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TRENDS, RISKS AND OPPORTUNITIES IN MANAGEMENT: A COLLATERAL MANAGEMENT WHITE PAPER

Collateral is viewed as a solution to and a trigger of massive financial losses that occurred as a result of the financial crisis of 2008. In response, policymakers around the world have enacted new rules and legislation, including the Dodd-Frank Act (DFA) in the United States, European Market Infrastructure Regulation (EMIR) and Basel III regulations, to increase market stability and resiliency, enhance transparency and reduce risk. As a result, these rapid changes in the financial markets are impacting the management, mobilization and transformation of collateral.

In “Trends, Risks and Opportunities in Collateral Management,” The Depository Trust & Clearing Corporation (DTCC) pro- vides an overview of collateral and highlights key drivers for change. The paper also discusses solutions and opportunities to respond to regulatory and industry challenges.

TRENDS AND RISKS FROM COLLATERAL MANAGEMENT WHITE PAPER WHAT IS COLLATERAL AND COLLATERAL MANAGEMENT? Demand for High Quality Collateral Difficult to Meet: • Collateral is the security provided by one Organizations have attempted to calculate the amount of party to another to mitigate counterparty collateral that will be needed by financial firms as a result risk for any extension of credit or financial of new derivatives legislation, liquidity requirements and exposure. In financial markets, collateral is regulatory mandates. Driving the increase in collateral broadly interpreted but typically includes requirements are new rules that mandate central clearing for the majority of over-the-counter (OTC) derivatives trad- , securities and, at times, commodities ing and the introduction of operational controls and capital such as gold. requirements for non-cleared, OTC derivatives trades. In practice, clearinghouses will have to impose initial • Collateral management is the efficient and requirements as well as reduce or eliminate thresholds effective allocation of collateral to reduce risk for variation margin, which will dramatically increase the and encompasses both supply and demand demand for high-quality collateral. components.

A September 2012 study by the Bank of England estimated margin for both counterparties and a reduction or that new collateral demands could reach as high as $800 removal of thresholds for variation margin. The inclusion billion as a result of new regulatory requirements. of initial margin will significantly increase the amount of collateral required, and will create additional margin Despite the anticipated massive increase in demand for calls. The removal or reduction of thresholds for varia- collateral, many financial institutions are either not fully tion margin will mean any change in may cognizant of their eligible collateral or unable to efficiently trigger daily margin calls. In the past, thresholds limited mobilize collateral to allocate it against specific exposures. these calls to times of significant changes in underlying In addition, many firms are not optimizing their collateral, valuations. which could create a gap between supply and demand. • New Standard Credit Support Annexes (SCSA): Credit Support Margin Call Activity to Increase Up to 1000%: A number Annexes (CSAs) establish rules that govern the posting of of drivers are expected to dramatically increase margin collateral for OTC derivatives. Historically, margin calls call activity, which will likely have a significant impact on have primarily been met in EUR or USD. liquidity and risk. Discussions with participants in the OTC New SCSAs looks to encourage better risk mitigation derivatives markets indicate that this activity could jump through matching the currency of the collateral with the 500-1000%. Primary drivers of the increase in margin call currency of the underlying trade. The challenge with this activity include: approach is that the volume and complexity of collateral • Regulatory changes: DFA and EMIR could require initial calls and their will increase as a result. • Clearing Fragmentation: With new clearing requirements for margin activity, is expected to have an impact on costs and OTC derivatives transactions, CSAs, which have histori- risk in a number of areas including funding costs; opera- cally covered an entire portfolio of deals with one margin tional capabilities and settlement expectations manage- call, now may exclude products offered by different ment; and reporting and recordkeeping. clearinghouses – which may drive individual daily or even intraday margin calls for each clearinghouse. This Transparency Critical for Managing Risk: During periods clearing fragmentation reduces the historical advantage of of extreme market stress, the volume and value of margin calculating margin across a multi-product portfolio. This calls increases exponentially. The inability of firms to fragmentation effect may be exacerbated in the US by the seamlessly connect collateral obligations and their ensu- regulatory requirement that creates multiple collateral ing settlements creates opacity in the market. This has accounts for specific types of underlying transaction the potential to cause destabilizing market reactions and being collateralized: security-based , non-security impact the decision-making of policymakers responsible for based swap, Future and Option, or non-cleared (bilateral) managing the crisis. activity. • Regionalization: The potential creation of multiple regional Strategic vs. Costly Fragmented Solutions: Industry clearing venues per product may have a splintering effect participants have indicated that they would prefer strategic on collateral, increase the number of margin calls, and solutions to address the challenges related to collateral to alter the mix of acceptable collateral globally. avoid costly fragmentation.

Impact on Firms: Regulatory changes are making it diffi- For example, one area of concern for prime services provid- cult for industry participants to keep their internal systems ers is the cost of operating separate clearing platforms for and procedures responsive to meet new challenges. Firms listed and OTC derivatives – including different platforms are concerned because the increase in collateral require- for the U.S. and Europe – which fragments margin process- ments, along with the subsequent increase in underlying ing and collateral management.

SOLUTIONS AND OPPORTUNITIES Dramatic market changes are spurring new solutions and opportunities in collateral management, which can be grouped into multiple categories, including: 1. Exposure Calculation and Margin Management - a variety of in-house and outsourcing options exist for collateral processing that support a variety of client types

2. Portfolio Margining - calculates a margin requirement for a portfolio of exposures in such a way that offsetting risks are used to reduce the requirement for collateral

3. Collateral Optimization – an essential component to addressing and resolving the gap between collateral supply and demand

4. Record Keeping and Reporting - Global trade repositories for derivatives that hold collateral data have the ability to identify potentially large margin calls that could be difficult for firms to satisfy. Repositories can also provide the tools to track “payment failures” across jurisdictions that may not be visible to individual national or regional authorities. Standardization of reporting is another area of focus as it eliminates the need for firms to assimilate and manage data.

The evolving regulatory environment will continue to place significant pressures on financial firms and create myriad challenges for managing collateral. It is essential that strategic collaborative solutions are employed to the expertise and knowledge of multiple providers as well as address the issue in a more holistic manner. Toward that end, DTCC is continuing to collaborate with industry partners to develop solutions that address the operational costs and risks associated with the increased demand for collateral.

For more information, view “Trends, Risks and Opportunities in Collateral Management” available at http://www. dtcc.com/~/media/Files/Downloads/WhitePapers/CollateralMGMT_WhitePaper.ashx

To reach DTCC’s regulatory and legislative offices, please contact: United States European Union and Asia 1455 Pennsylvania Ave, NW Suite 725 Rue Montoyer 47 B- 1000 Washington, DC 20004 Brussels, Belgium 202.383.2661 +33.2.645.9877, +44.7798.568.713 (c) Ali Wolpert, Vice President, [email protected] Andrew W. Douglas, Managing Director, [email protected]

The Depository Trust & Clearing Corporation • 55 Water Street, New York, NY 10041-0099 10121_ER01/2014