An unfinished tapestry
07 January 2014
Ted Leveroni of Omgeo gives a timeline of the collateral story
so far, and discusses solutions to the inevitable collateral shortage
Image: Shutterstock
The collateral story continues to attract attention from participants in the derivatives market, and concerns over the potential collateral squeeze are still evident in the industry. The new rules relating to how and where trades are executed, settled and cleared will, as a consequence, place a strain on collateral availability.
There have been various attempts over the past 12 to 18 months to analyse how much additional collateral will be required as a result of central counterparty clearing for standardised derivatives. However, it’s impossible to know what the final collateral requirement will be as estimates are based on existing volumes. Regulatory rules will change the way market participants behave—some may chose not to trade swaps, while others may turn to new products such as futurised swaps. This will impact which collateral obligations firms need to adhere to, and in turn, how much collateral they will need.
A collateral shortage, of some degree, is inevitable. This year, the US got off the starting blocks and began phased implementation of central clearing under the Dodd-Frank Act. Europe is following suit with its own variation of rules under the European Market Infrastructure Regulation (EMIR). This is already impacting how firms are using their collateral.
But the story does not end here. Two further initiatives will heighten the problems around collateral availability. The first is the new requirements for two-way margining for forward-settling agency mortgage-backed security transactions (ie, to be announced transactions) and the second is Basel Committee on Banking Supervision/International Organisation of Securities Commissions (BCBS/IOSCO) rules relating to the margining requirements for bilateral OTC derivatives transactions. These initiatives, while necessary from a risk mitigation perspective, will cause additional strain on collateral resources, which will reverberate across the entire derivatives markets.
The US Treasury Market Practices Group (TMPG) published new recommendations for best practices for mortgage-backed securities markets in November 2012. Its recommendation that “forward-settling agency MBS transactions be margined in order to prudently manage counterparty exposures” will significantly impact the industry, to varying degrees across market participants, especially given the end of the year deadline to be substantially complete in implementing a margining process.
While predominantly a US market, any foreign entities trading TBA’s with US counterparties will be subject to the new rules. And regardless of the geographical scope of the MBS market, its sheer size of approximately $270 billion in value traded daily (where the majority of transactions are forward-settling TBA trades) means that the impact on collateral availability will be global.
A similar sentiment applies to BCBS/IOSCO’s rules relating to the margining of bilateral OTC derivatives transactions. There is wide acceptance that OTC derivatives play an important role in firms’ abilities to hedge their risk, but the decision has been made and these trades will soon be subject to both initial and variation margin requirements. As a result, firms which trade these instruments are now under increased pressure to define and implement an effective response to this forthcoming requirement.
Policymakers have, seemingly, listened to the industry’s concerns about the potential collateral squeeze and extended the list of eligible collateral, including, for example, equities. It is now up to national regulators to devise their own rules, based on BCBS/IOSCO recommendation, but the fact that the list has been expanded is a positive move.
Today, equities aren’t that commonly used as collateral. However, with the appropriate haircuts and protection strategies to account for what might come of the equity markets, such as concentration limits and market cap weightings, more firms are likely to be comfortable using equity as collateral.
But even with an expanded list of eligible collateral, firms that do not have a robust, flexible, sophisticated collateral management process and technology in place will be affected the most.
Some firms already have collateral management departments that leverage sophisticated and flexible technology across asset classes. For those firms, it will be important that they review their processes and technology to ensure that they can handle all changes in margining processes where applicable.
However, others firms do not have the operational or technical expertise in collateral operations, nor do they have the systems to properly support collateral processes. For those, building an in-house solution or leveraging their existing licensed technology is not an option. They will need to find a suitable collateral management solution that can process and manage collateral. In either case, firms must consider the impact on their operations—people, processes and systems—when selecting a solution to address these new requirements.
There have been various attempts over the past 12 to 18 months to analyse how much additional collateral will be required as a result of central counterparty clearing for standardised derivatives. However, it’s impossible to know what the final collateral requirement will be as estimates are based on existing volumes. Regulatory rules will change the way market participants behave—some may chose not to trade swaps, while others may turn to new products such as futurised swaps. This will impact which collateral obligations firms need to adhere to, and in turn, how much collateral they will need.
A collateral shortage, of some degree, is inevitable. This year, the US got off the starting blocks and began phased implementation of central clearing under the Dodd-Frank Act. Europe is following suit with its own variation of rules under the European Market Infrastructure Regulation (EMIR). This is already impacting how firms are using their collateral.
But the story does not end here. Two further initiatives will heighten the problems around collateral availability. The first is the new requirements for two-way margining for forward-settling agency mortgage-backed security transactions (ie, to be announced transactions) and the second is Basel Committee on Banking Supervision/International Organisation of Securities Commissions (BCBS/IOSCO) rules relating to the margining requirements for bilateral OTC derivatives transactions. These initiatives, while necessary from a risk mitigation perspective, will cause additional strain on collateral resources, which will reverberate across the entire derivatives markets.
The US Treasury Market Practices Group (TMPG) published new recommendations for best practices for mortgage-backed securities markets in November 2012. Its recommendation that “forward-settling agency MBS transactions be margined in order to prudently manage counterparty exposures” will significantly impact the industry, to varying degrees across market participants, especially given the end of the year deadline to be substantially complete in implementing a margining process.
While predominantly a US market, any foreign entities trading TBA’s with US counterparties will be subject to the new rules. And regardless of the geographical scope of the MBS market, its sheer size of approximately $270 billion in value traded daily (where the majority of transactions are forward-settling TBA trades) means that the impact on collateral availability will be global.
A similar sentiment applies to BCBS/IOSCO’s rules relating to the margining of bilateral OTC derivatives transactions. There is wide acceptance that OTC derivatives play an important role in firms’ abilities to hedge their risk, but the decision has been made and these trades will soon be subject to both initial and variation margin requirements. As a result, firms which trade these instruments are now under increased pressure to define and implement an effective response to this forthcoming requirement.
Policymakers have, seemingly, listened to the industry’s concerns about the potential collateral squeeze and extended the list of eligible collateral, including, for example, equities. It is now up to national regulators to devise their own rules, based on BCBS/IOSCO recommendation, but the fact that the list has been expanded is a positive move.
Today, equities aren’t that commonly used as collateral. However, with the appropriate haircuts and protection strategies to account for what might come of the equity markets, such as concentration limits and market cap weightings, more firms are likely to be comfortable using equity as collateral.
But even with an expanded list of eligible collateral, firms that do not have a robust, flexible, sophisticated collateral management process and technology in place will be affected the most.
Some firms already have collateral management departments that leverage sophisticated and flexible technology across asset classes. For those firms, it will be important that they review their processes and technology to ensure that they can handle all changes in margining processes where applicable.
However, others firms do not have the operational or technical expertise in collateral operations, nor do they have the systems to properly support collateral processes. For those, building an in-house solution or leveraging their existing licensed technology is not an option. They will need to find a suitable collateral management solution that can process and manage collateral. In either case, firms must consider the impact on their operations—people, processes and systems—when selecting a solution to address these new requirements.
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