CMI in Focus: Collateral Management

Transcription

1 CMI in Focus: Collateral Management Introduction Collateral is a common mechanism that has been utilised in financial transactions for centuries to provide a lender with security against the possibility of default by the borrower. Collateral management began in the 1980s, but there were no legal or contractual standards until the first ISDA documentation appeared in Collateral is mostly pledged to cover repos, derivatives, securities lending and some long-dated forward FX transactions. Collateral management involves monitoring the pledged asset for changes such as corporate events, revaluing the collateral regularly, providing for substitution of collateral and calling for additional collateral when required. Changes to the collateral pledged are identified quickly and adjustments to quantity or quality of collateral required under the agreement are made, usually within a day. Collateral has been a key component of the capital markets and therefore has been included in several of the recommendations issued to raise market standards in the post-trade infrastructure. The revised Group of 30 (G30) recommendations for Global Clearing and Settlement in 2003 included one on collateral (Recommendation 15), to advance legal certainty over rights to securities, cash or collateral. But these recommendations were more related to the legal basis for taking and pledging collateral rather than the practicalities of handling and optimising collateral. However, the latest CPSS-IOSCO Principles for Financial Market Infrastructures (FMI) of April 2012 provide a specific item on Collateral (Principle 5), which establishes that an FMI that requires collateral to manage its or its participants credit exposure should accept collateral with low credit, liquidity, and market risks. An FMI should also set and enforce appropriately conservative haircuts and concentration limits. This has forced CSDs, CCPs and other market infrastructure entities to find solutions to monitor collateral and calculate collateral requirements on a daily basis. Background The 2008 financial crisis, including the default of Lehman Brothers and the bail out of other large banking groups, continues to be felt throughout financial markets around the world. Globally, regulators responded by drafting a number of reforms that are intended to reduce systemic risk through transparency and the increase in the amount of risk-weighted capital that firms are required to hold, together with requirements to collateralise exposures through entities such as central counterparties (CCPs). This has increased the pressure for market participants to obtain good quality collateral to meet increasing collateral requirements. At the same time, many OECD governments have increased bond issuance to fund deficits, which increases the supply of low risk collateral. However, the amount of top quality (AAA-rated) collateral has been diminished as sovereign downgrades have reduced the eligibility of the mainstay type of collateral, government bonds, particularly in the Eurozone. Collateral managers have therefore come under increasing pressure to provide mechanisms to optimise collateral usage, and collateral takers are being driven to come up with solutions to reduce the gross levels of required collateral

2 from participants without compromising risk management. The securities lending market has become active in providing collateral upgrade trades to assist the process in the US. The list of new regulations derived from the crisis include: the Dodd-Frank Act in the US, the tri-party repo infrastructure reform, Basel III, and in the EU, the Markets in Financial Instruments Directive (MiFID) II, the European Market Infrastructure Reform (EMIR) plus a number of regulations being issued or drafted to address these issues in other markets. Many will have a significant impact on the relevant markets and will allow financial institutions to be better prepared to endure volatile markets and unexpected shocks. Part of the focus of the new regulations is in respect of the creation of a robust and transparent market infrastructure through which an ever increasing amount of securities and derivatives trading and settlement is expected to take place. Accordingly, business models are changing and traditional practices in the repo, securities lending and derivatives markets have also adapted. Brokers, banks, institutional investors and other market participants are adjusting their systems and processes to cope in a highly regulated environment where many exposures are about collateral values. Following the financial crisis, the interconnectivity between financial institutions and the inherent risks that this brings globally became evident. As a result, the global financial community became aware of the impact that large institutions can have on the broader financial markets and the local and global economy during periods of stress. In response to the new regulations and the challenging economic environment, market participants are facing new issues in obtaining funding, managing counterparty credit risk and securing appropriate collateral. In this new environment, market participants face significant challenges not only to post appropriate collateral to mitigate risks, but also to have sophisticated systems in place to be able to monitor and calculate their liquidity requirements / exposures, or optimise their use of collateral. Regulatory Pressures Among the most significant of the new regulations are those focussed on bringing all standardised OTC derivatives into central clearing regimes, (Dodd-Frank Act in the US, and EMIR in the EU) and hence becoming subject to the standard risk management models of CCPs. These require collateral to be posted as initial and variation margins to cover default under normal market conditions to a high confidence level (99%+), with the default fund managing the residual tail risk. The Dodd-Frank Act was passed in July 2010 and the resultant regulations drafted by the SEC and CFTC became live for central clearing of interest rate swaps (IRS) and indexed credit default swaps (CDS) on 11 th March EMIR was adopted by the European Parliament on 29 th March 2012 and the mandatory clearing deadline under EMIR is expected to fall in mid-2014, with reporting requirements beginning from September Although there are some variations on applicability between the two reforms, both will require substantially more collateral to be posted to cover the hugely increased volume of centrally cleared contracts. A BIS Working paper in March concluded that clearing members had sufficient unencumbered assets to meet initial margin requirements. However, both sets of new rules mean the buy-side will be forced to pay initial margin against swaps exposures for the first time, and have processes in place to post variation margin on an intraday 1 Collateral requirements for mandatory central clearing of over-the-counter derivatives by Daniel Heller and Nicholas Vause

