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The urgent need to integrate change

The urgent need to integrate change

To bring good luck in marriage, an English bride is often advised to wear ‘something old, something new, something borrowed, something blue’ on her wedding day. Some derivatives contacts last longer than marriages these days, but relationships between the counterparties are no longer trusted to luck. Starting September, a stricter global regulatory framework is being introduced for bilateral OTC derivatives transactions, including rules that ensure the assets of one counterparty are unaffected by default of the other, thus avoiding being tied together, ‘for richer, for poorer’.

Banks preparing for the new rules could do worse than accept traditional bridal advice as they look to comply with the new rules. While the new regime for non-centrally cleared OTC derivatives – which follows principles laid out by the Basel Committee for Banking Supervision and the International Organisation of Securities Commissions – does entail some new processes and roles, some practices can be borrowed from existing markets, such as repo. As for something blue, let me get back to you on that one.

The new framework

The introduction of new international standards for the exchange of margin to underpin bilaterally cleared OTC derivatives contracts borrows a number of practices from the exchange-traded world. For example, the fairly customised counterparty credit arrangements of the bilateral world will be tightened up by formalised rules on initial and variation margin, similar to those prevalent in the centrally cleared and exchange traded environment. To an extent, the relationship between the buyer and the seller of an OTC swap will bear greater resemblance to that of a Futures Commission Merchant (FCM) or a clearing member and the clearing house. The obvious remaining difference is that the buyer and the seller of the swap are still on opposite sides of a bilateral transaction, while the FCM is an agent to its client, with a clearing house standing in the middle of the transaction, acting as the counterparty to both sides. However, the new bilateral rules do call for a third party to be inserted to the bilateral swap relationship, to ensure protection of assets in the event of default.

Under the new rules for bilateral derivatives – expected to be introduced in Europe in the first half of 2017 via the European Market Infrastructure Regulation – counterparties must undertake two-way posting of gross initial margin, subject to strict segregation and control requirements, which forbid re-use of collateral. Collateral assets posted as margin must be available to the collecting party (or pledgee) in the event of counterparty default, while the posting party (pledgor) must also be protected in the event of the collecting party entering bankruptcy.

What are the options?

Parking counterparties’ collateral assets in multiple separate dedicated accounts is undoubtedly an administrative burden for banks. Equally, the restrictions on re-hypothecation cut off an opportunity to offset costs. An additional challenge is agreeing where to locate the account for optimum usage, safety and accessibility. As such, pledgors and pledgees are seeking environments in which to access, transfer, segregate and monitor collateral on a scalable, legally enforceable and operationally robust manner.

Although many of the necessary tools, processes and capabilities for the new regulatory framework were not previously required by OTC derivatives desks, they have been developed in – and can be borrowed from – the repo and securities lending markets, notably via triparty agents which provide collateral transformation and management services.

International Central Securities Depository or securities settlement system are ideally positioned to play the new role of the neutral third-party in the bilateral OTC derivatives transaction chain. Inevitably, banks will require different account structures depending on volume and frequency of OTC business and types of counterparty. For some, especially initially, it may be sufficient to place collateral in a segregated account opened in the name of the entity acting as a neutral third-party pledge holder, which would support collateral exchange, reporting and asset servicing in line with established industry standards.

For others, perhaps with higher volumes of transactions, there may be need for a more comprehensive approach, in terms of margin and collateral reporting, allocation, substitution, transfer and monitoring support that enables orderly management of a default event. Such firms may seek to link their segregated account with the services of a neutral triparty collateral management agent. In a triparty environment, once notified of default or potential default, the neutral third party can stop servicing triparty activity and oversee the orderly transfer of the collateral held in the pledged account to the non-defaulting counterparty.

For very high volume OTC derivative market participants, typically those servicing the interbank market, the administrative burden can be considerable. Banks that are collecting collateral for multiple pledging counterparts for margin purposes, may have complex, sophisticated account structure requirements. For such firms, it may be possible to combine a collateral management service agreement with a third-party pledged account agreement per pledgee/pledgor relationship, but with the pledgee having full reporting access as if the pledged account was held in its name. This would allow the pledgee to face off against multiple pledgers, and benefit from greater operational efficiencies.

New or borrowed tools are increasingly available to support margin transfer and collateral management. But banks, their clients and counterparties must also look to their internal processes and capabilities as well as third-party providers. The consequences of inaction may be severe.

The cost of fails

The industry-wide unsupported exposure to collateral settlement fails was reported at USD 26.7 billion by the International Securities and Derivatives Association in 2015 and will only rise as volumes of collateral exchanges increase under the new bilateral OTC derivatives rules. Even if settlement fail rates for collateral movements remain at 3%, the annual operating cost of remedying these fails for banks could rise by 377% to USD 2.4 million, per firm, by 2020 .

The main underlying causes of collateral settlement fails – miscommunication, constrained technology, insufficient collateral, and counterparty insolvency – can largely be resolved through more effective communication between counterparties and increased visibility of available and transferred collateral.

Adopting best practices and harnessing advances in technology can help market participants reduce fail rates. Better internal coordination can improve efficiency and visibility, while reliance on outmoded, semi-manual processes and technologies can be replaced by experienced platforms being offered by reputable service providers to increase automation and STP levels. Despite continued regulatory uncertainty and delays, many firms are looking to achieve compliance in the short term, with more thorough, permanent solutions to be implemented in due course. But action to comply with the new framework is required promptly – no one can say it came out of the blue.

The main underlying causes of collateral settlement fails  can largely be resolved through more effective communication between counterparties

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