Phase 1 of Dodd Frank commenced in March this year, requiring swap dealers and major swap participants to clear their OTC derivative contracts (i.e. liquid IRS and CDS) through central counterparties (CCPs). With Phase 2 commencing in June, buy-side firms in the US are now fully engaged in getting operationally ready.
The shift towards OTC clearing is a huge collective undertaking for clearing houses, clearing firms and buy-side clients. The use of a CCP is a mutualised risk model that shifts the market away from what were exclusively bilateral arrangements – under Master Agreement and Credit Support Annex (CSA) - to one where both the FCM (as a clearing house member) and the client will be required to post margin into the CCP. It is a radical departure. Many are still coming to terms with the concept that all derivative contracts like IRS and CDS (and not only interdealer ones) will now have to be cleared with initial margins and variation margins based on the mark-to-market’s daily fluctuations, just like exchange-traded derivatives.
One of the biggest concerns that hedge fund managers have relates to collateral management. Every day, all CCPs will demand (or return) “eligible” collateral, mainly cash and highly rated government bonds, thus generating more transfers, in both the number and value of movements, compared to the bilateral ISDA CSAs.
What this means, in a nutshell, is that the sheer volume of collateral that managers will need to monitor going forward is about to grow exponentially. Collateral management will become a spider web of complexity. Keeping track of margining requirements through the lifecycle of every derivative portfolio will be a daunting task.
Even though in Europe, the mandate to clear OTC derivatives under EMIR is not expected to be implemented until 2014, BNP Paribas Securities Services has already noticed a sharp spike in collateral volumes.
“Some of our clients are having to clear their derivative contracts already, due to the fact that they trade with US counterparties and fall under Dodd Frank regulation. As they face these initial margining requirements, we are seeing an increase in the amount of collateral needed by their clearing brokers,” confirms David Beatrix (pictured), senior business developer for OTC derivatives at BNP Paribas Securities Services.
As a global custodian to hedge fund and other asset managers, BNP Paribas Securities Services plays a vital role. This entails providing the right solutions for managers’ collateral management needs, in terms of accessing, protecting, managing and ultimately using their assets to meet collateral demands under new market regulation.
Collateral Access is just that solution set. It spans collateral management, sourcing, optimisation and protection.
Beatrix notes that one of the drawbacks of the OTC regulation is that it will generate complexity and fragmentation of processes between cleared derivatives, under potentially multiple clearing agreements, and non-clearable ones remaining under the scope of bilateral agreements with each counterparty.
Moreover the bilateral CSA allows managers to net their full exposure to a given counterparty in a single currency, with thresholds and minimum transfer amounts.
“However, in the new OTC clearing environment, managers don’t have this flexibility. They have to pay variation margins in different currencies. This is why the volumes of collateral being moved are exploding in number. Managers will have to closely monitor what will become a more complex collateral management process.”
The impacts of regulations on systems and operations are subsequent and the reporting of collateral to Trade Repositories under EMIR also needs to be considered.
Collateral Access – Smart Allocation
Not only will managers have to pay variation margins to their clearing brokers in the currency of the underlying contracts, they will also need to post collateral on a same-day basis.
Having a clear view on the collateral/cash management position within the portfolio and its adequacy versus various margin requirements will be vital for the front office.
“Our belief is that managers should have the possibility to allocate their collateral in the most efficient manner. They need to perform it as quickly as possible because of the increased outflow of collateral they face under OTC clearing rules. We will directly handle the collateral calls coming from managers’ clearing firms and counterparties, 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”.
“If you consider the fact that asset managers will face collateral requirements on a same-day basis, we don’t have time to pick up the phone and ask each portfolio manager what collateral they wish to post. You’ve got to have that automation in place to be as efficient as possible and minimise the degree of manual intervention. That’s key and what we as a collateral manager can provide to our clients.”
But before European managers even begin to adapt to OTC clearing, getting the right clearing agreement(s) in place is expected to be the heaviest part of the planning exercise, in Beatrix’s opinion.
“This is something that is totally new for the legal departments in the buy-side community. I would say that getting the clearing agreement in place is certainly the first major hurdle to overcome.”
Quite what impact this greater emphasis on collateral management will have on European hedge fund managers, in terms of how they run their investment portfolios, will be challenging going forward. For example, a fund invested in high yield debt instruments would have most of its assets ineligible as collateral for its clearers and counterparties.
If the portfolio strategy moves out of synch with the collateral profile of its counterparty, it might require the portfolio manager to substitute the fund’s assets for eligible collateral. At the same time, however, the portfolio manager must ensure that this does not harm the performance of the investment strategy. The need for greater liquidity in the portfolio to meet collateral obligations could change the way managers run their strategies. Although this will obviously vary greatly, depending on the extent to which a manager uses derivatives.
Collateral Access – Margin Protect
Margin Protect is just one part of the solution set that BNP Paribas Security Services offers to manage the collateral needs of its clients. It is, in essence, a collateral segregation tool that was designed originally for hedge funds’ non-cleared trades. The plan is to make this more visible to the wider buy-side community.
“There will be a significant percentage increase in both buy-side and sell-side institutions having to exchange initial margins bilaterally. The only way to manage that process effectively is by having those margins segregated with a third-party custodian."
“Another important driver has been the fact that we’ve worked hard to create an automated framework. We are now working closely with SWIFT (the global provider of secure financial messaging services) to make the end-of-day operational process for institutions as easy as possible. The messaging framework sits behind the account control agreements that are in place with our clients,” explains Beatrix.
This basically means that managers will have a much greater, automated process for securing, accessing and monitoring their collateral. This is vital when one considers the greater margining demands that may be imposed on non-cleared derivatives and as such is a distinct benefit to the clients of BNP Paribas Securities Services.
Collateral Access - Direct to CCP
Another important addition to Collateral Access is Direct to CCP. This, says Beatrix, is basically a “quick solution” to help all actors settle the collateral more efficiently. This is evidently understandable when one considers the number of actors involved in clearing through the CCP - the custodian, clearing broker, buy-side client, and the CCP itself - a quad-partite relationship!
“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. Furthermore, in this model, we can cope with full physical segregation, which is an important requirement for a number of our clients.
“The clearing broker sits between the CCP and the final client. They are debited in the morning by the CCP but re-credited on an intra-day basis as soon as the client’s collateral is posted to the CCP’s account. It’s an automated process, with specific reporting to allow the clearer to monitor its risk, and basically streamlines the settlement process across all four parties.”
Solutions like this will be the future of the market, with respect to enhanced collateral management, according to Beatrix who concludes: “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.”