The road ahead
Those that lead and innovate will strive to provide competitive advantage and agility. Helen Nicol of Lombard Risk explains how
The new and complex rules mandated by the US Commodity Futures Trading Commission, the European Securities and Markets Authority and other regulators has caused the focus on collateral management to change considerably for both buy- and sell-side organisations globally.
The impact of the 2008 financial crisis demonstrated potential areas of weaknesses in the over-the-counter (OTC) derivatives markets. As a result, the G20 requested that the Basel Committee on Banking Supervision (BCBS) and International Organization of Securities Commissions (IOSCO) develop a consistent global set of standards for uncleared margin requirements resulting in the most recent regulatory technical standards (March 2016). The importance of the framework to the financial services industry cannot be underestimated as it lays out several key parameters as guidelines for the OTC derivatives market, including the exchange of daily variation margin, gross initial margin to be exchanged by both parties and held in such a way as to ensure that: (i) the margin collected is immediately available to the collecting party in the event of the counterparty’s default; and (ii) the collected margin must be subject to arrangements that fully protect the posting party. The calculation of both initial and variation margin should also be consistent and any assets collected as margin should be highly liquid and be able to hold its value in times of financial stress.
The regulatory response to the financial crisis has been globally coordinated but has been locally implemented across jurisdictions—leaving much open to interpretation. Those institutions that are affected by the 1 September 2016 deadline have been reviewing the impact of the final draft in order to interpret the rulings and any global variances with the US and Asian regulations. The size of the uncleared market is substantial and despite a push towards central clearing, much of the derivatives market remains uncleared due to lack of standardisation, liquidity and customisation.
As a result of the changes, we have also seen interest from organisations looking to move non-OTC business lines onto a central clearing platform where possible. Extensions to central clearing business lines, such as those now offered by Eurex, CME and other exchanges for both repo and securities lending, are of interest to many participants. However, other regulations also affect these areas. For example, for repo and securities lending, the Financial Stability Board framework to standardise repo haircuts is yet to be fully implemented, as are the shadow banking requirements. The Securities Financing Transaction Regulation (SFTR), which is targeted at reforming shadow banking and improving transparency in securities finance transactions, creates additional reporting requirements to a trade repository. In addition, the SFTR mandates holding requirements for at least five years and reuse restrictions that reach beyond the scope of just the EU.
The European Market Infrastructure Regulation introduced reporting requirements and mandated clearing of swaps on central counterparties and the second Markets in Financial Instruments Directive (MiFID) creates new trading venues with obligations coming into effect from 2017. MiFID II and Packaged Retail and Insurance-based Investment Products Regulation will require increased disclosure relating to costs.
The complexity of the regulations across all areas of the business, combined with the jurisdictional variations, is causing buy- and sell-side organisations to rethink their operational processes, review their counterparty trading activity, and evaluate compliance implications. The clearing fragmentation reduces the advantages of calculating margin across a multi-asset portfolio, especially in the US where there are a variety of different accounts depending on whether they are for security, non-security, futures or swaps. Differing rules for US and European participants relating to segregation criteria adds to the complexity as organisations strive to manage costs effectively while attempting to provide a service to their end users.
Although many organisations continue to operate their collateral management functions in silos for multiple reasons, including legacy infrastructure and resource allocations, there now appears to be a drive toward a more streamlined approach as institutions look to reduce operational and technical overheads, automate internal processes and benefit from connectivity with external providers. The long standing debate over build versus buy appears to have lost impetus as organisations recognise the burden of attempting to keep pace with dynamic nature of regulatory changes.
Financial entities of all sizes are now looking for options to assist them with meeting the compliance criteria, coping with increased volumes and minimising trading costs. The increase in margin volumes as firms deal with both legacy and new regulatory agreements, and the additional initial margin required by central securities depositories, mean that many organisations may now have to manage four agreements (with clearing) rather than one for each relationship. The repapering challenge alone means many organisations may not be fully prepared for the deadlines.
The costs of assets considered eligible for collateral are likely to increase significantly due to an increase in demand. This in turn causes other issues, such as increased settlement risk due to the additional volumes and potentially puts pressure on organisations to additionally manage liquidity buffers. Managing the intra-day exposures and related settlements only increases existing funding pressures particularly in times of stressed markets. Firms need to review and understand costs for each product and look to streamline where possible. Sell-side organisations will look towards how those costs are provided to clients as they demand increased transparency.
In Europe, the additional concentration limit and wrong-way risk rules create added complexity for those looking to use alternatives to cash. The need for system enhancements, whether in-house or vendor provider, to be delivered within a short timeframe has created further burdens that may prove onerous to some of the smaller players.
Segregated custody accounts for uncleared margin are now being required in relation to initial margin and both principal and counterparties need to be able to send required value notifications for matching and validation to triparty agents as opposed to just the exposure and margin requirements. Limit rules mean that connectivity to multiple custodians may be required. This in turn creates additional costs and fragmentation as organisations attempt to record what they hold and where.
Operational risk increases with the rise in expected substitutions as the margin volumes and reasons for potential ineligibility grow. Ineligibility reasons, tracking of substitutions and associated settlements add further pressure on resources as does the expected increase in dispute tracking as a result of differing variation and initial margin exposure calculations.
The new proposals currently being developed for risk exposure measurement will have far reaching implications on current processes and result in increased demands in terms of the systems required to calculate exposures and the amount of capital needed to be held. As a result, technology will remain at the forefront of financial institutions focus for the foreseeable future and investment in both people and platforms will be vital. Solutions need to cover all instruments and enable holistic management across regions and business lines for both cleared and uncleared products—with the flexibility to be offered as an installed platform at a client site or in the cloud.
Those that lead and innovate will strive to provide competitive advantage and agility while others will be content to follow the market. Increasing focus will be on resilience and connectivity, automation and scalability across platforms. The spotlight will be on utilities and their proposed offerings and ability to keep pace as the market evolves—as will the big data and blockchain activities. What is certain is that the collateral landscape will change dramatically over the coming months.