3 basis. The affordability of this for the buy-side is less clear with some apocalyptic scenarios suggesting some institutions would stop using centrally cleared OTC contracts altogether. As a result of these commitments from the US and Europe, multiple regulatory reform initiatives are taking place globally. Many of these initiatives (most especially Dodd-Frank) have extraterritorial effects because they include the foreign branches of US banks. For end users with global trading operations, it is possible that difficult compliance and choice-of-law questions will arise as the new global regulatory landscape for OTC derivatives evolves. Collateral Management Solutions Increasing collateral and margin requirements, coupled with a shorter list of eligible collateral instruments, will likely result in a collateral shortage, potentially on both buy and sell-sides, but probably particularly on the buyside. According to a study by Clearstream and Accenture, up to 15% of collateral available to financial institutions is left idle costing the global industry more than EUR 4 billion a year. In addition, the study found that the total value of securities currently being used as collateral in the financial system worldwide is estimated to be approximately EUR trillion (excluding cash). The total amount including cash is believed to be well in excess of EUR 12 trillion. There is therefore, a need to ensure that collateral usage is optimised inside the institution, before looking for more sophisticated efficiency models (e.g. collateral transformation, collateral tracking, and cross-product and cross-ccp collateral netting) from external parties. However, the readiness of the whole industry to implement these systems and models is open to question. Omgeo and others are only now providing enhanced collateral optimisation systems to institutions. Although, General Clearing Members (GCMs) are being asked to provide enhanced collateral management/transformation services for low or no cost, many are unwilling or unable to do so since collateral management has traditionally being a basic back-office operation. Responses from custodians are currently being developed but are not yet fully developed across all products. Historically, collateral has been used in product silos, and the need to optimise collateral usage across multiple product lines has only recently been recognised. The market infrastructure s response has been patchy, but there are some entities attempting to coordinate multiple players to provide centralised collateral pools and collateral management services. Most notably, the two ICSDs, Euroclear Bank and Clearstream, ideally positioned through their international links and broad client base, are leading the efforts in the creation of global collateral hubs. Clearstream has developed its Liquidity Hub Global Outsourcing (GO) service which allows central banks, CSDs or exchanges to connect directly to Clearstream s collateral management engine. The service can be whitelabelled and requires no contract changes between the service user and its customers. Under this model, Clearstream handles all the allocation, optimisation and substitution but the assets do not leave the domestic market, a legal requirement in many jurisdictions. Currently, Clearstream has put in place agreements with CETIP in Brazil, the Canadian Depository for Securities (CDS), Australia s ASX, South Africa s Strate and Iberclear in Spain to form the Liquidity Alliance. Initially, the project only involves the provision of technology for collateral management purposes. However, the idea is to create a collateral pool whereby participants can use securities

4 held in Clearstream as collateral in the local market and vice versa. Clearstream also has similar agreements with Standard Chartered Bank, Citibank and other financial entities. Similarly, Euroclear has developed its Collateral Highway, a service that incorporates central banks, central securities depositories (CSDs) and central counterparties (CCPs) as a pool of collateral givers and takers sharing a single infrastructure run by Euroclear. The service allows participants to move securities collateral more efficiently from wherever it is held to wherever it is needed to cover their exposures. So far several liquidity providers and takers have joined including Korea Securities Depository (KSD), BNP Paribas Securities Services, Citibank, and CME Clearing Europe. It should also be noted that Euroclear s existing tri-party collateral service includes a variety of sophisticated options including auto-substitution and cross-product collateral optimisation. Bank of New York Mellon (BNY Mellon) have taken a more unilateral approach by recognising the hubbing capacity for collateral of the ICSDs, but deciding to establish their own. They have successfully applied to establish BNY Mellon CSD SA/NV, a Belgian incorporated and regulated entity, named as a CSD but with a business model and service capabilities of an ICSD. Being able to manage and transfer their clients collateral globally in one platform was one of the key criteria for making this bold move from global custody into market infrastructure. CCPs as major takers of collateral should also be considering ways in which collateral offsets and collateral velocity can be enhanced. Unfortunately in Europe, the fragmentation of the clearing landscape post-mifid resulted in multi-ccp models in many markets. This has generated collateral inefficiencies despite the existence of interoperability relationships between some of the major groups. As competition raged, European CCPs cut clearing fees to the bone (or further in some cases), then rationalised their margining models in a classic race to the bottom. This has left CCPs with nowhere to go except to merge, and the first major mergers in Europe have recently been announced with EuroCCP and EMCF forming an agreement, and the London Stock Exchange s (LSE) takeover of LCH.Clearnet Group is likely to swallow LSE s Italian clearing house, CC&G, also. Consolidation in the clearing space is not being confined to Europe however. In Brazil, BM&FBOVESPA is consolidating its four clearinghouses - equity, derivatives, securities and FX - into a new unified platform and risk model with real-time risk calculation. The consolidation of the clearing houses is expected to be completed in In Argentina, deals have been struck between all market infrastructure entities to form a single integrated group which will eventually result in the consolidation of all Argentine CCPs. Conclusions The financial crisis highlighted the importance of managing counterparty risk and the operational and financial environment. The regulatory reaction and the global financial crisis have created a perfect storm of increased demand with insufficient supply of top quality collateral. Neither market intermediaries nor infrastructures appear to have a full response in place, but associations and alliances are being formed in efforts to find a global solution. Whether these can be mature enough in time to cope with the demand remains to be seen. However,

5 where collateral management was previously considered a routine task in the middle and back office operations of the banks and brokers, it is now centre-stage in controlling risks in the entire financial market food-chain. For further information contact: Ana Giraldo Associate Director, Americas & Eurasia Thomas Murray +44 (0) agiraldo@thomasmurray.com Jim Micklethwaite Director, Capital Markets Thomas Murray +44 (0) jmicklethwaite@thomasmurray.com