What are the key regulations affecting the OTC derivatives?
The Dodd Frank Act (DFA) in the US and the European Market Infrastructure Regulation (EMIR) in Europe are two of the big impact regulatory reforms. Both the reforms mandate that all standardised OTC derivatives be:
- Traded on Swap Execution Facilities (SEF) or a on regulated market place
- Cleared through a central counterparty (CCP)
- Collateralised on bilateral basis
- Reported to Swaps Data Repositories (SDR)
The reforms also come with stricter rules on margin, record keeping and reporting. It is expected that approximately three-quarters of the current bilateral trade volume will shift and be cleared through CCPs.
With the arrival of CCP clearing, it is estimated that the additional collateral required will be between USD 3 and US$ 4 trillion. This in turn will increase collateral funding cost and in my view is driven to a large extent by the following:
- The CCPs will demand higher initial margins. It is estimated that the initial margins could rise up to 10% of the notional capital for an interest rate swap with 30 year maturity.
- As the trades are fragmented across various clearers and counterparties, the benefits of netting are lost.
- The CCPs will apply stricter rules, as mandated by regulators, to filter the eligible collateral for initial margin as well as the variation margin; haircuts will be applied.
Collateral optimisation is all about centralising the collateral function and making the allocation of collateral an efficient rule based process. This involves assigning funding costs to each asset that can be pledged as collateral. The objective is to give out the cheapest collateral that matches the eligibility criteria of its counterparty.
To optimise collateral efficiently, the technology systems need to be configured with a variety of parameters including eligibility and concentration criteria, haircut rules, substitutions, funding costs, optionality and settlement costs. A global view of the collateral across the organisation and across business lines is another fundamental functionality to make best use of the collateral assets.
The CCPs and the Clearing Members will need to amend their systems to filter the collateral posted based on their quality, as well as build workflows to ensure the collateral posted across their entire clearing portfolio is diversified.
There is no one size fits all solution. Technology solutions must be highly configurable as every client’s need of collateral optimisation will be different.
So what optimisation techniques should be applied as a norm? Collateral optimisation is a relatively new paradigm. From my experience, even the most advanced organisations are not adopting all possible techniques to optimise collateral, yet every organisation is striving to strike that balance between sound risk management and minimal impact to the balance sheet.
The following diagram summarises the building blocks of collateral optimisation.
Collateral optimisation not only drives the collateral funding cost down but will also bring organisation-wide transparency, better management of inventory, and more importantly facilitate the best execution decision. When it comes to the buy vs build decision, the above capabilities need to be evaluated.
In summary, it is evident that the new regulations will change the way OTC derivatives are settled, collateralised and reported. The increased need for quality collateral will increase the cost of collateralisation. As a result, collateral management, once considered a support function, will get its share of the popularity. The technology systems must be strengthened to support the increased operational complexity. Easier integration with market, static, reference data systems, timeliness of data availability and the quality of the data held will all help the cause.
Collateral optimisation is no longer a nonessential function. I believe a transparent, fully integrated and rules based optimisation mechanism is the order of the day.