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.