Knocking on the door
04 November 2014
SunGard’s Alex Soane assesses the possible impact of BCBS/IOSCO on collateral
Image: Shutterstock
First it was Messrs Dodd and Frank and the European Market Infrastructure Regulation that brought in sweeping regulatory reform across the major markets. Later it became apparent that non-standard trades, not subject to mandatory clearing, still posed risk. Given that anything uncleared is by definition non-standard, it could be argued that this is where the majority of risk is situated.
As a result, the Basel Committee on Banking Supervision (BCBS) and the International Organization of Securities Commissions (IOSCO) proposed a plan to further mitigate the risk of non-cleared derivatives. In September 2013, they released the final recommendations for margin requirements for non-centrally cleared derivatives and the market began to prepare for yet another regulatory challenge. Further consideration must be given to local regulators defining the governance of this global mandate. All of this has significant ramifications for collateral operations for both the buy and sell sides.
Kick-off is December 2015, when bilateral derivatives will be traded under new collateral agreements and market participants will start putting the preparation for the new requirements in to practice. In order to allow adequate time for all market participants to adhere to the new market rules, the implementation of initial margin (IM) transfer will be phased in gradually to 2019. The BCBS/IOSCO framework has been designed to reduce systemic risks related to over-the-counter (OTC) derivatives, in addition to providing firms with incentives to centrally clear eligible trades and provide assistance in managing the overall liquidity impact of the requirements.
It is important to understand that the impact of this regulation is far reaching, arguably more so than central clearing due to the breadth of liable parties and the non-standard trade types covered. Under the new globally agreed standards, all financial firms and ‘systemically important non-financial entities’ engaging in non-cleared derivatives trading will have to exchange initial and variation margin with their counterparties.
While the exchange of IM and variation margin (VM) is by no means revolutionary, the mandate covers a large section of the market which historically has not been affected by collateral. This means many trades may not currently be covered by credit support annexes (CSAs), or it may be as simple as an organisation having no existing collateral operation or expertise. Either way, BCBS/IOSCO means that the cost of non-cleared OTC derivatives will increase.
For those that may be new to collateral, as some non-financial organisations will be, two options await:outsourcing or internal investment. It is highly possible that trade volumes may be low enough to manage internally for many, in which case a rapid roll out of a collateral system providing agreement management and margin calculation may well suffice.
What of those who have the necessary wherewithal, what are their main concerns?
Yet another increase in call volumes is expected, with one Tier 1 bank recently forecasting volumes to increase 15-fold. This, added to the multitude of intra-day, multi-currency calls experienced under central clearing, conjures images of entire cities of collateral personnel busily crunching data. Of course throwing people, like money, at a problem is not the answer. Exception-based, straight-through processing (STP) workflows are the ally of the dynamic, future proof organisation. Let the infrastructure you invest in do the work. We are moving from an age of system fed manual labour into an era of intelligent platforms and enhanced collateral utilisation.
As well as ‘crippling’ call volumes, the new requirements call for new style agreements. These will include standard eligibility rules and haircut schedules, and will apply to derivatives traded post-1 December 2015. Collateral managers will have to maintain multiple agreements spanning cleared business and the pre/post-IOSCO bilateral business.
It may be prudent to invest in the impending shortfall in legal resources; renegotiating existing CSAs to make them BCBS/IOSCO compliant. The task of introducing asset segregation and currency silos will be lengthy. All of this is in addition to negotiating new agreements with non-collateralised counterparties.
Other features of the IOSCO framework are intended to assist in managing the liquidity impact of margin requirements. The European Supervisory Authority’s Regulatory Technical Standard (RTS) includes more asset classes, such as convertible bonds, than originally listed in the IOSCO standardised schedule.
The application of concentration limits promote explicit diversification and prevent counterparties inadvertently becoming exposed to specific assets, issuers or domiciles. The standard schedule of haircuts means that while more collateral may be required, organisations will be encouraged to think strategically about the collateral they pledge.
IM is a central focus of the BCBS/IOSCO framework. It is used in the centrally cleared world to great effect and is seen as fundamental to reducing systemic risk. As with most of the current regulatory initiatives, there is much focus on the apparent collateral squeeze due to increased IM requirements.
In an effort to combat this, the framework allows an IM threshold of €50 million. Maintaining this across a large organisation, with many legal entities may prove difficult operationally. There will be instances where organisations may apply the threshold to their largest, most profitable business, leaving smaller entities to fend for themselves. Maintaining thresholds at a counterparty level, as well as at agreement level is a key consideration for collateral processes.
While VM will be separated into currency silos, movements will be calculated net. IM will be calculated and settled gross. Counterparties within non-netted jurisdictions will be familiar with this method, however, two-way exchange of collateral is not currently common market practice.
