Mark Jennis, Managing Director, DTCC [email protected]

Mathew Keshav Lewis, Vice President, DTCC [email protected]

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If you Google “,” the top collateral has had to become much search result is a 2004 thriller starring more analytical. Finding the lowest cost MANY HANDS Tom Cruise and Jamie Foxx. While collateral eligible for a particular purpose, collateral in the financial sense may not for example, can help a financial bring to mind the same level of action institution raise crucial finance, hedge an MEAN RISK AND or adventure, the reality is surprisingly exposure, or save a great deal of money. dynamic. Sweeping and rapid changes The need to source eligible collateral are occurring in financial markets that and allocate it to the right counterparty OPPORTUNITY are having a significant impact on creates markets in collateral with similar the management, mobilisation and supply and demand characteristics INCREASE transformation of collateral. to those of any market, with Collateral has a contradictory commensurately complicated servicing reputation. It is remembered as the requirements. The demand for collateral Regulation and industry developments trigger of massive financial losses in is driven by the daily reconciliation the acute phase of the financial crisis of trades and investment portfolios are changing the nature of collateral in 2008. But it is also viewed as an between counterparties, and the daily important part of the solution to the calculations of the net exposure between management. These changes are putting problems highlighted by the crisis. them, based on movements in the prices Policymakers around the world have of the underlying assets and liabilities pressure on the collateral supply chain, enacted new rules, including the and collateral posted already. increasing the volume of calls Dodd-Frank Act in the United States, Once the exposure is calculated, a the European Market Infrastructure margin call is executed at an agreed and collateral movements, and vastly Regulation (EMIR) and the Basel III value. The margin call can take one of regulations in Europe, all of which have at least three forms. The first is simply complicating the operational processes implications for the markets in collateral. a bi-lateral matching of the margin call The primary objective of these new between collateral provider and collateral that support the collateralisation of swaps, regulations is to increase market stability taker. The second is an affirmation of and resilience, enhance transparency, the terms of the trade between a prime futures, repos, stock and payments. and reduce counterparty, operational, broker (usually a major investment bank) Mark Jennis, managing director, strategy and and liquidity risk. Collateral, as the and their client (typically a security provided by one party to another manager). The third, in which collateral business development at DTCC and Mathew to mitigate counterparty risk in any is posted to a clearing broker for onward extension of credit or other financial transmission to a central counterparty Keshav Lewis, vice president, strategy and exposure, has an important part to play (CCP), is ultimately in achieving these goals. Managed well, settled between the CCP and the business development at DTCC, explore the collateral solves many more problems clearing broker. than it creates. These collateral demands necessitate risks and opportunities this is creating for Because it is used in so many lines the efficient identification, aggregation, market intermediaries, service providers and of business (payments, repo, securities optimisation and allocation of collateral lending, swaps) and takes such a wide on the supply side to meet these three market infrastructures. variety of forms (, bonds, equities, different needs. Market participants mutual fund shares, commodities and cannot efficiently pledge collateral unless precious metals) the management of they know where it is located and

