivatives contracts should be reported to trade repositories and that non-centrally cleared contracts should be subject to higher capital requirements.
This reform was meant to take effect at the end of 2012 but implementation has proven to be far more than a mere matter of flipping a switch. Many issues remain unresolved, not the least of which are the differences between the US and European rules.
In the US, centralised clearing became mandatory for interest rate swaps in March 2013. Adoption took a three-phased approach for different types and sizes of participants: swap dealers, major swap participants and active funds with 200 or more swaps per month were in the first phase; commodity pools, private funds and other financial entities were second with all other participants in the final phase.
In Europe, meanwhile, regulators are in the process of registering central clearing houses and determining which instruments require central rather than bilateral clearing.
Putting transparency into practice
The main thrust of the agreement was to bring greater transparency to what had been a fairly opaque marketplace, and the general consensus is that this increased transparency combined with competition among CCPs will ultimately benefit all participants. However, the new structure puts the onus on firms to be more sophisticated and systematic in collateral management, which will have a significant operational impact going forward.
Fund managers now need to take an urgent look at how they manage collateral. And at such a late stage delaying the inevitable could prove costly. Those accustomed to low margin requirements and handshake agreements may be in for a shock as the new rules mean that firms that trade in OTC derivatives will be required to make larger margin commitments and will be subject to more frequent margin calls along with more prescriptive counterparty demands.
Implications of the new market structure
The implications for both buy- and sell-side participants in the derivatives market will be far-reaching. Collateral management, largely an afterthought in the less regulated environment, will become an imperative and unless firms take measures to streamline the process and mitigate the impact of the new regulations, it will consume time and resources and potentially eat into profitability.
Under the new structure, funds will send a trade through a Swap Execution Facility, which will put the trade out to brokers. The executing broker will send the trade through a Clearing Member (usually a bank) that is responsible for satisfying the Central Counterparty’s requirements. The CCP sets the margin call based on its proprietary valuation methodology. The margin call thus moves down the chain from the CCP through the Clearing Member and ultimately to the fund initiating the trade.
The first major implication will be that different CCPs will have different asset valuation methodologies and margin calculation models, meaning that firms will need to find methods of tracking these disparities. Asset eligibility requirements are expected to vary among CCPs as well; in most cases they are likely to be narrower and more stringent.
Another major issue will be with margin calls and commitments. Previously, in the bilateral world, broker trading desks that could be flexible about margin calls when it suited them and their clients would simply take the spread on the trade. Now they need to know the impact of the margin and cost of carry on all their capital requirements.
Similarly, entities that trade in OTC derivatives—hedge funds, global asset managers, pension funds, insurance funds and others—must now be prepared for higher margin commitments and more frequent (perhaps intraday) margin calls. It is also believed that clearing houses are likely to take a harder line on margin amounts and the timing of transfers than their predecessor bilateral trading partners.
It is assumed that with the introduction of CCPs, larger funds will no longer be able to expect preferential treatment that typically meant once-a-month calls. And furthermore, dispute resolution is likely to be more cumbersome with complicated arms-length relationships, (firms that experience discrepancies may find they have less or very little recourse).
The ability to net margin for multiple transactions will also disappear. Funds accustomed to trading both an underlying security and a hedging instrument with a single broker used to be able to take advantage of netting margin for both transactions but the new structure does not allow for that as the derivative trade must be cleared through a CCP.
Cross-margining opportunities will decrease significantly and funds will no longer be able to net funding of multiple transactions to a single currency. However, the CME in its July 2013 overview update included the fact that their portfolio margin offering had accounted for over $1 billion in initial margin savings. Although this is currently only a service that applies to interest rate swaps and rate futures, the intended introduction of cleared swaptions by both the CME and LCH means some degree of cross-margin relief will still be possible for those willing to find it.
It is estimated that the additional collateral burden demanded by Dodd-Frank and EMIR could be over US$2 trillion globally, according to a 2013 report from KPMG: ‘The Next Operational Hurdle for Hedge Funds—Collateral Management: The Multi-Prime Broker Model Colliding with Regulatory Reform’. Funds and brokers will now have to consider much more than the sell-side price of the contract when entering into a trade. The “real” price encompasses costs of collateral, fees for collateral transformation, cost of carry and other transaction-related expenses.
The case for proactive collateral management
The demand for greater transparency and the increased costs call for significant cultural shifts in a number of areas. Firstly, where calculating margin used to be a post-trade analytic, it must now be factored in before the trade is placed in order to avoid excessive margin commitments, and costs.
Secondly, firms will be challenged to replicate and validate CCP margin calculations in advance of trades to manage costs and determine where to direct trades in order to optimise collateral. This may mean that firms may also need more frequent collateral transformation trades with third parties in order to satisfy the differing asset eligibility requirements of the CCPs.
And thirdly, while certain instruments and transactions will not require central clearing, bilateral trades will have more onerous margin requirements under the new regulations.
In this new environment, firms that do not actively manage collateral run the risk of posting more than they have to, liquidating unnecessarily to cover margin calls, diminishing their trading capacity, and missing opportunities for incremental profit. With a more complex market structure and stricter rules, paying closer attention to margin requirements is clearly in a firm’s best interest.
Many firms have already adopted more systematic collateral management practices as a result of the squeeze on returns in the wake of the 2008 crisis. In volatile markets, when firms are challenged to generate alpha, controlling collateral costs becomes a way of adding incremental profitability to the bottom line.
Emerging best practices
The introduction of centralised clearing houses and a stronger focus on collateral management places an additional burden on a firm’s operational staff and infrastructure: it will no longer be acceptable to calculate margins from spreadsheets and evaluating the different clearing houses’ collateral requirements will be time consuming and a drain on resources, with risk of errors and opportunity costs.
In the era of “doing more with less,” firms will need systems that will enable them to do all this efficiently and accurately. And because the CCPs are continually tweaking their valuation models and adding to their product coverage, firms will need regular updates of different margin calculation methodologies.
In order to sustain profitability, firms must find the most efficient way to manage collateral. We have seen a number of best practices emerge as firms figure out what it takes to manage collateral optimally. These include:
- The ability to replicate and validate different clearing houses’ margin calculations. As each CCP will have its own margin calculation methodology, fund firms must gain control to ensure that the calculation is accurate, consistent and fair.
- The ability to compare and evaluate different clearing houses’ collateral requirements, in terms of both amounts and types of collateral accepted.
- The ability to identify the best clearing venue for a particular trade in order to optimise collateral.
- The ability to manage the full range of margin calls, ideally in one platform, from the traditional prime broker and listed futures calls to both bilateral and centrally cleared OTC calls under the new regulations.
- The ability to track and confirm fees as well as correctly allocate cost of carry and use of capital back to each position.
Much of what firms need to do can be automated, using technology specifically designed for managing margin in a multi-counterparty environment. Firms that can automate the replication and reconciliation of all CCPs’ margin costs and requirements stand to make significant benefits in a variety of ways.
They can reduce the risk of being overcharged. Firms can validate each CCP’s margin calculations and see side-by-side cost comparisons of different clearing houses. They can reduce operational risk with automated identification and resolution of breaks. And they can reduce margin levels with optimised asset placement by performing what-if analysis on proposed trades to determine the optimal combination of Direct Clearing Member (DCM) and CCP to clear through. They can also improve decision-making with a single view of all margin rules and expected margin requirements.
It is imperative that firms adapt to the new structure, and with thoughtful planning they can minimize the disruption to their businesses. We believe that with the right technology, firms can go a long way toward reducing the added operational burdens and mitigating the impact associated with the new regulations.
By Ben Broadley, Advent Software.