A PRACTICAL 10 STEP-GUIDE TO COLLATERAL MANAGEMENT WHITE PAPER | FEBRUARY 2016 WWW.CLOUDMARGIN.COM INTRODUCTION Traditionally, financial institutions viewed collateral management not as a necessity but as something that had to be performed with little concern; a reactive function positioned at the culmination of the trading cycle that didn’t require too much attention or thought. Put simply, a process that was not important. The 2008 financial crisis and the years following have had an unprecedented and drastic impact on the perception of collateral management and the importance of its operations. The regulatory changes that have come hand in hand with the credit crisis have seen a rise in central clearing for OTC derivatives, use of trade depositories, Basel III capital charges and a change of internal counterparty credit risk management practices to name but a few. The level of visibility and scrutiny that collateral management is now facing means that firms need to know that the data they are receiving is without doubt correct and they are indeed covered from any exposure that may occur. As the role of collateral grows in your organisation in terms of both importance and cost, it is increasingly important to take full control of your collateral management programme, irrespective of company size or traded instrument. With this in mind, CloudMargin has produced a white paper; outlining the basics of collateral management in a complete, easy to digest, practical 10-Step Guide. This Practical Guide to Collateral Management white paper will cover all fundamental aspects concerning the management of collateral, the associated risks and opportunities, as well as the key topics involved in establishing and running a collateral management function. WWW.CLOUDMARGIN.COM 3 A PRACTICAL GUIDE TO COLLATERAL MANAGEMENT | 01. WHAT IS COLLATERAL MANAGEMENT? Collateral management refers to the process of two parties When collateral management was first introduced in the 1980s, operational and treasury departments within exchanging assets in order to reduce credit risk associated with any various institutions carried out this risk management function unobtrusively in the background. unsecured financial transactions between them. Such counterparties include banks, broker-dealers, hedge funds, pension funds, asset One can, however, comment that this business function was thrown in the limelight with the shattering financial managers and large corporations. The fundamental idea of collateral crash in 2008. The crisis caused treasury and operational departments to be hauled to the front end of businesses, coming under scrutiny and evaluation like never before. It is no secret that market participants now management is very simple: cash or securities are passed from one need to face up to the harsh reality of onerous changes and restrictive and time-consuming regulations, seeing counterparty to another as security for a credit exposure. the way in which they operate impacted greatly. Most prominently, firms now need to provide in-depth reports to meet the requirement for transparency set upon them by a number of regulatory constraints, EMIR reporting for Any two parties that trade financial instruments that give rise to future cash derivatives to name but one. flows, such as OTC (Over-the-Counter) Derivatives, run the risk that one of the parties to the trade may default on a future payment, leaving the non- defaulting party with a financial loss. Collateral management is the process The financial industry has evolved two-fold in just the last 10 years, and as a esult,r collateral management can by which one party provides assets to the other as security against the become a seemingly complex process with interrelated functions involving multiple parties, due to increased possibility of payment default. On any given day, which party is required usage of collateral equating to increased risk for all parties involved. to post collateral to the other is determined by calculating the NPV (Net Present Value) of all future cash flows for each open trade or transaction. The multitude of functions include repos, tri-party, collateral outsourcing, collateral arbitrage, collateral tax treatment, cross-border collateralisation, credit risk, counterparty credit limits, and enhanced legal protections BELOW IS A STANDARD OTC DERIVATIVE COLLATERAL using ISDA collateral agreements. TRANSACTION BETWEEN TWO PARTIES. 1 The two parties negotiate and execute a Credit Support Annex (CSA), this contains the terms and conditions under which collateralisation will take place, and is an annex to the ISDA (International Swaps and Derivatives Association) Master Agreement. 2. The trades subject to the collateral agreement are regularly marked-to-market (MTM). Their net valuation is then agreed. 3. The party with the negative MTM on the trade portfolio delivers collateral to the party with the positive MTM. 4. As prices move and new deals are added the valuation of the trade portfolio will change. 5. Depending on what is agreed, the valuation is repeated at frequent intervals - typically daily. 