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can aggregate it accordingly. Once of robust operational controls and capital Coupled with limited internal will request initial margin be held in the appropriate inventory is secured, requirements even for OTC derivatives optimisation of collateral, inefficiencies of segregated accounts. the collateral can then be optimized. trades that do not need to be centrally this kind could exacerbate the potential In addition, the removal or reduction Essentially, this means allocating cleared. In practice, CCPs will have gap between supply and expected of the thresholds for variation margin the collateral, based on a variety of to impose initial margin requirements new demand identified by the Bank currently used in bi-lateral trades means parameters that are defined by the (which can be met in the form of of England, ISDA and the BIS. That is any change in is likely to trigger collateral provider (such as minimal cost) securities as well as cash) and make a non-trivial problem. An inability to a margin call, and most likely on a daily and that also satisfy the demands of daily variation margin calls (which can be view all available collateral, and limited basis. In the past, the use of thresholds the collateral taker (such as less risky met only in cash). This can be expected capacity to mobilise and allocate it limited these calls to occasions when collateral). to dramatically increase the demand for during periods of market stress, could the value of the underlying trade This is easier said than done. It means cash and high-quality collateral that can make the difference between surviving a moved significantly. reviewing the collateral eligibility criteria be turned into cash. financial crisis and succumbing to it. But factors other than regulation of the counterparty, understanding A study by the Bank of England in The stress will be intensified are also at work. These include the the terms of the agreement with the September 2012 estimated that new by the sheer volume of transactional fragmentation of CCPs between counterparty, calculating the relative collateral demands stemming from activity stemming from rising demand countries and regions and asset costs and risks of putting a single piece regulatory change could amount to for collateral. Margin call activity, for classes, and the knock-on effects on of collateral to different uses, taking as much as $800 billion. In a separate example, can be expected to increase the documentation required to cover into account the internal requirements analysis, the International Swaps and dramatically as OTC derivatives the collateralisation of OTC of the in-house or third party source of Derivatives Association (ISDA) calculated move from bi-lateral markets to transactions. For example, the new the collateral, and then actually moving that new initial margin requirements centralised clearing. Discussions with standard credit support annex (CSA) the collateral between accounts via for centrally cleared OTC derivatives participants in the OTC derivatives published by ISDA encourages variation networks of custodian banks. Allocation could top $10 trillion. And, most markets indicate that this activity could and intra-day margin calls to be settled is where the supply of collateral meets recently, a committee of the Bank for increase by anywhere between 500 and in the same currency as the underlying the demand for it. International Settlements (BIS) estimated 1,000 per cent. A follow-up study by the trade (for many good reasons). This With the demand for collateral rising that the combination of new liquidity London School of Economics, funded is likely to result in an increase in the as a result of regulatory change, supply requirements and OTC derivatives by DTCC, is underway to validate volume and complexity of collateral calls. is becoming a source of animated clearing could push new collateral needs these predictions. Today, margin calls are primarily met discussion in the industry. Over the to $4 trillion. A primary driver of these astonishingly in euro or US dollars. In the immediate last 18 months, several organizations Despite these potentially massive high rates of increase is the regulatory future, margin calls will be settled in have attempted to calculate the amount increases in demand for collateral, mandate to clear transactions. This any of the five main currencies, and of collateral that will be needed by many financial institutions have yet to has led to the proliferation of clearing eventually in any one of up to 17 financial firms as a result of the new OTC fully grasp the value of the pools of venues in various countries and regions different national currencies within derivatives measures taken under Dodd eligible collateral in their possession and for specific derivative types. Each the Group of 20 (G-20). Frank and EMIR, and the new capital or, where they are cognisant of it, are of these venues will be issuing margin In addition, CSAs previously allowed and liquidity requirements specified in struggling to find ways of mobilising calls daily. Adding further to the number an entire portfolio of deals with one Basel III. There is a concern that there the collateral efficiently to post against of calls, users will be obliged to post counterparty to be covered by a single will not be sufficient eligible collateral to specific exposures. As much as 15 initial margin to each of these venues, margin call. Now that swaps are centrally meet all needs. per cent of the collateral available to many for the first time. The introduction cleared, CSAs will have to exclude Driving the increase in collateral financial institutions is currently left idle. of initial margin will significantly increase products offered by different CCPs, each requirements are new rules that mandate According to a recent joint study by not only the number of calls, but also of which is specialising in a particular centralised clearing through CCPs for and Accenture, this under- the amount of collateral required. Adding contract, such as interest swaps being the majority of over-the counter (OTC) utilisation is costing the industry around further to the complexity of the process, cleared by CME Clearing and LCH. derivatives trades, and the introduction the world more than €4 billion a year. it is expected that most buy-side firms Clearnet, credit swaps by ICE

