By James Williams – On Monday 10 June 2013, phase two of OTC clearing for interest rate swaps and credit default swaps began under the Dodd-Frank Act. For the buy-side community, collateral management is set to become a more complex, far-reaching exercise involving higher volumes of collateral, increased margin calls, and more counterparties to deal with.
Market reforms will see clearing houses become the de facto central counterparty (CCP), into which both managers and their clearing brokers will have to post margin. Quite what the final number of CCPs operating in this new market structure will be is unknown. What is known, at least currently, is that each CCP will implement its own eligible collateral rules and cost structure.
Global custodians are only too aware of the challenges managers will face, and are fully focused on enhancing their technology capabilities in order to make collateral management as straightforward for managers as possible in this new multilateral counterparty environment.
One of the first custodians to recognise how regulation would potentially impact the markets is BNY Mellon. Back in 2009, when the Dodd-Frank Act was passed in the US, the firm started to move quickly to deploy new technology to support the buy-side. This was nothing new for the firm. It has had an established collateral management business for decades and with currently USD2trillion in assets under custody, it is one of the industry’s leading custodians.
“Our systems and processes have been in place a long time and they have been refreshed and repurposed, if you will, to support the buy-side community as they start their journey into the clearing space,” explains Nadine Chakar (pictured), Executive Vice President and head of product development and strategy for BNY Mellon’s Global Collateral Services business.
“We have therefore been supporting cleared trades for a number of years now and it’s nothing new for us. But what we’ve had to do is make enhancements, where possible, to automate things a little more for hedge fund managers. Our automation previously focused on the trade capture process and reconciliation for bilateral arrangements. Under OTC clearing, there are more players involved so reconciliation has become a lot more eclectic, you’ve got to do it daily.”
The aim has been to deploy a new generation of systems that are fully geared to support the needs of buy-side clients in both the cleared and non-cleared world (which will still exist for certain OTC derivative contracts but will require higher initial margining) and provide as much integration as possible.
As Chakar explains: “What we’ve done with our technology is link it all together so that any time a client books a trade they know exactly what collateral they have, they know exactly what is the cheapest collateral to deliver, they know exactly what is the intrinsic value of that collateral – do they want to put it out for loan or use it for collateral management purposes? – and which CCP is the most efficient to trade with.
“We’ve been on this journey now since 2008, and in the past 18 months we have been really focused on enhancing the experience for buy-side clients, giving them as much connectivity as possible.”
Kyla Lapierre is a Senior Vice President within Global Operations at State Street. At the beginning of 2013, Lapierre says that a strategy group was established to focus not only on State Street’s collateral management offering, but also processing and how best to consolidate its operations and technology around the world.
“We are looking to consolidate our locations as well as transform the way collateral management is being performed. At the current time we have a variety of applications being used around the globe and we are looking to consolidate them into one or two primary systems that will support our clients.
“The first one is called the Collateral Management Workstation, an in-house built platform. This will be the primary system that we use. In addition, we currently have an RFP on the Street for collateral optimisation,” confirms Lapierre.
Continuing the integration theme referred to above, Lapierre adds: “We have an end-to-end product offering from execution, servicing, clearing, collateral management, valuation and risk analytics. All of those components sit in that end-to-end offering, which we are presenting to our clients.”
When ready, the optimisation tool will simply integrate into Collateral Management Workstation with Lapierre confirming that the aim is to get this tool ready by Q4 2013.
At BNY Mellon, the collateral management framework is based on SOLVE: Segregation, Optimisation, Liquidity, Value, Efficiency.
“We’ve created the SOLVE framework to help our clients deal with the full range of clearing issues. At the end of the day, our scope is to help clients move their collateral anywhere in the world, any time, and to help them do that as effectively and cost-efficiently as possible,” explains Chakar.
There are several key concerns that hedge fund managers have with respect to moving into an OTC clearing environment: initial margin optimisation and collateral segregation being two important ones.
With respect to initial margining, Misys has upgraded its front-to-back platform, Misys Sophis VALUE, so as to enable managers to calculate their initial margining at the pre-trade level. They want to know exactly how much certain trades will cost, and, crucially, what impact this will have on their collateral.
“We have already created an initial margin calculation tool and what we are currently working on is a solution to help clients optimise their initial margining and reduce costs by netting everything (which they can currently do with their broker/dealers),” says Laurent Villiers, Risk Product Manager at Misys.
The next step will be to give clients the ability to select from the best choice of counterparties – who is offering the best price, which CCP is best suited, from an eligible collateral perspective, for certain types of trades?
