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With ongoing fiscal concerns in Europe once more raising the specter of counterparty defaults, financial reforms created under Basel, EMIR and Dodd-Frank may be quickly put to the test. Buy-side participants are assessing how the migration toward central clearing affects their counterparty risk. Will it leave them better protected or simply concentrate risk with a clearing broker or central counterparties (CCPs)? In addition, proposed restrictions on eligible collateral, portfolio composition and the cost of collateral need to be considered. Finally, far more sophisticated processes need to be in place to manage collateral across a complicated network of multiple clearing brokers, CCPs and bilateral counterparties while integrating input from data vendors, other providers and existing operational relationships. Even in the most placid times, such wide-ranging reforms would create some level of confusion and uncertainty. In the current volatile environment, buy-side institutions arepressed to identify and solve issues that stem from the mandated move to central clearing. Among their primary concerns:
Risk: mitigation or concentration? While the move toward central clearing should mitigate counterparty risk, the impact of recent downgrades is having a clear impact on buy-side trading strategies. Some asset managers have reported that credit downgrades have dropped some banks below their required credit levels, reducing their number of eligible counterparties. The recent downgrades add to more general concerns about long-term strength of the CCPs. Many institutions have expressed serious concerns about concentrating trade volume in a single CCP, noting parallels to problems with prime brokers during the recent financial crisis. These asset managers saw what happened in 2008 to those who funnelled the majority of their business to the wrong prime broker. Just as they now divide their business among several prime brokers, most buy-side firms are looking to spread trade volume across multiple CCPs and clearing brokers. Even smaller firms have noted that the added flexibility and risk mitigation outweigh possible netting benefits and volume discounts that would be achieved through greater concentration. Adding multiple clearing broker relationships to existing bilateral clearing structures creates considerable operational complexity. In addition to making sure thatall documentation is in place, collateral must be managed efficiently across multiple platforms. The difficulties in achieving timely and accurate reporting generate a strong element of operational risk. Liquidity: the coming scarcity of quality collateral and the impact on portfolio composition As Dodd-Frank and other worldwide regulations are phased in, there will be a crunch on certain instruments and currencies. CCP-mandated transactions are likely to create a surge in demand for the highest rated government securities, which may also be required as initial or variation margin in a considerable majority of bilateral transactions. If all high quality collateral is tied up, it will be neither liquid nor available to anyone wishing to purchase it in the market. Given that once pledged to the CCP, rehypothecation of such securities is unlikely; a significant amount of liquidity will be pulled out of the markets if the CCPs adhere to their announced preference for sovereign debt (from a handful of issuers), agencies and cash. To add liquidity back into the system, either new sources of the highest quality collateral have to be identified or there will have to be some easing of collateral eligibility requirements. The buy-side also expects collateral transformation options to be available in order to help participants meet eligibility. The cost and availability of such options are an ongoing concern. The buy-side expects a robust bilateral market to remain as centralized clearing takes effect, aided by the fact that initial and variation margin, or independent amounts for bilateral trades, may accept different asset classes than the CCPs. There is some indication that regulators, as evidenced in a recent BIS consultative document,* may allow for a broader set of eligible asset classes in collateral schedules so long as adequate liquidity and haircut parameters are met. Finally, as additional clarity is available on margin requirements, asset eligibility and compliance timelines for both cleared and bilateral transactions, investors will need to evaluate their existing portfolios, particularly in light of the demand for high quality securities. For institutions whose portfolios are focused on these assets, new opportunities may arise to meet sell-side demand by lending these securities on a fully collateralized basis. Cost: the impact of more expensive collateral, a more complex process and the associated infrastructure Under any foreseeable scenario, the overall cost of collateralizing trades is likely to rise. Increased demand will raise the cost of collateral, collateral management operations will have to be beefed up or outsourced, and portfolio and collateralization strategies will demand heightened oversight to ensure they can achieve desired objectives. However, through netting, efficient collateral optimization and amalgamation of trade volume, the buy-side has the opportunity to mitigate the impact. In looking to reduce trading costs, firms have to decide how much of their trade flow they are willing to direct to a single clearing broker and/or CCP in order to benefit from volume discounts. Some institutions report that they may choose to clear certain transactions that are not required to go through a CCP, either to improve their volume discounts or accommodate counterparty preferences, resulting in a cost structure that may compare favorably to bilateral arrangements. As the scarcity of collateral rises, the ability to deploy portfolio assets efficiently will become a primary focus for the buy-side. Where a buy-side firm is able to consolidate the collateral available to a fund or legal entity across multiple transactions, they are likely to find themselves with a significant competitive advantage. For optimal collateral management, buy-side firms will want to review their opportunities to combine collateral related to repo, stock loan, futures and options, and swaps transactions. Conclusion Global financial reform has been a long time in the making. There has been considerable confusion along the way, and the full implications of Basel III, EMIR, Solvency II and Dodd-Frank are still far from certain. It's not surprising, therefore, that a sort of regulation fatigue has started to set in. Some firms have simply selected a CCP or clearing broker and left it at that. They may be waiting for greater certainty before taking on broader liquidity, risk and segregation challenges, or they rely wholly on these partners for services that could be provided more efficiently or cheaply elsewhere. Either approach is understandable but, ultimately, short sighted. When the final decisions are made, buy-side firms expect a short implementation window and a turbulent first year. Thus, firms should stay abreast of industry developments and do what they can to prepare. The split market model will result in faster collateral movements, more complex operational and reporting needs, higher volumes and increased costs. Faced with this added complexity, many notable buy-side institutions are choosing collateral agents in addition to clearing brokers and CCPs. An agent can help efficiently manage bilateral OTC and centrally cleared derivatives transactions, optimize the use of collateral and cope with the increased challenges that stem from an abundance of regulatory change.
Thought, Fall 2012
"Margin Requirements for Non-Centrally Cleared Derivatives," Part B, |
