Collateral Management in OTC Derivatives Market

Collateral management is at the center of over-the counter (OTC) derivatives regulatory changes. Many industry initiatives are being developed to improve collateral management and optimize the supply of collateral - collateral optimisation and transformation solutions, automation, evolution of CCP practices to allow cross margining and expand the range of eligible assets to a certain extent. Collateral are assets that are pledged or transferred as security on the value of a loan or more generally of a credit exposure in order to mitigate the risk that a counterparty will default on its payment obligation. Collateral decreases the credit exposure by the mark-to-market value of that collateral. Haircuts are used to adjust the value of collateral according to its quality.

Collateral, which has been chosen by regulators as the main risk mitigation tool for putting in place the G20 commitments, is used to secure many types of transactions:

• Funding by banks at central bank
• Funding by banks or broker dealers at banks, by fund managers at prime brokers
• Derivatives transactions: i.e. initial and variation margin posted for on-exchange and OTC derivatives deals, contribution to the CCP default fund
• Securities lending
• Securities transaction settlement.

International Swaps and Derivatives Authority (ISDA) estimated that collateral used in uncleared OTC derivatives transactions reached approximately $ 3.6 trillion in 2011 and has grown at a compound annual rate of 17% over the past 6 years. The most predominant forms of collateral used for derivatives transactions are cash and sovereign debt from the main developed countries (G7 countries). Resort to collateral and demand for high quality liquid assets are expected to grow significantly in the coming years with the implementation of new regulations following the financial crisis.

Collateral Management Challenges (Source: Deloitte)

Central clearing of standardized OTC derivatives transactions due would become mandatory by the end of 2012. This is expected to raise the needs of dealers and their clients for high quality collateral since CCPs often demand more collateral and of a higher quality for equivalent positions than bilateral arrangements. Basel III liquidity coverage ratio (LCR) requiring banks to hold enough liquid assets to get through a 30-day period of severe funding stress will further reduce the availability of safe assets.

The increasing awareness of counterparty risks following the Lehman bankruptcy and the downgrade of bank ratings are additional drivers to the usage of collateral, as well as the impact of the sovereign debt crisis on related banks e.g. Spanish and Italian banks having to pledge higher quality securities (such as covered bonds) to access funding. Reduced availability of collateral in a context of increasing demand should increase the cost of obtaining and using collateral and may potentially lead to a liquidity squeeze and systemic risks if demand cannot be satisfied. Many solutions detailed below have been developed in the industry to improve collateral management:

An impact assessment of existing and projected collateral management solutions could be conducted at market level, in order to evaluate their potential capacity to address as a whole the increased demand for collateral in the coming years, taking into account the main milestones of on-going regulatory reforms. This would allow a better evaluation and anticipation of the possible shortages of collateral over time and a calibration of required solutions. Additional solutions could be envisaged for cash and non-cash collateral in order to e.g. increase the pool of collateral which is at present provided mainly by traditional buy-side participants (for example by involving some cash rich corporate players in financing mechanisms) or enhance the safety of traditional financing vehicles such as repos for borrowers.

Collateral optimization services:

Collateral agents propose a range of services to optimize the handling of collateral. Specific infrastructures have also being developed by the main triparty collateral agents to allow collateral to flow more easily, leveraging the pool of collateral available in these infrastructures or handled by these players. Their objective is to consolidate collateral pools at market level, enable market participants to keep track of the assets deposited and help holders of collateral to channel securities.

Collateral transformation services

Collateral transformation involves clients swapping non-eligible collateral for eligible collateral (e.g. cash or higher quality securities) via the repo market which can then be posted with CCPs.

Evolution of CCP practices

CCP practices could evolve in order to optimize collateral requirements (i.e. reducing overall margin requirements for related products), but these evolutions will probably remain limited in order to preserve market integrity and investor safety. Cross-margining can be used in order to reduce overlaps in collateral between closely related products e.g. between OTC interest rate swaps and interest rate futures products or between cash and derivative fixed income. Expanding the range of eligible collateral e.g. accepting some high-quality corporate bonds as collateral for OTC swaps can be another option.