6. The collateral position is then adjusted to reflect the new valuation. The process continues unless one of the parties defaults 4 WHITE PAPER WWW.CLOUDMARGIN.COM 5 02. 03. COLLATERAL MANAGEMENT WHAT TYPE OF FIRMS NEED TO GLOSSARY HAVE A FUNCTION IN PLACE TO COLLATERALISE TRADING? The terms and acronyms used within the collateral management world are vast, and can often confuse Simply, virtually all firms that have access to the financial markets either directly or indirectly, and are trading the most experienced collateral ‘guru’. We have listed below the most essential terms that will allow you to a financial instrument with a counterparty, will need to have a system in place to facilitate managing their better understand collateral management, and the processes it involves. collateral obligations. According to an ISDA (International Swaps and Derivatives Association) report in 2009, approximately 50% of collateralised counterparties of the largest derivatives dealers are hedge funds or institutional investors, while 15% of their collateralised counterparties are corporations and 13% are • Credit Support Annex (CSA): A legal agreement that might occur from exiting the deal in the open banks. which sets forth the terms and conditions of the market, but uses the same or similar transaction credit arrangements between the counterparties. prices as indicators of value. The catalogue of financial firms needing to effectively manage their collateral is vast, but below is a small list of • Over-The-Counter (OTC): A security traded in some • Independent Amount: An additional amount, which firms that CloudMargin’s collateral management solution appeals to, due to the need for such a function within context other than on a formal exchange such is paid above the mark-to-market value of the trade their operations: as the NYSE, TSX, AMEX. The phrase “over-the- or portfolio. The Independent Amount is required counter” can be used to refer to stocks that trade to offset the potential future exposure or credit risk • Asset Managers via a dealer network as opposed to on a centralised between margin call calculation periods. • Hedge Funds exchange. • Threshold Amount: the amount of unsecured • Pension Funds • Base Currency: The currency set out within the credit risk that two counterparties are willing to CSA that will be used in all collateral transactions accept before a collateral demand will be made. • Insurers between the counterparties, unless otherwise The counterparties typically agree to a Threshold stated. Amount prior to dealing, and will be set out within • Corporates the CSA. • Initial Margin (IM): Initial Margin (IM) is the amount • Buy-side Banks of collateral that must be posted up front to enter • Minimum Transfer Amount (MTA): The smallest • Sell-side institutions into a deal on day one. Historically, bilateral OTC amount of currency value that is allowable for derivatives have rarely had a requirement to post transfer as collateral. IM, but that is rapidly changing as a result of Within these firms, markets that are widely collateralised include: • Haircut: A percentage applied to the mark-to- regulation. market value of collateral, which reduces its value • Repo Markets • Variation Margin (VM): The amount of collateral that for collateralisation purposes. The haircut, also must be posted by either party to off set changes in known as the Valuation Percentage protects the • TBA Trading the value of the underlying deal. collateral taker from drops in the collateral’s value • between margin call periods. Exchange Traded Futures & Options • Margin Call: A request made by the party with a net • positive gain, to the party with net negative gain to OTC Derivatives – both cleared and bilateral post additional collateral to offset credit risk. The use of the collateral is on the rise within the • Securities Lending financial industry, and is becoming a fundamental • Mark to Market (MTM): Currency valuation of a operation to mitigate risk within many organisations. • FX margining trade, security, or portfolio based on available comparative trade prices in the open market It is fitting to point out that it is not just hedge funds and other sophisticated investors are involved within the within a stated time frame. MTM does not take collateral management world. Any multi-national company, small or large, who trades in a variety of currencies into account any price slippage or liquidity effect may want to hedge their currency exposures, and can therefore be drawn into the world of collateral. 6 WHITE PAPER WWW.CLOUDMARGIN.COM 7 A PRACTICAL GUIDE TO COLLATERAL MANAGEMENT | 04. WHY DO FIRMS NEED TO COLLATERALISE THEIR TRADING ACTIVITIES? The overwhelming drive for the use of collateral is to provide security against the possibility of payment default by the opposing party in a trade. An ISDA 2009 report states, “The most important reasons for using collateral are reduction of credit risk and freeing up of credit lines with counterparties”. It is now customary that firms do not trade with counterparties without collateral agreements.