Collateral management, a revolution already under way

By Marc Poinsignon, Product Manager - Global Funding & Financing – Clearstream

The revolution in derivatives as well as in funding and financing markets, initiated by global regulatory and political factors is taking place in conjunction with the rapid emergence of new financial technology (“FinTech”) where data is underpinning our collateral eco-system.

Regulatory requirements have led to a surge in demand by market participants for high-quality collateral to cover their exposures, notably in relation to OTC derivatives trading. Capital and liquidity constraints affecting the sell-side have further put under stress the availability of high-quality collateral and increased the need for enhanced collateral mobility in the funding and financing markets.

In parallel, the increase in volumes and complexity have shaken up the collateral processes and workflows hence overall operating models. This has been an additional major challenge for many firms, particularly on the buy-side.

Integrated solutions, data and technology support the firms and markets in adapting their approach to the way they are organised and function while bringing efficiency gains to collateral management.

As a result of the turbulences caused by the global financial crisis, regulators worldwide continue to focus on derivatives markets. Given the risks posed by the formerly unregulated off-exchange (“over the counter”/OTC) market, there has been a growing recognition that greater transparency in exchange trading, reporting of trades to central trade repositories and higher collateral requirements for non-cleared OTC contracts will significantly contribute to the future stability of international financial markets.

Regulatory developments have pushed the trading of standardised derivatives instrument types onto exchanges or into a central counterparty (CCP)-cleared environment.

This is prompting counterparties to review how they utilise derivatives contracts, but it does not portend the disappearance of bilateral OTC trading. From a diversification perspective, it is clear that many banking counterparties continue to value the benefits of maintaining a broad network of bilateral relationships that they can draw upon to meet their funding and financing needs.

The European Market Infrastructure Regulation (EMIR) in Europe and the Dodd Frank Act in the US and other regulations in different jurisdictions require that firms post initial margin and variation margin against their bilateral non-cleared OTC derivatives. The requirements for the exchange of variation margin entered into force in the first quarter of 2017 while initial margin requirements are being phased in from 2016 to 2020, depending on the size of the average aggregate outstanding notional amounts.

Two sets of margins addressing different risks:

• The purpose of variation margin is to cover the daily mark-to-market movements of the derivatives portfolio exposures.
• Initial margin aims to mitigate potential future exposure in the event of liquidation of positions or hedging of market risk following counterparty default.

Variation margin is primarily exchanged in the form of cash when the initial margin is mostly exchanged in the form of securities, for example, government debt, corporate bonds, equities etc. The new rules increase the need to hold enough high-quality collateral, in the right form, at the right place and at the right time to meet the stringent margin requirements.

The new rules create significant operational challenges driving firms to re-evaluate current processes and workflows. Such challenges include (not exhaustive and dependent on precise details of the relevant regulation):

• Variation margin: Mandatory collateralisation, daily margin call calculation and zero thresholds drive up margin call volumes significantly.
• Initial margin: Daily collateral valuation, margin call exchange (gross basis) and segregation at a non-affiliated third party custodian or triparty agent. Rehypothecation/reuse of margin is not permitted.
• Eligible collateral, haircuts and concentrations defined by the different regulators. Stringent minimum transfer amounts and thresholds applicable to both variation margin and initial margin.
• Parallel streams for legacy and regulatory variation margin and, if in scope, initial margin calls vs the same counterparty.
• Strain on daily operational workflows driven by a hike in call volumes and greater complexity, often combined with earlier notification deadlines and shrinking settlement windows.

Today, funding and financing activities are affected by a range of factors, including global regulation on capital and liquidity management and of course market conditions such as the European Central Bank’s asset purchasing programme (APP) and negative interest rates.

As a result of the regulation-driven move towards more secure funding and financing mechanisms, firms have experienced a noticeable impact on their repo and securities lending and borrowing activities and naturally, at their core, on their collateral management.

The Basel Committee on Banking Supervision (BCBS) proposed reforms to strengthen global capital and liquidity markets as aftermath response to the global financial crisis.

OTC derivatives regulation has increased demand for high-quality collateral, while the Liquidity Coverage and Net Stable Funding ratios (BCBS rules) have stressed the importance of the quality and maturity of securities on the balance sheet pushing banks to focus on collateral and balance sheet efficiency.

As a result of the challenges induced by the Basel III capital and liquidity requirements, the role of the sellside as a provider to the market of liquidity has been constrained thereby affecting collateral accessibility and mobility. Further regulatory challenges, such as MIFID II, SFTR and the discussions on the mandatory buy-in rules have complicated matters further.

