Mark Jennis, Managing Director, DTCCMJennis@dtcc.com

Mathew Keshav Lewis, Vice President, DTCCMathewLewis@dtcc.com

collateral has had to become much more analytical. Finding the lowest cost collateral eligible for a particular purpose, for example, can help a financial institution raise crucial finance, hedge an exposure, or save a great deal of money. The need to source eligible collateral and allocate it to the right counterparty creates markets in collateral with similar supply and demand characteristics to those of any market, with commensurately complicated servicing requirements. The demand for collateral is driven by the daily reconciliation of trades and investment portfolios between counterparties, and the daily calculations of the net exposure between them, based on movements in the prices of the underlying assets and liabilities and collateral posted already. Once the exposure is calculated, a margin call is executed at an agreed value. The margin call can take one of at least three forms. The first is simply a bi-lateral matching of the margin call between collateral provider and collateral taker. The second is an affirmation of the terms of the trade between a prime broker (usually a major investment bank) and their client (typically a hedge fund manager). The third, in which collateral is posted to a clearing broker for onward transmission to a central counterparty clearing house (CCP), is ultimately settled between the CCP and the clearing broker. These collateral demands necessitate the efficient identification, aggregation, optimisation and allocation of collateral on the supply side to meet these three different needs. Market participants cannot efficiently pledge collateral unless they know where it is located and

If you Google “collateral,” the top search result is a 2004 thriller starring Tom Cruise and Jamie Foxx. While collateral in the financial sense may not bring to mind the same level of action or adventure, the reality is surprisingly dynamic. Sweeping and rapid changes are occurring in financial markets that are having a significant impact on the management, mobilisation and transformation of collateral. Collateral has a contradictory reputation. It is remembered as the trigger of massive financial losses in the acute phase of the financial crisis in 2008. But it is also viewed as an important part of the solution to the problems highlighted by the crisis. Policymakers around the world have enacted new rules, including the Dodd-Frank Act in the United States, the European Market Infrastructure Regulation (EMIR) and the Basel III regulations in Europe, all of which have implications for the markets in collateral. The primary objective of these new regulations is to increase market stability and resilience, enhance transparency, and reduce counterparty, operational, and liquidity risk. Collateral, as the security provided by one party to another to mitigate counterparty risk in any extension of credit or other financial exposure, has an important part to play in achieving these goals. Managed well, collateral solves many more problems than it creates. Because it is used in so many lines of business (payments, repo, securities lending, swaps) and takes such a wide variety of forms (cash, bonds, equities, mutual fund shares, commodities and precious metals) the management of

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MANY HANDS MEAN RISK AND OPPORTUNITY INCREASERegulation and industry developments are changing the nature of collateral management. These changes are putting pressure on the collateral supply chain, increasing the volume of margin calls and collateral movements, and vastly complicating the operational processes that support the collateralisation of swaps, futures, repos, stock loan and payments. Mark Jennis, managing director, strategy and business development at DTCC and Mathew Keshav Lewis, vice president, strategy and business development at DTCC, explore the risks and opportunities this is creating for market intermediaries, service providers and market infrastructures.

will request initial margin be held in segregated accounts. In addition, the removal or reduction of the thresholds for variation margin currently used in bi-lateral trades means any change in valuation is likely to trigger a margin call, and most likely on a daily basis. In the past, the use of thresholds limited these calls to occasions when the value of the underlying trade moved significantly. But factors other than regulation are also at work. These include the fragmentation of CCPs between countries and regions and asset classes, and the knock-on effects on the documentation required to cover the collateralisation of OTC derivative transactions. For example, the new standard credit support annex (CSA) published by ISDA encourages variation and intra-day margin calls to be settled in the same currency as the underlying trade (for many good reasons). This is likely to result in an increase in the volume and complexity of collateral calls. Today, margin calls are primarily met in euro or US dollars. In the immediate future, margin calls will be settled in any of the five main currencies, and eventually in any one of up to 17 different national currencies within the Group of 20 (G-20). In addition, CSAs previously allowed an entire portfolio of deals with one counterparty to be covered by a single margin call. Now that swaps are centrally cleared, CSAs will have to exclude products offered by different CCPs, each of which is specialising in a particular contract, such as interest swaps being cleared by CME Clearing and LCH.Clearnet, credit default swaps by ICE

