A case for proactive collateral management

The impact of centralizedderivatives clearing

This communication is provided by Advent Software, Inc. (“Advent”) for informational purposes only and should not be construed as or relied on in lieu of, and does not constitute, legal advice on any matter whatsoever discussed herein. Advent shall have no liability in connection with this communication or any reliance thereon.

The switch to centralized clearing of derivatives is proving to be more complicated than anticipated, but fund managers ignore this change at their peril. Fortunately, greater transparency and competition in this market stands to benefit all parties.

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2 | The Impact of Centralized Derivatives Clearing

Taking Shape—Slowly

It turns out it is far easier to enact regula-tory reform than to implement it. A prime example is the centralized clearing of OTC derivatives. Mandated by both the US Dodd-Frank Act and the European Market Infrastructure Regulation (EMIR), the clearing of over-the-counter derivatives through central counterparties (CCPs) was meant to take effect at the end of 2012. Implementation, however, has proven to be far more than a mere matter of flipping a switch. Many issues remain to be resolved, not the least of which are the differences between the US and European rules.

In the US, centralized clearing became mandatory for interest rate swaps in March 2013. Adoption took a three-phased approach for different types and sizes of participants:

> Phase 1: Swap dealers, major swap participants and active funds with 200 or more swaps per month.

> Phase 2: Commodity pools, private funds and other “financial entities.”

> Phase 3: All other participants not included.

In Europe, meanwhile, regulators are in the process of registering central clearinghouses and determining which instruments require central rather than bilateral clearing. The process is expected to run into 2014.

Under the new rules, firms that trade in OTC derivatives will be required to make larger margin commitments and will be subject to more frequent margin calls. Moreover, different CCPs will have different asset valuation methodologies and margin calculation models, which firms will need a way of tracking. Asset eligibility requirements are expected to vary among CCPs as well, and in most cases are likely to be narrower and more stringent.

All of this would suggest that fund managers need to take a new look at how they manage collateral. Yet because of the lag time in implementation, many are not yet feeling the impact and are taking a wait-and-see approach, comfortable that they have the capacity to cover margins under any circumstances.

The new regulations and changing market structure have far-reaching implications for both buy- and sell-side participants in the derivatives market.

Centralized Clearing

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Under the new structure, entities that trade in OTC derivatives must be prepared for higher margin commitments and more frequent (perhaps daily) margin calls.

4 | The Impact of Centralized Derivatives Clearing

Delaying the inevitable could prove costly. Those accustomed to low margin requirements and handshake agreements may be in for a shock, as they face higher margin requirements and more prescriptive counterparty demands. Collateral management, largely an afterthought in the less regulated environment, will become an imperative. It will consume time and resources and potentially eat into profitability—unless firms take measures to streamline the process and mitigate the impact of the new regulations.

The New Market Structure

Under the new structure, it is proposed that funds will now send a trade through a Swap Execution Facility, which will in turn put the trade out to brokers. The executing broker will send the trade through a Clearing Member (usually a bank) that is responsible for satisfying the Central Counterparty’s requirements. The CCP sets the margin call based on its proprietary valuation methodology. The margin call thus moves down the chain from the CCP through the Clearing Member and ultimately to the fund initiating the

trade. Broker trading desks, who in the bilateral world simply took the spread on the trade, now need to know the impact of margin and cost of carry on their capital requirements.

What it Means

The Real Cost of ComplianceThe new regulations and changing market structure have far-reaching implications for both buy- and sell-side participants in the derivatives market. In the bilateral environment, margin calculations were fairly straightforward, and brokers could afford to be somewhat flexible about margin calls when it suited them and their clients. Under the new structure, entities that trade in OTC derivatives—hedge funds, global asset managers, pension funds, insurance funds and others—must be prepared for higher margin commitments and more frequent (perhaps daily) margin calls. Clearing houses are likely to take a harder line on margin amounts and the timing of transfers than bilateral trading partners. Larger funds can no longer expect preferential treatment that typically meant once-a-month calls. Dispute resolution is likely to

be more cumbersome with complicated, arms-length relationships, and firms that experience discrepancies may find they have less or very little recourse.