Profound changes in both securities finance and derivatives businesses have redefined the collateral ecosystem and its flows. The multiplicity and complexity of the new collateral requirements across activities and trading counterparties (often accentuated by segregation rules) now implies having to manage liquidity across various settlement locations and under different account structures. Firms struggling to centrally manage their holdings versus exposure requirements but also trading opportunities, for example, in securities finance, face inventory management inefficiencies and ultimately higher costs across the organisation.

The implementation of new collateral requirements for non-cleared derivatives (“Uncleared Margin Rules”) in 2017, which remains ongoing, required many buy-side firms to look at more effective collateral sourcing and management solutions. Limited capacity by existing sell-side relationships to optimise the collateral utilisation and to streamline processes in order to mobilise collateral more efficiently has weighed on the buy-side. For instance, for many pension funds and insurance companies collateral transformation is key to accessing the required high-quality collateral in cash or securities to honour margin requirements.

Within an organisation, the structuring of collateral functions in “opaque” compartments is now an impediment to achieving proper collateral mobility and to overcoming collateral fragmentation. Today´s strong interlinkages between the margin requirements for OTC derivatives and/or exchange traded derivatives, but also repo and securities lending and borrowing activities, underpin the need for more integration. Approaching collateral management from a holistic perspective should be viewed as an opportunity to use inventory where and when it is needed at the best cost but also to generate revenues. Such adaptations have proven to be a major challenge for most buy-side firms from both a technological and organisational standpoint.

New margin requirements on OTC derivatives alone have created a substantial additional workload for the middle and back-office areas. Indeed, the hike in the number of calls to manage with counterparties along with the increased complexity and timing pressures are a strain on manual processes, which have become a source of operational risk and additional cost. This is only exacerbated where structures with underlying funds under management, for example, for asset managers, as the collateral needs to be segregated at fund level. Furthermore, managing collateral workflows is often not the core activity of the involved teams and their capabilities can be put to better use.

Against the backdrop of the changing environment, solutions exist to support the industry and to create a secure and efficient market with improved access to liquidity and collateral mobility

Inefficiencies and costs due to outdated organisational models may indeed induce sell-side, but also buy-side firms to undertake the necessary efforts to redefine these and to look into building a centralized collateral function that brings transparency. Eventually, firms need to weigh the benefits of internalising processes versus using outsourced solutions of collateral agents or a combination of both. When internalising, complexity and volumes to be managed are to be considered mainly in light of the implied resource deployments and training, technology developments and maintenance, licencing arrangements, data management across assets classes, eligibility profiles and settlement locations.

One of the main concerns notably for many buy-side firms has been maintaining access to liquidity within the aforementioned challenging environment. Developing trading relationships with various liquidity provider counterparties has been one option, for example, increase the number of repo trading counterparties to maximise the use of their assets and secure access to cash. Another one has been to turn to cleared solutions to gain access to numerous participants while facing a CCP as sole counterparty to all trades, such as Eurex Clearing. Clearstream as collateral agent and market infrastructure providing services to the cleared and non-cleared collateral spaces supports both options by helping firms to connect to a network of trading counterparties.

Firms having to meet increased variation and initial margin requirements for cleared and non-cleared derivatives need solutions that enable them to manage these in a streamlined manner. In that regard, regulatory compliance will have to be also supported by leveraging funding and financing solutions to manage liquidity and above all, by the capacity to manage collateral from a single pool.

Clearstream helps firms navigate towards a holistic approach to collateral management and achieve the targeted operational excellence to overcome fragmentation. This entails, for instance, offering them the ability to mobilise collateral between different noncleared and cleared activities, to bridge the bilateral and triparty collateral management spaces, source collateral from different settlement locations and access CCP services. Margin management services for CCP-cleared and non-CCP derivatives include OTC collateral management for variation margin and initial margin as well as triparty services for the segregation.

Ultimately, the customers benefit from netting, collateral transformation, reuse and optimisation opportunities but also from a global collateral network built through collaboration and partnerships (e.g. Central Securities Depositories, vendors…) aimed at increasing collateral efficiency.

The implementation of TARGET2-Securities (T2S) has simplified the challenge of mobilising collateral cross-border by introducing a single pan European settlement platform allowing the pooling of domestic collateral portfolios. At the same time, Clearstream's T2S offering has opened new opportunities for market participants to combine CSD and ICSD liquidity across asset classes.