More than seven years have gone by since one of the most significant financial crises in history began. This event has exposed multiple inefficiencies in the way most of the players in the financial markets manage risk. A high volume of OTC (Over-the-counter) trading is taking place, which has prompted regulatory authorities to focus their efforts on achieving market stability. They are largely accomplishing this by implementing measures that have a direct impact on credit risk and liquidity risk management.
Regulatory reforms, passed by the economic powers in the international landscape, have been mainly executed through the Dodd-Frank Wall Street Reform and Consumer Protection Act in the US and through EMIR (European Market and Infrastructure Regulation) in Europe. Amongst the changes introduced by these regulations, one of the key factors, and the subject of this article, is the use of collateral as a guarantee to reduce the potential credit risk associated.
One of the core risk mitigation measures, and a controversial one, is based on clearing trades through CCPs (Central Counterparties), demanding their members the delivery of the necessary collateral to cover possible events of default, and therefore reducing the associated systemic risk. This practice has extended as well to bilateral transactions, since it is nowadays required to assume credit risk by providing collateral in the same way. In this case, there is more flexibility in setting the terms of the agreement, although in most instances they are covered by master agreements (GMSLA, ISDA, GMRA, etc.)
It is evident that important challenges will arise from these new changes, not only because of the need to carry out collateral management processes correctly, but also because of the impact on decision-making and the potential costs that could result from inefficient strategies. Here are some of the areas affected:
Collateralisation requirements will have significant consequences over the funding activity of the industry’s institutions. Faced with constantly growing margin requirements, the involvement of those responsible for liquidity within financial entities will be essential, as an efficient collateral management strategy will allow a cost reduction. The possibility of delivering cash or different types of securities, together with factors like financial and opportunity costs or interest remuneration for collateral payments in cash, makes it necessary to apply algorithms in order to optimise collateral management. This optimisation can even achieve the designing of arbitrage strategies.
At the start of the crisis, faced with a liquidity shortage central banks became the only sources of funding for financial institutions. Therefore, the management of inventories encompassing instruments subject to being delivered as collateral was aimed at optimising them in order to enhance the response to exceptional liquidity problems.
New clearing houses have emerged to replace this role of central banks, increasing financial entities’ funding options and enabling multiple solutions to respond to liquidity needs. Among the new advantages offered by some clearing houses, such as EGC Pooling, we can highlight the flexibility to adapt eligible asset pools to standard criteria like those set by the European Central Bank or the LCR.
Those working in collateral management departments can face uncertainty when facing decision making. One of such decisions is to choose between CCP and bilateral trading. Advantages of trading through CCPs include a lower counterparty risk, due to the substantial liquidity buffers they offer, to the possibility of netting exposures and to the transfer of automated processes for collateral calculation, which relieves the entity’s management workload. On the other hand, bilateral transactions mean a lower collateralisation cost, as well as more flexibility and sophistication in trading.
Banks trading through CCPs will be subject to lower regulatory capital charges. However, they must face a different margin calculation methodology at each CCP, as well as great obstacles when estimating margins. This fact has an impact on the ability to forecast the day-to-day collateral requirements.
Effect on liquidity ratios
The latest regulatory liquidity requirements, such as the LCR (Liquidity Coverage Ratio) set by Basel III, force banking institutions to maintain a certain volume of liquid assets compliant with minimum standards, where different haircuts (or valuation discounts) are applied depending on the asset type. Thus, the decision over what collateral to be delivered in each agreement will significantly influence regulatory requirements in terms of liquidity levels. This is why an optimum collateral management system should be able to take into account these criteria when selecting the assets to be delivered.
Resources employed by financial institutions in the management of collateral have increased considerably. This task, originally conceived as a middle or back office responsibility, has become a cross-cutting function that begins with decision-making in the front office and finishes in the back office with settlement processes. This is why it has become essential to use tools that enable an efficient management of operational processes, as well as centralisation of information throughout the collateral lifecycle, from origin to clearing.
The implementation of a collateral management system is the first building block of a successful collateral management strategy. As it requires attention to the needs of all the stakeholders involved, it is essential that the implementation team has an expertise in both information technology and capital markets.
Eduardo joined Optimissa as a management consultant in 2012. He has successfully completed several software implementation and change management projects, leading the delivery of gap analysis and workflow design for risk and trading processes. He has specialised in collateral management and is Product Manager of 2Cover, Optimissa’s collateral management system. Prior to joining Optimissa, he held positions as a Business Analyst in different companies, gaining valuable experience in consultancy and business management. Eduardo has an MSc (Hons) in Financial Markets and Alternative Investments from BME (Bolsas y Mercados Españoles) and is currently studying at the IEB (Instituto de Estudios Bursátiles) for an MSc in Asset Management.
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