The standard schedule for IM, as set out by BCBS/IOSCO, appears simplistic at first glance with the framework setting out a percentage of notional that can be easily calculated by a collateral system. However, on further examination, in addition to calculating the percentage of notional required, the system would also need to calculate the net to gross ratio (NGR) and apply this to the IM requirement, as below:
While this calculation provides a ‘simple’ way to calculate IM, particularly for smaller market participants, there is much evidence that this method is punitive. It was stated in the key findings of BCBS/IOSCO’s second consultative document that initial margin requirements under the standardised schedule are roughly 6 to 11 times higher than model-based initial margin. Moves for a standardised, market-wide IM quantitative model are well under way.
The International Securities Derivatives Association (ISDA) has proposed a standard initial margin model. The next logical step may appear to be a market-wide calculation tool but we should be cognisant of other initiatives, such as standard CSA, where uptake was limited due to overly complex rules which effectively penalise buy-side firms. Smaller market participants will not have the same needs as Tier 1 banks.
In a bid to ‘lock in’ IM, IOSCO set out with recommendations to limit rehypothecation. However, preventing rehypothecation entirely would have detrimental effects on liquidity. As a result, the final framework recognises the possible funding impact by allowing the rehypothecation of collateral for the purpose of hedging positions.
In addition, any rehypothecation of IM can be done only once. Firms must be able to flag rehypothecated assets and ensure that no onward reuse occurs. One simple way of doing this is rehypothecation to a clearinghouse, which would hold those assets without reusing, however, this option is not available to many organisations.
A flexible, global inventory would allow the enhanced monitoring, tracking and reporting of assets needed to manage this requirement. It would also provide the required information for asset reconciliation.
Additionally, a global inventory would provide the facility to link into segregated custodian accounts in order to monitor assets placed as IM. Triparty agreements are widely used, however, all parties will be required to sign account control agreements allowing them to support gross bilateral requirements.
The operational problems faced increase the network or scope of the collateral manager. If we consider a central clearing model, the buy side faces off against clearing members, or brokers that provide collateral services, such as collateral upgrades and allocation. For uncleared derivatives, the buy side will have to choose whether to manage those functions internally or outsource operations.
One key impact to the buy side would come from concentration limits on collateral assets, meant to promote explicit diversification, which pose the challenge of sourcing multiple assets across multiple funds/strategies. Increased activity in securities finance markets to generate funding may be widespread. In many organisations, an integrated trading and collateral system will provide huge benefits.
What do all these requirements mean? The answer is simple. Strategic investment in effective collateral operations is paramount.
Many organisations recognise that existing collateral operations systems are not fit for purpose. This is driving investment in new technology. However, after the large outlay of the past few years this investment should be carefully considered with the aim of providing a future proof solution covering multiple requirements, including collateral trading, inventory management, optimisation, as well as collateral operations.
In a market that demands utmost efficiency and control, organisations need to make the right decision in selecting a new collateral system.
As a result, the Basel Committee on Banking Supervision (BCBS) and the International Organization of Securities Commissions (IOSCO) proposed a plan to further mitigate the risk of non-cleared derivatives. In September 2013, they released the final recommendations for margin requirements for non-centrally cleared derivatives and the market began to prepare for yet another regulatory challenge. Further consideration must be given to local regulators defining the governance of this global mandate. All of this has significant ramifications for collateral operations for both the buy and sell sides.
Kick-off is December 2015, when bilateral derivatives will be traded under new collateral agreements and market participants will start putting the preparation for the new requirements in to practice. In order to allow adequate time for all market participants to adhere to the new market rules, the implementation of initial margin (IM) transfer will be phased in gradually to 2019. The BCBS/IOSCO framework has been designed to reduce systemic risks related to over-the-counter (OTC) derivatives, in addition to providing firms with incentives to centrally clear eligible trades and provide assistance in managing the overall liquidity impact of the requirements.
It is important to understand that the impact of this regulation is far reaching, arguably more so than central clearing due to the breadth of liable parties and the non-standard trade types covered. Under the new globally agreed standards, all financial firms and ‘systemically important non-financial entities’ engaging in non-cleared derivatives trading will have to exchange initial and variation margin with their counterparties.
While the exchange of IM and variation margin (VM) is by no means revolutionary, the mandate covers a large section of the market which historically has not been affected by collateral. This means many trades may not currently be covered by credit support annexes (CSAs), or it may be as simple as an organisation having no existing collateral operation or expertise. Either way, BCBS/IOSCO means that the cost of non-cleared OTC derivatives will increase.
For those that may be new to collateral, as some non-financial organisations will be, two options await:outsourcing or internal investment. It is highly possible that trade volumes may be low enough to manage internally for many, in which case a rapid roll out of a collateral system providing agreement management and margin calculation may well suffice.
What of those who have the necessary wherewithal, what are their main concerns?
Yet another increase in call volumes is expected, with one Tier 1 bank recently forecasting volumes to increase 15-fold. This, added to the multitude of intra-day, multi-currency calls experienced under central clearing, conjures images of entire cities of collateral personnel busily crunching data. Of course throwing people, like money, at a problem is not the answer. Exception-based, straight-through processing (STP) workflows are the ally of the dynamic, future proof organisation. Let the infrastructure you invest in do the work. We are moving from an age of system fed manual labour into an era of intelligent platforms and enhanced collateral utilisation.