Funds accustomed to trading both an underlying security and a hedging instrument with a single broker used to be able to take advantage of netting margin for both transactions. In the new structure, that advantage will disappear, as the derivative trade must be cleared through a CCP. Cross-margining opportunities will decrease significantly. Funds will no longer be able to net funding of multiple transactions to a single currency.

Although, the CME in its July 2013 overview update1 included the fact that their portfolio margin offering had accounted for over $1 billion in initial margin savings. While this is currently only a service that applies to interest rate swaps and rate futures, the intended introduction of cleared swaptions by both the CME and LCH suggests that some degree of cross margin relief will still be possible for those willing to find it.

Entering into a trade, funds and brokers will have to consider much more than the

1 http://www.cmegroup.com/trading/interest-rates/cleared-otc-interest-rate-swaps-overview.html

Clearing Member

Traditional OTC

Clearing Domain

SEF Swap Execution Facility

OTC Executing Broker Fund

Clearing Member

Central Counterparty

The New Market Structure: Know the Players

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Those accustomed to low margin requirements and handshake agreements may be in for a shock, as they face higher margin requirements and more prescriptive counterparty demands.

sell-side price of the contract. The “real” price encompasses costs of collateral, fees for collateral transformation, cost of carry and other transaction-related expenses. According to a 2013 report from KPMG entitled The Next Operational Hurdle for Hedge Funds—Collateral Management: The Multi-Prime Broker Model Colliding with Regulatory Reform, “Recent industry papers have estimated that the additional collateral burden demanded by Dodd-Frank and EMIR could be over US$2 trillion globally.” This is to say nothing of the added operational strain and the internal costs that will accompany it.

A Case for Proactive Collateral Management

The change in the market structure and transaction flow calls for a cultural shift. Where calculating margin used to be a post-trade analytic, it must now be factored in before the trade is placed in order to avoid excessive margin commitments and costs. Firms will be challenged to replicate and validate CCP margin calculations in advance of trades to manage costs and determine where

to direct trades in order to optimize collateral. Firms may also need more frequent collateral transformation trades with third parties in order to satisfy the differing asset eligibility requirements of the CCPs. And while certain instruments and transactions will not require central clearing, bilateral trades will have more onerous margin requirements as well under the new regulations.

In this new environment, firms that do not actively manage collateral run the risk of posting more than they have to, liquidating unnecessarily to cover margin calls, diminishing their trading capacity, and missing opportunities for incremental profit. With a more complex market structure and stricter rules, paying closer attention to margin requirements is clearly in a firm’s best interest. Many firms have already adopted more systematic collateral management practices as a result of the squeeze on returns in the wake of the 2008 crisis. In volatile markets, when firms are challenged to generate alpha, controlling collateral costs becomes a way of adding incremental profitability to the bottom line. “In the competition to raise capital for funds today, investment managers can use all

Implications of Inactive Collateral Management

> Excessive margin commitments and costs

> More frequent collateral transformation trades

> Unnecessary liquidation to cover margin calls

> Diminished trading capacity

6 | The Impact of Centralized Derivatives Clearing

With a more complex market structure and stricter rules, paying closer attention to margin requirements is clearly in a firm’s best interest.

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Fortunately, much

of what firms

need to do can

be automated.

8 | The Impact of Centralized Derivatives Clearing

of the help they can get to achieve better returns for their funds and be more attractive to potential investors. If a fund can positively impact its performance by a few basis points (or more) by optimizing its collateral management in the new centrally cleared environment, it may very well be worth the effort. While there is a project at hand to change the support processes to optimize collateral management, there are technologies and advisors available to help complete this project at an affordable cost,” says Mikael Johnson, Lead Partner–Alternative Investments at KPMG.

