Changes to OTC derivatives margining and what it means for the buy-side
Fragmentation looms for buy-side firms looking at their options for sourcing, mobilising and protecting collateral assets to be used as margin for cleared and non-cleared OTC derivatives. But firms are finding ways to address this problem.
Sources of fragmentation are multiple, but a key factor is that – depending on size - many asset managers run multiple funds containing varying types of assets owned by clients with divergent priorities and requirements across many external custodians. But some operational improvements can help asset managers address these challenges.
It's just about efficiency.
Remember it is the fund, not the asset manager, that is the relevant legal entity from a regulatory perspective. A key challenge posed to asset managers by non-cleared OTC derivatives margin rules is managing segregation of collateral assets efficiently and securely at the fund level.
Unlike central clearing of standardised OTC derivatives under the European Market Infrastructure Regulation (EMIR), the new rules for non-cleared, non-standardised derivatives demand that initial margin should be exchanged on a gross basis. It should be held and made immediately available to the collecting party in event of counterparty default. The posting party is also protected should the collecting party enter bankruptcy.
(As a reminder to our readers, EMIR requires asset managers to post collateral for initial and variation margin with central counterparty clearing houses via clearing brokers, starting Q4 2016.)
The challenge of asset segregation
In Europe, the deadline for the start of buy-side compliance with the new non-cleared rules has been pushed back several times.
But, once regulatory obligations become clearer, it will still be no easy task to segregate assets in a way that is compliant with the new rules, the terms offered by broking counterparts and the mandates set by asset owners, who may wish to be ring-fenced from fellow investors.
One point of contention could be the location of the segregated assets exchanged for initial margin purposes.
Under the new rules, this has to be a neutral third party, but it might not be possible to agree on the use of a custodian that is already working for one or other party to the transaction.
As well as questions over the enforceability of a pledge within the relevant jurisdictions, both sides to the transaction will be keen to have absolute certainty that there are no impediments to the accessibility of collateral. The event of default is one example.
It seems market infrastructure operators, such as central securities depositories, may have a key supporting role with their neutrality and security.
To ensure beneficial owners of pledged assets achieve satisfactory level of access, asset managers may need to hold discussions with each of the custodians selected by their asset owner clients in order to put the necessary structures and processes in place to isolate and protect assets.
Defragmenting the processes
From an internal perspective, the need to supply initial and variation margin for non-cleared as well as centrally-cleared OTC derivatives transactions means that many asset managers are looking to develop an increasingly coordinated and automated approach to collateral management.
In large insurance and asset management firms, the central treasury has historically concerned itself primarily with cash and liquidity management, overseeing short- and long-term funding requirements, while trading desks and their back-office counterparts handle the nuts and bolts of investment implementation, including the collateral implications of OTC derivatives transactions.
Use of OTC derivatives has been a largely decentralised activity overseen by individual portfolio managers in league with trading teams and various third-party providers, albeit within a closely-monitored risk framework. This partly due to the various funds and accounts overseen by an asset management business having different requirements and mandates.
But the future volume and complexity of collateral movements is driving change, in the form of centralisation, automation and standardisation.
Whether led by the central treasury or a head of investment operations, asset managers are looking to take a more coordinated approach, both to ensure all underlying funds are able to access the types of collateral required to make margin calls, and to handle the higher volume of collateral transfers by eliminating existing error-prone manual processes
For larger firms, the biggest challenge might be the organisational one that places the treasury at the center of the collateral optimisation effort.
In particular, ensuring that upcoming margin requirements are fully understood, factored into the investment process and accommodated if necessary through collateral transformation trades, perhaps effected by an internal securities lending and/or repo desk, and increasingly in league with a triparty agent (TPA).
In many cases, this is likely to involve a considerable degree of organisational restructuring, alongside technology investment, and may require a redrawing of lines of responsibility as well as a recalibration of processes across the front and back offices.
Traders will need to factor in collateral considerations – e.g. availability of assets – before they put on a trade, not after.
Although collateral has not yet become the scarce resource that was initially feared as a consequence of post-crisis regulatory reforms and the convergence of macro-economic conditions, efficiency in its management is imperative due to the incoming rules around its usage, complexities around ownership and likely surge in volumes.
Mobilising, transforming and delivering collateral in an efficient, secure and compliant fashion has organisational and operational challenges. Accurate and timely intelligence on the whereabouts and availability of collateral assets will be important.
Taking advantage of existing market infrastructure
This may result in new requirements on custodians in order to take advantage of the moves by central securities depositories and other market infrastructure operators to remove traditional barriers to the movement of securities.
Where the required assets cannot be made available for use in meeting margin calls, buy-side firms are likely to increasingly rely on TPAs to help them source and manage collateral, typically with recourse to the repo markets.
Larger firms may in future have increasingly sophisticated demands on TPAs – potentially providing as well as sourcing collateral. Smaller firms may need to carefully examine outsourcing options, albeit with appropriate levels of oversight.
And given the operational excellence and scalability developed by TPAs to effectively provide outsourced collateral management to the buy-side, asset managers will naturally look to such firms to support the segregation challenge posed by the new margin rules for non-cleared OTC derivatives.
It it clear that the ability to provide collateral segregation at a sub-account level to buy-side non-cleared OTC derivatives users – with requisite levels of scale and protection – may prove an important arena of competition for TPAs.
Smoothing and standardising the collateral process
Large or small, all asset managers will look to streamline their internal processes to ensure collateral calls are anticipated and handled with minimal scope for fails, which will prove both costly and time-consuming if they increase in step with collateral transfer volumes.
On one level, this need for operational efficiency is leading to greater pressure for the adoption of industry-standard processes and technologies that provide buy-side firms with the ability to independently calculate margin calls and reconcile margin payments with broking counterparts on a faster and more automated basis.
On another, it has the effect of heightening buy-side awareness of the inefficiencies in certain processes – internal and external – in the collateral management transaction chain.
Asset managers are gradually adding their voice to the increasing pressure on custodians and market infrastructure providers to support initiatives that remove proprietary barriers to information and technology flows.
As such, the new regulatory environment for non-cleared OTC derivatives transactions may lead to a greater use of common standards and utility-type solutions to smooth collateral processes.