As well as ‘crippling’ call volumes, the new requirements call for new style agreements. These will include standard eligibility rules and haircut schedules, and will apply to derivatives traded post-1 December 2015. Collateral managers will have to maintain multiple agreements spanning cleared business and the pre/post-IOSCO bilateral business.
It may be prudent to invest in the impending shortfall in legal resources; renegotiating existing CSAs to make them BCBS/IOSCO compliant. The task of introducing asset segregation and currency silos will be lengthy. All of this is in addition to negotiating new agreements with non-collateralised counterparties.
Other features of the IOSCO framework are intended to assist in managing the liquidity impact of margin requirements. The European Supervisory Authority’s Regulatory Technical Standard (RTS) includes more asset classes, such as convertible bonds, than originally listed in the IOSCO standardised schedule.
The application of concentration limits promote explicit diversification and prevent counterparties inadvertently becoming exposed to specific assets, issuers or domiciles. The standard schedule of haircuts means that while more collateral may be required, organisations will be encouraged to think strategically about the collateral they pledge.
IM is a central focus of the BCBS/IOSCO framework. It is used in the centrally cleared world to great effect and is seen as fundamental to reducing systemic risk. As with most of the current regulatory initiatives, there is much focus on the apparent collateral squeeze due to increased IM requirements.
In an effort to combat this, the framework allows an IM threshold of €50 million. Maintaining this across a large organisation, with many legal entities may prove difficult operationally. There will be instances where organisations may apply the threshold to their largest, most profitable business, leaving smaller entities to fend for themselves. Maintaining thresholds at a counterparty level, as well as at agreement level is a key consideration for collateral processes.
While VM will be separated into currency silos, movements will be calculated net. IM will be calculated and settled gross. Counterparties within non-netted jurisdictions will be familiar with this method, however, two-way exchange of collateral is not currently common market practice.
The standard schedule for IM, as set out by BCBS/IOSCO, appears simplistic at first glance with the framework setting out a percentage of notional that can be easily calculated by a collateral system. However, on further examination, in addition to calculating the percentage of notional required, the system would also need to calculate the net to gross ratio (NGR) and apply this to the IM requirement, as below:
While this calculation provides a ‘simple’ way to calculate IM, particularly for smaller market participants, there is much evidence that this method is punitive. It was stated in the key findings of BCBS/IOSCO’s second consultative document that initial margin requirements under the standardised schedule are roughly 6 to 11 times higher than model-based initial margin. Moves for a standardised, market-wide IM quantitative model are well under way.
The International Securities Derivatives Association (ISDA) has proposed a standard initial margin model. The next logical step may appear to be a market-wide calculation tool but we should be cognisant of other initiatives, such as standard CSA, where uptake was limited due to overly complex rules which effectively penalise buy-side firms. Smaller market participants will not have the same needs as Tier 1 banks.
In a bid to ‘lock in’ IM, IOSCO set out with recommendations to limit rehypothecation. However, preventing rehypothecation entirely would have detrimental effects on liquidity. As a result, the final framework recognises the possible funding impact by allowing the rehypothecation of collateral for the purpose of hedging positions.
In addition, any rehypothecation of IM can be done only once. Firms must be able to flag rehypothecated assets and ensure that no onward reuse occurs. One simple way of doing this is rehypothecation to a clearinghouse, which would hold those assets without reusing, however, this option is not available to many organisations.
A flexible, global inventory would allow the enhanced monitoring, tracking and reporting of assets needed to manage this requirement. It would also provide the required information for asset reconciliation.
Additionally, a global inventory would provide the facility to link into segregated custodian accounts in order to monitor assets placed as IM. Triparty agreements are widely used, however, all parties will be required to sign account control agreements allowing them to support gross bilateral requirements.
The operational problems faced increase the network or scope of the collateral manager. If we consider a central clearing model, the buy side faces off against clearing members, or brokers that provide collateral services, such as collateral upgrades and allocation. For uncleared derivatives, the buy side will have to choose whether to manage those functions internally or outsource operations.
One key impact to the buy side would come from concentration limits on collateral assets, meant to promote explicit diversification, which pose the challenge of sourcing multiple assets across multiple funds/strategies. Increased activity in securities finance markets to generate funding may be widespread. In many organisations, an integrated trading and collateral system will provide huge benefits.
What do all these requirements mean? The answer is simple. Strategic investment in effective collateral operations is paramount.
Many organisations recognise that existing collateral operations systems are not fit for purpose. This is driving investment in new technology. However, after the large outlay of the past few years this investment should be carefully considered with the aim of providing a future proof solution covering multiple requirements, including collateral trading, inventory management, optimisation, as well as collateral operations.
In a market that demands utmost efficiency and control, organisations need to make the right decision in selecting a new collateral system.
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