Regulation’s tightening hold
04 November 2014
Counterparty risk management is critically enhanced through the effective sourcing and use of collateral as part of an architecture supporting multiple requirements, says Ted Leveroni of DTCC
Image: Shutterstock
Collateral is a fundamental aspect of mitigating risk and the efficient and adequate exchange of collateral has become a matter of prudent risk management.
Managing collateral through effective margining creates two specific operational priorities. Where a firm that has not received enough of the right type of collateral from a counterparty, is exposed to the risk of the counterparty’s default. But a firm that delivers too much collateral as margin to a counterparty is also running unnecessary risks—both in terms of exposure to default and through lost opportunity costs entailed by not putting those over-collateralised assets to better use.
New rules governing the margining of non-cleared trades serve to codify best practices for firms seeking to manage counterparty risk. The latest global rules were issued in September 2013 by the Basel Committee on Banking Supervision (BCBS) and the Board of International Organization of Securities Commission (IOSCO).
While European supervisory authorities are consulting on draft technical standards for rules, these and other compliance deadlines may seem a long way off, and many buy-side firms may ultimately not be covered.
In addition, there is still debate surrounding how the guidelines should treat initial margin.
Even though the rule is not yet part of regulatory compliance, implementing the current BCBS-IOSCO recommendation covering variation margin is a matter of prudent risk management. Operational risk management is an increasingly important part of due diligence for investors and perceived weakness in this area can have a material effect on whether a firm wins new business.
Whether receiving or delivering collateral, efficient operational processes are critical to ensure that eligible and adequate assets are selected. Counterparty risk management is critically enhanced through the effective sourcing and use of collateral as part of an architecture supporting daily variation margin (VM) calls, initial margin (IM), eligibility monitoring, concentration limits, haircuts and valuations.
Focus on full collateralisation
Since finalisation of the BCBS-IOSCO proposals for non-cleared margin last September, there have been abundant industry discussions on IM, particularly around calculations (see Box 1 overleaf).
These are important discussions and we expect them to continue. However, outside of the IM calculation question, the remainder of the BCBS-IOSCO framework reflects market best practices for risk mitigation through prudent collateralisation—quite apart from the question of future regulatory compliance.
The proposed European technical standards, which have been developed based upon the BCBS-IOSCO framework, also gives equal emphasis to these best practices.
At the core is the daily exchange of VM.
Key risk principles in the exchange of margin
To ensure controlled risk management, a valuation margin framework should recognise the following principles:
Failing to receive sufficient VM on a daily basis creates counterparty risk.
Failing to properly implement and monitor eligibility, concentration, haircuts and valuations creates counterparty and operational risk.
It is essential that operational processes ensure timely receipt of the full amount of collateral that a firm’s risk assessment has deemed prudent.
Posting collateral also creates counterparty risk if too much collateral is posted or it is not properly segregated (see Box 2).
If firms focus only on minimising operational costs by over-collateralising to limit margin call volumes, they expose themselves to greater potential costs in the event of counterparty default.
Key requirements and scope
In particular, the final BCBS-IOSCO report specifies requirements of derivatives parties in a number of key areas which prudent strategy should follow:
Collateral eligible as margin will be specified by national regulators but should include cash, high-quality government securities, corporate and covered bonds, major (eg, index-featured) equities and gold.
Haircuts on posted collateral, ranging from zero (cash matching the derivative currency) to 15 percent (gold and major equities). These are relatively high and firms have the option to produce dynamic model-based haircut calculations, which have to be agreed upon with counterparties, adding further operational challenges.
Individual credit support annexes must be adjusted to protect concentration of collateral in a specific issuer, asset class, sector, or country.
BCBS-IOSCO rules allow one-time rehypothecation to hedge other positions with the same counterparty. This is on the condition that the collateral is adequately protected and such rehypothecation requires tracking. But European regulations rule it out entirely.
Segregation of collateral assets to ensure they are speedily accessible in the event of a default.
Thresholds currently €50 million for IM and zero for VM. Minimum transfer amounts for both IM and VM are €500,000.
Collateral management best practices
Given that the BCBS-IOSCO recommendations provide a best-practice blueprint to manage counterparty risk via efficient collateralisation, the challenge is how to implement them.