New Collateral Management Best PracticesStronger collateral management places an additional burden on a firm’s operational staff and infrastructure. In order to sustain profitability, firms must find the most efficient way to manage collateral. Best practices have begun to emerge as firms figure out what it takes to manage collateral optimally. These include:

> The ability to replicate and validate different clearinghouses’ margin calculations. As each CCP will have its own margin calculation methodology, fund firms must gain control to ensure that the calculation is accurate, consistent and fair.

> The ability to compare and evaluate different clearinghouses’ collateral requirements, in terms of both amounts and types of collateral accepted.

> The ability to identify the best clearing venue for a particular trade in order to optimize collateral.

> The ability to manage the full range of margin calls, ideally in one platform, from the traditional prime broker and listed futures calls to both bilateral and centrally cleared OTC calls under the new regulations.

> The ability to track and confirm fees as well as correctly allocate cost of carry and use of capital back to each position.

Done manually or with spreadsheets, these are time consuming tasks and a drain on resources, with risk of errors and opportunity costs. In the era of “doing more with less,” firms will need systems that will enable them to do all this efficiently and accurately. And because the CCPs are continually tweaking their valuation models and adding to their product coverage, firms will need regular updates of different margin calculation methodologies.

The Role of Technology

Fortunately, much of what firms need to do can be automated, using technology specifically designed for managing margin in a multi-counterparty environment. Firms that can automate the replication and reconciliation of all CCPs’ margin costs and requirements stand to benefit in a variety of ways:

> Reduce the risk of being overcharged. Firms can validate each CCP’s margin calculations and see side-by-side cost comparisons of different clearing houses

Stronger collateral management places an additional burden on a firm’s operational staff and infrastructure. In order to sustain profitability, firms must find the most efficient way to manage collateral.

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“Significant transformation is taking place in the clearing and collateral management domain due to regulatory, market and efficiency drivers—one of the key initiatives being undertaken at firms across the industry is the effective alignment and integration of people, process and technology supporting Cleared and Bilateral portfolios of OTC Derivatives, as well as those for Listed Derivatives.

Functions, such as pre-deal margin estimation and collateral optimiza-tion, that were traditionally orga-nized in silos are increasingly being integrated to offer seamless value-add services, rather than fragment-ed capabilities—the selection and deployment of robust and scalable systems is a primary success factor for such enterprise-wide initiatives.”

Manmeet BrarSenior ManagerSapient Global Markets

> Reduce margin levels with optimized asset placement. Firms can perform what-if analysis on proposed trades to determine the optimal combination of Direct Clearing Member (DCM) and CCP to clear through.

> Improve decision making with single view of all margin rules and expected margin requirements.

> Reduce operational risk with automated identification and resolution of breaks.

Firms must change their practices, but with thoughtful planning they can minimize the disruption to their businesses. With the right technology, firms can go a long way toward reducing the added operational burdens and mitigating the impact associated with the new regulations.

Why Collateral Transparency Benefits All

The goal of centralized OTC clearing is to bring greater transparency to what was a fairly opaque marketplace before the crisis of 2008—and widely regarded as one of the main causes of the crisis. Greater transparency, combined with competition among CCPs, should ultimately benefit all participants. It will, however, put the onus on firms to be more sophisticated and systematic in collateral management, which will have an operational impact.

Technology is available that can help firms manage collateral more effectively and adapt more quickly to the new market realities. Effective collateral management, combined with greater operational efficiency, also helps strengthen the bottom line during times of uncertain returns. Volatile markets have made effective collateral management a competitive advantage. The new regulations and a more complex centralized clearing environment will make it an imperative.

Volatile markets have made effective collateral management a competitive advantage. The new regulations and a more complex centralized clearing environment will make it an imperative.

10 | The Impact of Centralized Derivatives Clearing

About Advent SyncovaAdvent Syncova® is a highly configurable, calculation solution designed to improve the management and transparency of costs related to margin, financing, collateral and stock loan fees. It facilitates improved analysis, reconciliation, replication, optimization, alerting and reporting. Syncova makes it possible for buy- and sell-side firms to confidently manage the increasingly complex margin and financing terms between them. For more information on Syncova visit http://www.advent.com/solutions/by-product/syncova.

The shape of things to come

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