Coupled with limited internal optimisation of collateral, inefficiencies of this kind could exacerbate the potential gap between supply and expected new demand identified by the Bank of England, ISDA and the BIS. That is a non-trivial problem. An inability to view all available collateral, and limited capacity to mobilise and allocate it during periods of market stress, could make the difference between surviving a financial crisis and succumbing to it. The stress will be intensified by the sheer volume of transactional activity stemming from rising demand for collateral. Margin call activity, for example, can be expected to increase dramatically as OTC derivatives move from bi-lateral markets to centralised clearing. Discussions with participants in the OTC derivatives markets indicate that this activity could increase by anywhere between 500 and 1,000 per cent. A follow-up study by the London School of Economics, funded by DTCC, is underway to validate these predictions. A primary driver of these astonishingly high rates of increase is the regulatory mandate to clear swap transactions. This has led to the proliferation of clearing venues in various countries and regions and for specific derivative types. Each of these venues will be issuing margin calls daily. Adding further to the number of calls, users will be obliged to post initial margin to each of these venues, many for the first time. The introduction of initial margin will significantly increase not only the number of calls, but also the amount of collateral required. Adding further to the complexity of the process, it is expected that most buy-side firms

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can aggregate it accordingly. Once the appropriate inventory is secured, the collateral can then be optimized. Essentially, this means allocating the collateral, based on a variety of parameters that are defined by the collateral provider (such as minimal cost) and that also satisfy the demands of the collateral taker (such as less risky collateral). This is easier said than done. It means reviewing the collateral eligibility criteria of the counterparty, understanding the terms of the agreement with the counterparty, calculating the relative costs and risks of putting a single piece of collateral to different uses, taking into account the internal requirements of the in-house or third party source of the collateral, and then actually moving the collateral between accounts via networks of custodian banks. Allocation is where the supply of collateral meets the demand for it. With the demand for collateral rising as a result of regulatory change, supply is becoming a source of animated discussion in the industry. Over the last 18 months, several organizations have attempted to calculate the amount of collateral that will be needed by financial firms as a result of the new OTC derivatives measures taken under Dodd Frank and EMIR, and the new capital and liquidity requirements specified in Basel III. There is a concern that there will not be sufficient eligible collateral to meet all needs. Driving the increase in collateral requirements are new rules that mandate centralised clearing through CCPs for the majority of over-the counter (OTC) derivatives trades, and the introduction

of robust operational controls and capital requirements even for OTC derivatives trades that do not need to be centrally cleared. In practice, CCPs will have to impose initial margin requirements (which can be met in the form of securities as well as cash) and make daily variation margin calls (which can be met only in cash). This can be expected to dramatically increase the demand for cash and high-quality collateral that can be turned into cash. A study by the Bank of England in September 2012 estimated that new collateral demands stemming from regulatory change could amount to as much as $800 billion. In a separate analysis, the International Swaps and Derivatives Association (ISDA) calculated that new initial margin requirements for centrally cleared OTC derivatives could top $10 trillion. And, most recently, a committee of the Bank for International Settlements (BIS) estimated that the combination of new liquidity requirements and OTC derivatives clearing could push new collateral needs to $4 trillion. Despite these potentially massive increases in demand for collateral, many financial institutions have yet to fully grasp the value of the pools of eligible collateral in their possession or, where they are cognisant of it, are struggling to find ways of mobilising the collateral efficiently to post against specific exposures. As much as 15 per cent of the collateral available to financial institutions is currently left idle. According to a recent joint study by Clearstream and Accenture, this under-utilisation is costing the industry around the world more than €4 billion a year.

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operational impact, which will affect the economics of the services being provided. Regulators are introducing options for users of OTC derivatives in particular to insist collateral is held in segregated accounts. This follows the poor experiences of some firms during the failures of Lehman Brothers and MF Global. While offering collateral givers the assurance of greater safety and transparency, segregated collateral accounts also reduce scope for re-use and reinvestment of collateral, multiply the number of accounts, and add a further layer of complexity. Unsurprisingly, the increased use of collateral is placing greater demands and costs on broker-dealers, fund managers large and small, fund administrators and custodian banks, which has increased the interest of all of these market participants in finding rapid and cost-effective solutions to the challenges. These include buying third party services, investing in partnerships with specialists or like-minded firms, and the purchase of software applications and services from vendors, some of which are categorised and described in the sidebar (see the sidebar, ‘How to manage collateral efficiently, by Mark Jennis and Mathew Keshav Lewis,’ page 58). The pressure to act quickly has also increased interest in the use of industry standards to facilitate interoperability and provide the foundation for scalable products and services that canovercome challenges quickly and at low cost. The evolving regulatory environment is unlikely to lift the pressure soon. However, regulatory changes have benefits as well as costs. It is demonstrably spurring innovation,

