Mark Jennis, Managing Director, DTCC [email protected] Mathew Keshav Lewis, Vice President, DTCC [email protected] Feature Feature If you Google “collateral,” 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 margin 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 loan 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 hedge fund 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 clearing house (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 (cash, 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 Feature Feature 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 valuation 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 derivative 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 swap 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