Mark Jennis, Managing Director, Strategy and Business Development, DTCC
Jo Van de Velde, Managing Director, Head of Product Management, Euroclear
Earlier this year, the London School of Economics published an academic study on current and projected collateral supply and demand in the global financial system. Prompted by the G20’s reform agenda around the use of derivatives, there have been various and well documented studies into this very topic – most of which talk of a future collateral squeeze. However, the LSE authors’ conclusions differ from the general consensus of other analyses by stating that an actual aggregated collateral shortage is unlikely.
The problem instead, according to the authors, lies in the potential for bottlenecks due to weaknesses in the financial infrastructure. These weaknesses result in eligible collateral being immobilized in one part of the system and unattainable by credit-worthy borrowers. So, while in total sufficient collateral will exist in the post-reform system, it may be inaccessible to those who need it – an equally daunting prospect for most, if not all, users of derivatives.
Derivatives remain vital to the functioning of the financial markets
The problems in the derivatives market arose when some market participants used certain products to achieve greater leverage without adequately identifying and monitoring the subsequent risks. However, despite this derivatives of all types are critical to the functioning of financial markets. They were created to offset risk and continue to perform this function effectively when used by knowledgeable investors. The G20 agreement to introduce central clearing is a credible solution to improving risk mitigation, and containing the threat of a contagion to the greater financial markets posed by a single defaulting counterparty.
However, firms are becoming concerned about their ability to comply with new regulations governing the use of derivatives and are increasingly aware of the need to review their processes to account for new margin and collateral requirements.
Responding to regulatory reform
The introduction of central clearing for all standardized OTC contracts will mean two things: a significant increase in margin calls and a new obligation to post collateral with a central counterparty to act, effectively, as a form of insurance against a counterparty default. Mandated collateral obligations are now being extended to bilateral transactions as well, contributing even further to the increase in margin calls and the amount of collateral required.
The first consideration for the industry is that the scope of the derivatives reform programme is unprecedented in the financial markets, in both scale and intricacy. Its effect will be far-reaching and its requirements will force all market participants – on the buy- and sell-side – to review their derivatives strategy from an investment, trading and operations perspective. The bottom line is that firms will have to be smarter about how they operationally manage their collateral as well as what assets they use as collateral.
The second consideration is that derivatives markets are highly interlinked: a collateral bottleneck in one part of the system, in any location and at any point in time, is likely to have a knock on effect across the markets. The problems will become more acute the further along the regulatory reform roadmap we are. Regional implementation of rules intended to meet the G20 goal are in various stages of implementation, central clearing of swaps in the US is now largely a business-as-usual process, aside from some operational clean up and adjustment of processes, however many other milestones have yet to be reached – including the introduction of central clearing in the European and Asian markets. While progress has been steady, there is still a long way to go until global implementation is complete. Only then will the full impact of the reforms on collateral availability become apparent.
It is therefore critical to pre-determine a course of action to prevent or remove bottlenecks before the reform is fully implemented.
Preparations must be made at two levels. First, adequate internal (preferably automated) processes should exist at a firm level. Some firms already have collateral management departments that leverage sophisticated and flexible technology across asset classes. However, other firms do not have the operational or technical expertise in collateral management, nor do they have the systems to properly support collateral processes. A report by Celent in 2013, cited that nearly half of respondents (48 per cent) have not completed operational preparations to address regulatory requirements for derivatives clearing and collateralisation. And, even among those firms that have made some preparations, 38 per cent cite limitations with existing systems as a significant challenge.
Indeed, too often, collateral is managed in siloes across an organization, making it at best inefficient and at worst impossible to have a holistic view of where and what collateral is in use. For these firms, it will be important that they review their processes to ensure they can handle workflow changes – in many cases, legacy systems will no longer be flexible enough to adapt. Building an in-house solution or leveraging their existing licensed technology is not always an option: firms will need to find a suitable collateral management solution that can process and manage collateral. In either case, they should consider the impact on their operations – people, processes and systems – as well as review vendor solutions and industry offerings when selecting solutions to address these new requirements.
The second step is for collateral mobility to be addressed on an industry wide level.
Given that its supply is finite, collateral needs to move smoothly and efficiently throughout the financial markets – if collateral gets stuck in one part of the system, it risks choking the global flow of liquidity. Just as individual car owners do not control the traffic light system for the safe movement of traffic and reduction of congestion, nor can derivatives users be expected to manage global collateral mobility.
Implementing solutions at an individual firm level makes sense, but more is needed. This realization has resulted in an increased trend towards industry collaboration and community-based solutions.
To this end, DTCC and Euroclear recently announced a joint venture to create a global Collateral Management Utility (CMU) which will follow the development of a Margin Transit Utility (MTU).
The MTU, which is in advanced stages of development, will leverage DTCC-developed infrastructure, and will provide straight-through-processing of margin obligations. Leveraging electronic margin calls between market participants, the MTU will utilize Omgeo’s ALERT database to enrich the agreed margin calls with the standing settlement instructions for cash and securities transfers and pledges, and then automatically deliver the appropriate delivery/receipt, segregation and/or safekeeping instructions to the applicable depositories and/or custodians. The service culminates with the investment managers, FCMs, GCMs, Dealers, and Clearinghouses receiving electronic settlement status and record-keeping reports for all collateral movements.
This facility will mitigate systemic risk and provide significant additional risk and cost benefits to both sell-side and buy-side market participants by increasing scalability and operating efficiency, and providing greater transparency across collateral activity. Longer term, the solution will connect collateral data with information reported to the DTCC Global Trade Repository (GTR), providing a complete view of risk exposures during a market crisis.
As envisioned, the CMU will harness the open architecture of Euroclear’s Collateral Highway and enable users to consolidate assets under a single inventory and collateral management system. This provides them the possibility to optimally allocate mutualised assets to meet exposure obligations in both the European and North American time zones. The assets remain on the books of each depository, with each opening accounts in the other depository. Collateral allocations will seamlessly integrate with other settlement obligations at the relevant depository, significantly reducing the risk of blockages and settlement failures during market stress conditions.
The CMU will address the pressing problem of accessing collateral globally and automatically coordinate collateral settlements and substitutions with other settlement activity. Market participants often cite sub-optimal collateral mobility, allocation and settlement coordination as issues at a global level, and the CMU will fill this gap.
An uncertain future?
While there is less consensus on how collateral will and should be used and what this will mean for the future of the derivatives market, without question, it will become essential to have a near real-time consolidated view of counterparty exposures, collateral settlements, locations and availability as well as a robust collateral process across both cleared and non-cleared portfolios.
The effects of the new derivatives programme will be far-reaching and long-term. Ultimately, the rules being implemented are beneficial for the market, and for investor confidence. Market participants, and their derivatives strategies, must be able to adapt to these changes. The key to doing so is to understand their holistic impact – which is no small feat – and to prepare by leveraging sophisticated technology offerings as well as community-based and infrastructure solutions accordingly.