a potentially ten-fold increase in transactional activity. As a result, firms will need to invest in both technology and the re-engineering of their settlement processes, exceptions management policy and dispute resolution procedures. According to a study published by Deloitte in 2011, investment in the improved operational processes necessary to build and sustain advanced collateral management and optimisation capabilities will cost a top tier bank at least $50 million a year. The increase in margin call volumes will certainly necessitate more comprehensive record-keeping across a broad category of services. Already there are many fragmented processes and solutions that handle deal reconciliation, margin disputes, margin call reporting and settlement reports. In future, tracking and reporting collateral activity and collateral balances across multiple products and providers is bound to become more challenging. The growing interest of regulators in monitoring activity in the collateral markets, as part of their efforts to manage systemic risk, is set to add to this information-gathering burden. Regulators are requiring the establishment of trade repositories, to which market participants are expected to report their counterparty exposures. They believe greater transparency will reduce the risk of counterparties becoming prey to rumours or incompleteinformation, sparking a run on the firm. Trade repositories are also expected to accelerate the resolution of margin disputes. For clearing brokers and CCPs, buy-side clients will also have an important

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Clear and CME Clearing, and equity swaps by Eurex Clearing and the Options Clearing Corporation (OCC). This specialisation will necessitate separate margin calls for each CCP, instead of one for each portfolio with each counterparty. This splintering of collateral demands, and the shift away from the historical portfolio process of one collateral call for each portfolio of contracts, could lead to further increases in demand for collateral. It will certainly increase the number of calls, as well as operational risk, since the volume of collateral movements will be much greater. To manage and mitigate that operational risk, market participants will need to upgrade their internal systems, workflows and procedures, and keep them in a high state of readiness to respond quickly to new challenges. Many firms are understandably concerned that their increased need to source collateral, along with the accompanying increase in the number of collateral movements, will lead to higher costs and risks. They are not wrong. There are three reasons to expect funding costs to rise. First, the increase in the volume and value of collateral demands will require firms to fund larger cash balances to meet expected margin calls. Second, in the OTC derivatives market, it is standard practice to anticipate margin calls and seek offsets, in order to net down the cash that needsto be on-hand. With the increase in the sheer volume of margin calls and the risks associated with not meeting a call – CCPs, unlike clearing brokers, cannot be negotiated with – firms will need to maintain a larger liquidity buffer

to ensure all margin calls can be met on time. Third, the lack of certainty around intra-day obligations and settlements will magnify intra-day exposures and the risk of funding squeezes during times of extreme market stress. During an acute phase of the financial crisis in 2008, this is exactly what happened. There is a fourth reason why increased collateral demands will inflate costs. The interlude that elapses between a request for collateral from an investment manager, and the delivery of that collateral to a CCP or another counterparty, counts as an extension of credit. That means it attracts a capital charge. Banks may seek to recover the additional costs. Only by identifying, mobilising and settling collateral from the investment manager more quickly, can the gap be reduced and capital relief secured by the bank. Banks that can minimise or solve for this gap will distinguish themselves from less efficient peers. It is not only funding and capital costs that are at risk of going up. Operational risk will also be greater. The anticipated increase in the volume of margin calls has the potential to overwhelm existing processes and systems within banks and buy-side firms and their administrators. This risk is especially acute at times of extreme market stress, when the volume and value of margin calls will increase exponentially, and firms will need to settle collateral obligations seamlessly. To express concern that not all market participants are yet capable of accomplishing this is not a criticism of current platforms or operational teams. It is recognised that most firms do not have the spare capacity to absorb

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FeatureHow to manage collateral efficiently, by Mark Jennis and Mathew Keshav Lewis The collateral management and optimisation products and services now becoming available are of various types - some offerings focus on specific problems, while others attempt comprehensive coverage – but they can generally be grouped into one of six categories: exposure calculation and margin management; portfolio margining; collateral optimisation; record-keeping and reporting; communication standards; and reference data. The way they fit together is illustrated in the diagram below.

especially but not exclusively at market infrastructure firms that see opportunities in helping institutions meet the new collateral requirements in cost-effective and efficient ways. Regulatory pressure is also encouraging new forms of collaboration, with different parts of the industry coming together to help buy-side and sell-side firms adapt quickly to the rising demand for collateral. It is imperative that industry participants and service providers work together to address the operational costs and risk associated with the increase in collateral calls and demand for collateral before this challenge overwhelms financial institutions and negatively impacts long-term economic growth.

Want to find out more? Join us at:

Global innovations in collateral management,Wednesday 18 September2pm, Community room 3

The chart is a model of a collateral process. Not all collateral processes have these functions but the vast majority of them follow this model.