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Clear and CME Clearing, and equity to ensure all margin calls can be met on a potentially ten-fold increase in operational impact, which will affect swaps by Eurex Clearing and the time. Third, the lack of certainty around transactional activity. the economics of the services being Options Clearing Corporation (OCC). intra-day obligations and settlements As a result, firms will need to invest in provided. Regulators are introducing This specialisation will necessitate will magnify intra-day exposures and the both technology and the re-engineering options for users of OTC derivatives in separate margin calls for each CCP, risk of funding squeezes during times of of their processes, exceptions particular to insist collateral is held in instead of one for each portfolio with extreme market stress. During an acute management policy and dispute segregated accounts. This follows the each counterparty. This splintering of phase of the financial crisis in 2008, this resolution procedures. According to a poor experiences of some firms during collateral demands, and the shift is exactly what happened. study published by Deloitte in 2011, the failures of Lehman Brothers and away from the historical portfolio There is a fourth reason why investment in the improved operational MF Global. While offering collateral process of one collateral call for each increased collateral demands will processes necessary to build and givers the assurance of greater safety portfolio of contracts, could lead inflate costs. The interlude that elapses sustain advanced collateral management and transparency, segregated collateral to further increases in demand for between a request for collateral from an and optimisation capabilities will cost a accounts also reduce scope for re-use collateral. It will certainly increase the investment manager, and the delivery top tier bank at least $50 million a year. and reinvestment of collateral, multiply number of calls, as well as operational of that collateral to a CCP or another The increase in margin call volumes the number of accounts, and add a risk, since the volume of collateral counterparty, counts as an extension of will certainly necessitate more further layer of complexity. movements will be much greater. credit. That means it attracts a capital comprehensive record-keeping across a Unsurprisingly, the increased use of To manage and mitigate that charge. Banks may seek to recover the broad category of services. Already there collateral is placing greater demands and , market participants will additional costs. Only by identifying, are many fragmented processes and costs on broker-dealers, fund managers need to upgrade their internal systems, mobilising and settling collateral from solutions that handle deal reconciliation, large and small, fund administrators and workflows and procedures, and keep the investment manager more quickly, margin disputes, margin call reporting custodian banks, which has increased them in a high state of readiness to can the gap be reduced and capital and settlement reports. In future, the interest of all of these market respond quickly to new challenges. Many relief secured by the bank. Banks that tracking and reporting collateral activity participants in finding rapid and cost- firms are understandably concerned that can minimise or solve for this gap will and collateral balances across multiple effective solutions to the challenges. their increased need to source collateral, distinguish themselves from less products and providers is bound to These include buying third party along with the accompanying increase in efficient peers. become more challenging. services, investing in partnerships with the number of collateral movements, It is not only funding and capital costs The growing interest of regulators specialists or like-minded firms, and will lead to higher costs and risks. that are at risk of going up. Operational in monitoring activity in the collateral the purchase of software applications They are not wrong. risk will also be greater. The anticipated markets, as part of their efforts to and services from vendors, some of There are three reasons to expect increase in the volume of margin calls manage systemic risk, is set to which are categorised and described funding costs to rise. First, the increase has the potential to overwhelm existing add to this information-gathering in the sidebar (see the sidebar, ‘How to in the volume and value of collateral processes and systems within banks and burden. Regulators are requiring the manage collateral efficiently, by Mark demands will require firms to fund larger buy-side firms and their administrators. establishment of trade repositories, to Jennis and Mathew Keshav Lewis,’ page cash balances to meet expected margin This risk is especially acute at times which market participants are expected 58). The pressure to act quickly has also calls. Second, in the OTC derivatives of extreme market stress, when the to report their counterparty exposures. increased interest in the use of industry market, it is standard practice to volume and value of margin calls will They believe greater transparency standards to facilitate interoperability anticipate margin calls and seek offsets, increase exponentially, and firms will will reduce the risk of counterparties and provide the foundation for scalable in order to net down the cash that needs need to settle collateral obligations becoming prey to rumours or incomplete products and services that canovercome to be on-hand. With the increase in the seamlessly. To express concern that not information, sparking a run on the challenges quickly and at low cost. sheer volume of margin calls and the all market participants are yet capable of firm. Trade repositories are also The evolving regulatory environment risks associated with not meeting a call accomplishing this is not a criticism of expected to accelerate the is unlikely to lift the pressure soon. – CCPs, unlike clearing brokers, cannot current platforms or operational teams. resolution of margin disputes. However, regulatory changes have be negotiated with – firms will need to It is recognised that most firms do not For clearing brokers and CCPs, buy- benefits as well as costs. It is maintain a larger liquidity buffer have the spare capacity to absorb side clients will also have an important demonstrably spurring innovation,