OTC Derivatives under Central Clearing

Recent regulatory efforts, especially in the U.S. and Europe, are aimed at reducing moral hazard so that the next financial crisis is not bailed out by tax payers. Central Clearing was proposed by G20 as the solution (for OTC trading) after the financial crisis and mandated all these derivatives should move to Central Clearing by end of 2012. Failing to comply with this may result in charge of significant amount of capital. What this means is that rather than these derivatives being traded as mere contracts between two parties, these should go through one single entity. The financial crisis following Lehman’s demise and AIG’s bailout has provided the impetus to move the lightly regulated over-the-counter (OTC) derivative contracts from bilateral clearing to central counterparties (CCPs).The motive behind this proposal was to increase transparency on positions, reduce counterparty risk and reduce operational risk. This intends to reduce the exposure to default of each party. Per the OTC derivatives reform, standardized derivatives (~60% of the current OTC market) need to be electronically executed (SEFs), centrally cleared and publicly reported. Under the present regulatory overhaul, the OTC derivative market could become more fragmented. Furthermore, another taxpayer bailout cannot be ruled out. A key incentive for moving OTC derivatives to CCPs is higher multilateral netting, i.e., offsetting exposures across all OTC products on systemically important financial institutions’ (SIFIs) books. 

Of course, all this works only if the Central party is safe. The intent is also to keep Central counterparty  to be remote from bankruptcy and thus immunize it from default. For this CCP needs to have line of defence. Each of the parties trade with CCP and even though the trade is long-dated, those are marked to market every day and settle up with CCP. This is not how futures work. This entire process expedites the CCP’s ability to address any default immediately. Secondly, CCP maintains buffer to offset the default risk which is called risk/initial margin which accounts for the fact that the market move a bit or substantially. Third thing in the line of defence is guarantee or default fund which comes into involvement when these risk margins are not sufficient to handle the default risk. 

    

So the parties (which may include hedge funds, banks, and asset managers) now face new kind of risk. Earlier, the main exposure was to credit but the price of moving out the credit part out is liquidity. The market is going to move to either side of the pendulum every day and this calls for cash in hand. There are varieties of different entities providing services in different types of derivatives. Following figure shows how all these stakeholders' roles fit together. 

An important distinction among these is the degree to which they allow cross-margining. Cross margining is the ability to offset the marginal requirement of product trading with one in another product with the same counter party. The main three CCPs are CME, ICE and LCH.Clearnet. At the moment, the flow is really with these big three. LCH has cleared around 40% of IRS (interest-rate swaps) market. ICE cleared around 65% of the CDS market. Credit Valuation and Adjustment (CVA) is the mechanism that the banks used to account for the possibility of the counterparty default when they do derivatives trading with bilateral counterparties. This was very relevant when the main risk was credit. As we move into CCP world, arguably CVA becomes less important. The majority of dealing houses have moved to OIS (Overnight Index Swap) for the valuation of collateralized derivatives, however no such consensus exists for the valuation of uncollateralized derivatives. The recent Libor scandal has put the spotlight on the debate around how banks measure their cost of funding and highlighted the possibility of banks introducing a funding valuation adjustment (FVA) to more accurately reflect the cost of funding in their valuations.

All these are measures for standardized derivative products. There is a need for managing more complex products. It is expected to have higher margins for non-cleared swaps. CFTC is suggesting that it may double the initial margin for the non-cleared swaps. So the complex derivative trading is expected to become more expensive. Therefore, the P&L is going to be affected for these entities.

Making OTC derivatives more accessible to the investment community poses significant risks, as well as benefits. Whenever more firepower is vested into the hands of investors, the risk that they will do themselves damage increases. Although a number of factors will help to mitigate those risks—including increased transparency, the attraction of new forms of liquidity, and a central clearing structure to minimize bilateral counterparty credit risk—there is still the possibility that a rush of interest in OTC derivatives stokes the next bubble.