In Europe regulators are in the process of authorising Central Counterparty Clearing Houses (CCPs) and determining which instruments require central rather than bilateral clearing. The process is expected to run well into 2014.
The new regulations on centralised clearing of bi-lateral contracts and the changing market structure are set to have far-reaching implications for both buy- and sell-side participants in the derivatives market. Under the new structure, entities that trade in OTC derivatives—hedge funds, global asset managers, pension funds, insurance funds and others—must be prepared for higher margin commitments and more frequent margin calls.
Different CCPs will have different asset valuation methodologies and margin calculation models while asset eligibility requirements are also expected to vary; in most cases they are likely to be narrower and more stringent. This means that firms will need to find a way of tracking these different methodologies and eligibility requirements.
All of this would suggest that fund managers need to take a new look at how they manage collateral. Yet because of the lag time in implementation, many are not feeling the impact and are taking a wait-and-see approach, comfortable that they have the capacity to cover margins under any circumstances.
However, they may be in for a shock when these regulations finally come into force: clearing houses are likely to take a harder line than bilateral trading partners on margin amounts and the timing of transfers, while larger funds can no longer expect preferential treatment that typically meant once-a-week or infrequent calls. Dispute resolution is also likely to be more cumbersome with complicated, arms-length relationships, and any firms that experience discrepancies may find they have less or very little recourse.
In the new structure cross-margining opportunities will decrease significantly and funds will no longer be able to net funding of multiple transactions to a single currency while the derivative trade must be cleared through a CCP (previously, 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).
When entering into a trade, funds and brokers will have to consider much more than the sell-side price of the contract. The ‘real’ price encompasses costs of collateral, fees for collateral transformation, cost of carry and other transaction-related expenses. According to a 2013 report from KPMG entitled The Next Operational Hurdle for Hedge Funds—Collateral Management: The Multi-Prime Broker Model Colliding with Regulatory Reform, “Recent industry papers have estimated that the additional collateral burden demanded by Dodd-Frank and EMIR could be over US$2 trillion globally.” And this does not include the added operational strain and the internal costs that will accompany it.
A Case for Proactive Collateral Management
The change in the market structure and transaction flow calls for a significant cultural shift. 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. 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. 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 while certain instruments and transactions will not require central clearing, bilateral trades will have more onerous margin requirements as well under the new regulations.
In this new environment, firms that do not actively manage collateral run the risk of inefficiency, posting higher grade collateral than perhaps was needed, 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. In an Advent whitepaper entitled, "The Impact of Centralised Derivatives Clearing", Mikael Johnson, Lead Partner - Alternative Investments at KPMG, said: “In the competition to raise capital for funds today, investment managers can use all of the help they can get to achieve better returns for their funds and be more attractive to potential investors. If a fund can positively impact its performance by a few basis points (or more) by optimising its collateral management in the new centrally cleared environment, it may very well be worth the effort. While there is a project at hand to change the support processes to optimise collateral management, there are technologies and advisors available to help complete this project at an affordable cost."
New Collateral Management Best Practices
There is no doubt that stronger collateral management places an additional burden on a firm’s operational staff and infrastructure. In order to sustain profitability, firms must find the most efficient way to manage collateral. Best practices have begun to 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.
> Compare and evaluate different clearing houses’ collateral requirements, in terms of both amounts and types of collateral accepted.
> Identify the best clearing venue for a particular trade in order to minimise initial margin requirements.
> 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.
> Optimise and pledge collateral in a way, which most efficiently for the firm, satisfies all various requirements
> Track and confirm fees as well as correctly allocate cost of carry and use of capital back to each position.
Why Collateral Transparency Benefits All
Ultimately, the goal of centralised OTC clearing is to bring greater transparency to what was a fairly opaque marketplace before the crisis of 2008—and widely regarded as one of the main causes of the crisis. Greater transparency, combined with competition among CCPs, should benefit all participants. It will, however, put the onus on firms to be more sophisticated and systematic in collateral management, which will have significant impact on operations.
Volatile markets have made effective collateral management a competitive advantage. The new regulations and a more complex centralised clearing environment will make it an imperative.