“The goal will be to help clients see which prime brokers they should best be dealing with from an initial margining cost perspective. At the moment, the rules that are used to calculate initial margin are set by the clearing houses so we will need to incorporate all of these different rules,” explains Eleonore De Vial, a regulatory expert at Misys.
Managers will want to ensure that the right collateral is being posted to the right CCP at the right price: if a trade can be collateralised with corporate bonds rather than government bonds or cash, it will help avoid having to use high quality collateral for lower quality trades. This is especially important for broker/dealers as they strengthen their capital ratios under Basel 3.
“From our perspective, a lot of our tools around optimisation are designed to work after the manager has posted the trade – once we see the trade, we need to optimise it and make sure that our hedge fund clients are managing their liquidity as efficiently as possible,” comments Chakar.
“Can we catch the data early enough in the cycle to help managers figure out where they should settle that trade? That’s yet to be determined. A manager could have margin calls several times a day, so they are going to want an environment that is responsive and accurate.
“We are working on tools to be able to pull any type of collateral anywhere in the world into one integrated view for the client. But it’s not just about technology, it’s about having the intellectual capital – technology is the enabler that brings that intellectual capital to light and makes it useful for our clients.”
David Beatrix, senior business developer for OTC derivatives at BNP Paribas Securities Services, confirms that under the bank’s Collateral Access solution they will handle the collateral calls from managers’ clearing firms and make sure that “collateral management does not disrupt the portfolio management activity”.
“Part of the collateral management solution under Collateral Access is Smart Allocation, and the use of an algorithm to help clients deal with different eligibility rules used by clearing houses and counterparties.
“Our algorithm selects the most efficient collateral that needs to be posted to clearers and counterparties at any given time, taking into account various parameters, and manages automatic substitutions when required,” says Beatrix.
With respect to the other key concern, collateral segregation, Chakar notes that BNY Mellon is starting to see increased demand from both buy-side managers and, increasingly, the broker/dealers themselves.
“Large global fund managers are really trying to figure out how to segregate collateral. They’d rather make sure that the collateral is housed with a strong well-capitalised institution than worry about whether their collateral is being trapped in the system (i.e. rehypothecated by their prime brokers).
“We are doing a lot of work to set up those segregation mechanisms all the way from LSOC (Legal Segregation with Operational Commingling) in the US through to the 14 or 15 different flavours of segregation in Europe when you look at Eurex, LCH etc, who have yet to settle on the final version of segregation.”
Lapierre says that collateral optimisation and transformation – whereby if a CCP isn’t willing to accept corporate bonds could the custodian change them, for example, into euros as eligible collateral? – are important issues, but agrees that segregation will be paramount.
“We have a segregated account model in play already for one large client. We also have real-time viewing capability into those funds that the client can use, so they can get a clear view on their collateral positions as well as receive settlement confirmation, which can either be sent from our platform, or via SWIFT messaging.
“We think segregation of assets is going to be a big concern for our clients and hopefully they will rely on us as an independent party going forward. We have a solid offering, not only from a technology perspective but from an end-to-end service model perspective as well,” says Lapierre.
One technology solution that BNP Paribas Securities Services has recently developed for Collateral Access is “Direct to CCP”, designed to help clients settle collateral more efficiently.
“This framework has been designed to help the end investor avoid settlement risk by settling directly with the CCP, without having to go through the clearing broker. The aim is to facilitate the process for all those involved (custodian, clearing member, manager and CCP). Furthermore, in this model, we can cope with full physical segregation, which is an important requirement for a number of our clients.
“There are so many moving parts involved that streamlining the process for our clients, in an automated fashion, will be vital. At BNP Paribas we believe the flexibility of collateral solutions has become a key driver when selecting a custodian. Efficient risk mitigation, collateral protection and velocity as well as collateral optimisation are all essential in addressing the requirements of clients today,” says Beatrix.
Villiers adds that Misys is also working to enhance the cash and treasury management function within Sophis VALUE. This is understandable. As mentioned, under OTC clearing, managers will face daily margin calls. Therefore, having an accurate intraday window on the cash position of their portfolio will be hugely important.
“We are working on this enhancement now. Ultimately, OTC clearing is transferring credit risk into cash risk. Every manager will want to avoid a situation where they find themselves with no eligible collateral left to meet their margin calls. The enhanced cash management solution will enable portfolio managers to determine what would happen to their cash positioning were there to be a major move in the market, under different scenarios.”
“As a result of regulatory reforms, posting collateral for OTC clearing will cost managers and create some initial drag on performance. That’s going to impact end-investors such as pension plans, so you need to give managers the tools to make informed investment management decisions. We’re making sure that we are at the cutting edge of everything from collateral optimisation to segregation,” concludes Chakar.
