Among many likely changes to financial risk management processes necessitated by regulatory changes, many derivative end-users have likely had to implement or make changes to collateral management processes. In some cases, these changes were in direct response to a regulatory mandate or counterparty requirement and may not have been designed or implemented in an optimal manner.
Some other companies – daunted by the requirements of implementing a collateral management process – may have decided to avoid this route at all costs. So what opportunities to enhance counterparty credit risk management might arise from a review of a company’s approach to derivative portfolio collateralisation? For those that have implemented a process, there may be ongoing process improvement opportunities. For those that have not, there may be benefits in doing so.
How we Got to Where we are Now
In 2008, after the global financial crisis revealed the unprecedented impact of credit and liquidity risks on how companies fund their businesses and hedge their financial risks, the importance of managing counterparty financial risks became clear. Corporates realised the need to closely monitor and diversify counterparty risks, and market participants started to diversify bank relationships to reduce concentrations of exposures with financial counterparties.
However, when dealing with counterparty credit risk, diversification and close monitoring may not actually decrease risk. The only way to mitigate credit risk associated with derivative financial instruments is either not to hedge the financial risk in the first place or, alternatively, to exchange collateral with counterparties based on the mark-to-market (MTM) of the derivative portfolio.
As a response to the crisis, a wave of new regulations was intended to enhance financial market operations and reduce the likelihood that a crisis of similar proportions would happen again. Since 2008, various regulatory bodies have been taking actions to define and shape the derivative market to boost its transparency and reduce counterparty credit risk.
The cumulative impact of all these regulations has had a transformational effect on the financial markets. While the various regulations (Dodd-Frank, EMIR, Basel III) are broad and far-reaching, there were two primary goals with respect to financial instruments: to increase transparency and reduce credit risk. Essentially, to increase transparency in the over-the-counter (OTC) derivative market, the regulations have imposed reporting requirements on the market participants (i.e. Dodd-Frank in US, EMIR in Europe). Similarly, to decrease overall market credit risk, several collateral exchange requirements were imposed or are in process of being imposed on the market participants. In addition to Dodd-Frank and EMIR, the credit valuation adjustment charge in Basel III may also have an important role in leading banks to require collateral from their counterparties.
How Corporates have Responded to the New Regulatory Environment
In practice, as regulators were mostly concerned with portfolios that may represent a systemic financial risk, most of the mandatory requirements have been directed to financial entities. With the exception of those corporates that, for various reasons, are asked to post collateral by their counterparties (for example those with weak credit profiles), the decision about whether to post collateral is typically a corporate decision. So, specifically from a collateral posting perspective, most end-users have adopted a minimalist approach towards regulatory compliance, and prefer to maintain their existing processes and strategy where possible and avoid collateralising their derivative portfolios.
Corporates have highlighted the infrastructure costs required to implement a collateral management process and the required funding as major barriers to posting collateral. These barriers – along with questions about the benefits of posting collateral, including the pricing difference between collateralised and uncollateralised derivatives (due to Basel III rules, for highly-rated companies it may actually be cheaper to post collateral for non-collateralised derivatives, as banks need to allocate additional capital to the positions, therefore expectedly require wider trading spreads) – have deterred a majority of corporates from fully collateralising their derivative portfolios.
The question remains though, notwithstanding counterparty requirements, whether avoiding collateralising trades is still the best management decision.
The answer depends on each company’s facts and circumstances. While the commonly-cited impediments to posting collateral are real, they should be weighed against the potential risk reduction benefits of bilateral collateral arrangements. Systemic financial risk might have been addressed by the new regulatory environment, but individual companies are still responsible for ensuring that they understand and manage their own counterparty credit risk.
The integrity of the overall financial system will be of no more than small comfort if your company experiences a credit loss related to uncollateralised derivative assets.
What Does the Future Hold?
There are currently two frameworks under which collateral can be exchanged:
- Bilateral exchange of collateral in general regulated by a credit support annex (CSA), where both parties voluntarily decide to post collateral, or imposed by one counterparty to the other due to its lower credit rating.
- Centralised clearing, under which the risk is concentrated in a clearing house, and the clearing brokers, which need to be highly capitalised financial institutions (FIs). In case of default, this model is expected to provide a more orderly liquidation of the position of the defaulted institution.
As corporates should reassess on a frequent basis their decision to collateralise their derivative portfolio, the business case to move to a collateralised model under any of the two frameworks depends on a number of factors, including:
- Cost of the tools required to implement clearing.
- Availability of and cost of funding required to post collateral.
- Price advantage of derivative collateralisation.
- Reduction of counterparty credit risk.
- Set-up of contractual relationships to clear trades.
- The ability to forecast and manage day-to-day variability in margin requirements both from a process and funding requirement.
In summary, the changes required to implement a collateral management process, including additional funding required to post collateral and related operational processing is no small undertaking. However, corporates should continue reassessing on a frequent basis all the costs and benefits of collateralising their portfolio.
In essence, as existing regulations may be addressing systemic risk, it is up to each corporate to make its own decisions around how much counterparty risk they want to bear. Those that adopt a more diligent approach to counterparty risk management may be in better position to stay afloat in the event of any new financial crisis.
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