Feature How to manage Feature collateral efficiently, by Mark Jennis and especially but not exclusively at market The objective of exposure calculation markets. Where these can add value is infrastructure firms that see opportunities Mathew Keshav Lewis and margin management services by incorporating settlement netting and in helping institutions meet the new is to integrate the various collateral collateral account segregation functions. collateral requirements in cost-effective The collateral management and processes so that a higher proportion In fact, multiple collateral segregation and efficient ways. optimisation products and services now of information exchanged can be services are now being offered. Many Regulatory pressure is also becoming available are of various types - processed in an automated fashion are specific to a particular product, CCP encouraging new forms of collaboration, some offerings focus on specific problems, without manual intervention. These or jurisdiction. Service providers are with different parts of the industry while others attempt comprehensive reduce operational risk. developing services aimed at holders coming together to help buy-side and coverage – but they can generally be For example, portfolio of segregated accounts, such as daily sell-side firms adapt quickly to the rising grouped into one of six categories: reconciliation tools and intra-day collateral substitutions demand for collateral. exposure calculation and margin enable participants and collateral valuations. Developing a It is imperative that industry management; portfolio margining; collateral to reconcile deals standardised infrastructure to support participants and service providers optimisation; record-keeping and reporting; or transactions and collateral segregation will be essential as work together to address the communication standards; and reference valuations that are segregated accounts grow and become operational costs and risk data. The way they fit together is illustrated the primary inputs more complex. associated with the in the diagram below. to calculate margin The aim of portfolio margining products increase in collateral calls. These tools and services is to calculate a margin calls and demand for Mark Jennis may be specific to the requirement for a portfolio of exposures collateral before data being matched in such a way that offsetting risks can be this challenge by trade repositories or customised used to reduce the volume and value of reconciliations for margin processes. the collateral that must be allocated. For overwhelms There are also various calculation example, a counterparty holding an equity financial engines that compute variation and initial option can offset that exposure against institutions and margin. These may be part of a collateral the underlying equity or an equity index negatively management capability built internally, or in order to reduce the margin that must impacts long- purchased from a third party be posted. Portfolio margining is already term economic service provider or IT vendor, or common in the futures and swaps growth. computed by a CCP or other market markets, and the centralised clearing of infrastructure. It is likely that the initial swaps creates scope for margin offsets margin calculation engines used by CCPs between swaps and futures positions. in the cleared OTC derivative markets will The purpose of collateral optimisation spread to the bi-lateral OTC derivative products and services, on the other hand, Want to find markets as well. is to make the sourcing of collateral out more? Join us at: In addition, various providers are offering more efficient. The aim is to identify applications that enable counterparties collateral held in various locations; pool Global to agree and communicate margin that collateral so that it can be allocated innovations in calls. These tools can be industry-wide to a variety of exposures; allocate it in an collateral solutions. But they can also be developed efficient and methodical way, generally management, specifically by service providers such as based on price, risk, liquidity, haircuts and Wednesday custodian banks, fund administrators and financing costs; and create networks to 18 September prime brokers. facilitate the flow of collateral 2pm, Many collateral settlement functions can between counterparties. Community be automated in a fashion similar to the A number of service providers offer room 3 way that securities trades are matched some or all of these capabilities already. and settled in the securities However, there is growing demand from

The chart is a model of a collateral process. Not all collateral processes have these 59 functions but the vast majority of them follow this model.

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market participants for functionality collateral that can help counterparties that enables allocation of collateral on identify potentially large margin calls that a daily and even intra-day basis. Some could be difficult to satisfy. They also service providers are also enhancing their help regulators track cross-jurisdictional DTCC is proud to be collateral optimisation service by helping exposure and potential payment failures recognized by Risk Magazine clients choose the optimal venue for trade that may not be visible to individual as one of the Risk25 Firms execution and clearing based on the costs national or regional authorities. of the Future. and risks of the Encouraging the standardisation collateral requirements. of reporting formats is an important A burgeoning aspect of collateral benefit of collateral reporting products optimisation is collateral transformation. and services. At present reports are This offers clients the ability to exchange delivered in a variety of formats, and collateral that is not eligible at a CCP or incorporate different data. There is now other counterparty for something that an industry initiative under way that is acceptable. An obvious instance is aims to standardise margin reporting for the use of the repo market to transform cleared OTC derivatives. If successful, it securities into cash for posting as will eliminate the need for individual firms variation margin to a CCP. to download and re-format data, and However, there are a variety of other facilitate competition between collateral mechanisms that can be used to reporting products and services. transform collateral, The value of standardisation including stock lending and structured obviously reaches beyond collateral deals as well as reporting. Increasingly complex collateral DTCC GLOBAL TRADE REPOSITORY repo transactions. management and settlement processes The Industry’s Choice for Regulatory Reporting Choosing between can be managed much more successfully them will depend if they are supported with open partly on price - communication standards. Standards custodian banks, for margin call workflows and disputes In the global OTC derivatives market, DTCC is dedicated to helping customers meet their broker-dealers, prime are now being developed. regulatory reporting requirements and promote safety and soundness in the trading of these securities depositories Last but not least are reference data instruments. (CSDs) are all mindful services. The valuation of underlying DTCC operates global trade repositories for credit, , equity, FX and commodity Mathew Keshav of and transactions and the pricing of collateral derivatives. Lewis capital costs – but are both major inputs into any margin users of collateral calculation process, and the principal For more information, please contact: transformation services must also take cause of margin disputes. So the quality operational, market and and content of the data in the securities Europe and Middle East Asia Pacific and Japan Canada, North, Central implications into account. master file is essential to the optimisation [email protected] [email protected] The value of collateral reporting of the use of collateral. The use of and South America + 44 207 650 1433 Japan + 81 3 6721 8876 products and services lies in their ability standing settlement instructions (SSIs) [email protected] Singapore + 65 6407 1224 to help market participants meet their increases the level of automation, and + 1 212 855 2430 obligations to report OTC derivative ensures that collateral is delivered to the transactions to trade repositories and right location. Legal Entity Identifiers (LEIs) regulators. However, the transmission of have also been introduced to allow for information is not one-way. Global trade more accurate client identification and repositories also hold data about reporting as well. DTCC.COM/gtr 60 61