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markets. Where these can add value is by incorporating settlement netting and collateral account segregation functions. In fact, multiple collateral segregation services are now being offered. Many are specific to a particular product, CCP or jurisdiction. Service providers are developing services aimed at holders of segregated accounts, such as daily and intra-day collateral substitutions and collateral valuations. Developing a standardised infrastructure to support collateral segregation will be essential as segregated accounts grow and become more complex. The aim of portfolio margining products and services is to calculate a margin requirement for a portfolio of exposures in such a way that offsetting risks can be used to reduce the volume and value of the collateral that must be allocated. For example, a counterparty holding an equity option can offset that exposure against the underlying equity or an equity index in order to reduce the margin that must be posted. Portfolio margining is already common in the futures and swaps markets, and the centralised clearing of swaps creates scope for margin offsets between swaps and futures positions. The purpose of collateral optimisation products and services, on the other hand, is to make the sourcing of collateral more efficient. The aim is to identify collateral held in various locations; pool that collateral so that it can be allocated to a variety of exposures; allocate it in an efficient and methodical way, generally based on price, risk, liquidity, haircuts and financing costs; and create networks to facilitate the flow of collateral between counterparties. A number of service providers offer some or all of these capabilities already. However, there is growing demand from

The objective of exposure calculation and margin management services is to integrate the various collateral processes so that a higher proportion of information exchanged can be processed in an automated fashion without manual intervention. These reduce operational risk. For example, portfolio

reconciliation tools enable participants to reconcile deals or transactions and valuations that are the primary inputs to calculate margin calls. These tools may be specific to the data being matched

by trade repositories or customised reconciliations for margin processes. There are also various calculation engines that compute variation and initial margin. These may be part of a collateral management capability built internally, or purchased from a third party service provider or IT vendor, or computed by a CCP or other market infrastructure. It is likely that the initial margin calculation engines used by CCPs in the cleared OTC derivative markets will spread to the bi-lateral OTC derivative markets as well. In addition, various providers are offering applications that enable counterparties to agree and communicate margin calls. These tools can be industry-wide solutions. But they can also be developed specifically by service providers such as custodian banks, fund administrators and prime brokers. Many collateral settlement functions can be automated in a fashion similar to the way that securities trades are matched and settled in the securities

Mark Jennis

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market participants for functionality that enables allocation of collateral on a daily and even intra-day basis. Some service providers are also enhancing their collateral optimisation service by helping clients choose the optimal venue for trade execution and clearing based on the costs and risks of the collateral requirements. A burgeoning aspect of collateral optimisation is collateral transformation. This offers clients the ability to exchange collateral that is not eligible at a CCP or other counterparty for something that is acceptable. An obvious instance is the use of the repo market to transform securities into cash for posting as variation margin to a CCP. However, there are a variety of other mechanisms that can be used to transform collateral, including stock lending and structured

deals as well as repo transactions. Choosing between them will depend partly on price - custodian banks, broker-dealers, prime securities depositories (CSDs) are all mindful of balance sheet and capital costs – but users of collateral

transformation services must also take operational, market and credit risk implications into account. The value of collateral reporting products and services lies in their ability to help market participants meet their obligations to report OTC derivative transactions to trade repositories and regulators. However, the transmission of information is not one-way. Global trade repositories also hold data about

collateral that can help counterparties identify potentially large margin calls that could be difficult to satisfy. They also help regulators track cross-jurisdictional exposure and potential payment failures that may not be visible to individual national or regional authorities. Encouraging the standardisation of reporting formats is an important benefit of collateral reporting products and services. At present reports are delivered in a variety of formats, and incorporate different data. There is now an industry initiative under way that aims to standardise margin reporting for cleared OTC derivatives. If successful, it will eliminate the need for individual firms to download and re-format data, and facilitate competition between collateral reporting products and services. The value of standardisation obviously reaches beyond collateral reporting. Increasingly complex collateral management and settlement processes can be managed much more successfully if they are supported with open communication standards. Standards for margin call workflows and disputes are now being developed. Last but not least are reference data services. The valuation of underlying transactions and the pricing of collateral are both major inputs into any margin calculation process, and the principal cause of margin disputes. So the quality and content of the data in the securities master file is essential to the optimisation of the use of collateral. The use of standing settlement instructions (SSIs) increases the level of automation, and ensures that collateral is delivered to the right location. Legal Entity Identifiers (LEIs) have also been introduced to allow for more accurate client identification and reporting as well.

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Mathew Keshav Lewis

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