A solution needs to consider that counterparty risk can arise in both delivery and receipt of collateral. To mitigate the counterparty risk associated with inefficient collateral use, firms must develop an architecture supporting regular posting and receipt of VM. Effective posting ensures inventory is adequately used, and the operational process that delivers it is efficient enough to prevent over-collateralisation and the risks it creates. Effective receipt ensures supplied collateral is adequate, eligible and doesn’t create concentration risk.
Firms need to analyse their own unique business operations and determine whether or not their systems and processes will support their future needs. While businesses may choose to develop a bespoke solution in-house, a range of collateral management systems already exist. These have been developed to support best practice capabilities and should allow for quicker implementation, greater cost effectiveness and easier and faster adjustments to future changes in industry practice.
Leverage the knowledge and expertise of the DTCC, with its robust collateral management platform—Omgeo ProtoColl—to implement automated STP in order to manage margin and collateral calls across the entire trading operation. Automation of the collateral management lifecycle minimises manual intervention, enabling firms to increase operational efficiency while making smarter, more effective use of their collateral and subsequently reduce counterparty risk.
box1
Initial margin requirements
The current BCBS-IOSCO recommendations require the mandatory exchange of both initial (IM) and variation margin (VM). While VM is intended to cover the daily change in value of the derivative being collateralised, IM is required to cover the potential future change in value of a derivative, including in a period of stress—ie, one consistent with a one-tailed 99 percent confidence interval over a 10-day horizon. Current proposed initial margin requirements require the following:
By the end of the phase-in period in December 2019, IM requirements will be imposed on all firms whose non-centrally cleared OTC derivatives activity exceeds €8 billion in gross notional outstanding amounts. The threshold above which a firm must start collecting IM from a counterparty is currently set at €50 million. This threshold will be applied on a consolidated group basis to prevent the creation of affiliates and other legal entities to get around the threshold. Where netting agreements are struck with counterparties that are subsidiaries of the same group, the group can decide how to allocate the €50 million benefit among its entities. Home supervisors will be required to judge whether local subsidiaries of a group comply with the thresholds. As with VM, IM transfers are all subject to a minimum transfer amount not to exceed €500,000.
Calculation of IM may be done either by a firm’s own quantitative margin model, which must be approved by the national supervisor, or by a standard schedule.
IM should either be segregated or otherwise protected to preserve its ability to offset the risk of loss in the event of a default.
Two-way (gross) exchange of IM.
box 2
What are the risks in placing collateral?
The risks involved in not receiving sufficient collateral are self-evident, but how does placing too much collateral create risk for a firm? The collapse of Lehman Brothers provides some answers:
Hedge funds that were over-collateralised in trades with Lehman Brothers waited for years while administrators untangled their assets from the melee.
Even when assets were held without transfer of title, because they were physically delivered, the trustee put a ring fence around the assets when Lehman Brothers entered bankruptcy, from which many assets did not emerge for five years.
Even when assets are retrieved in the event of bankruptcy, differences in local insolvency regimes mean that the resolutions of bankruptcies may not allow customer first claim. Under UK (and most European) laws, title transfer retains some rights. In the US, segregation creates considerably less protection: client assets and company assets are co-mingled.
Managing collateral through effective margining creates two specific operational priorities. Where a firm that has not received enough of the right type of collateral from a counterparty, is exposed to the risk of the counterparty’s default. But a firm that delivers too much collateral as margin to a counterparty is also running unnecessary risks—both in terms of exposure to default and through lost opportunity costs entailed by not putting those over-collateralised assets to better use.
New rules governing the margining of non-cleared trades serve to codify best practices for firms seeking to manage counterparty risk. The latest global rules were issued in September 2013 by the Basel Committee on Banking Supervision (BCBS) and the Board of International Organization of Securities Commission (IOSCO).
While European supervisory authorities are consulting on draft technical standards for rules, these and other compliance deadlines may seem a long way off, and many buy-side firms may ultimately not be covered.
In addition, there is still debate surrounding how the guidelines should treat initial margin.
Even though the rule is not yet part of regulatory compliance, implementing the current BCBS-IOSCO recommendation covering variation margin is a matter of prudent risk management. Operational risk management is an increasingly important part of due diligence for investors and perceived weakness in this area can have a material effect on whether a firm wins new business.
Whether receiving or delivering collateral, efficient operational processes are critical to ensure that eligible and adequate assets are selected. Counterparty risk management is critically enhanced through the effective sourcing and use of collateral as part of an architecture supporting daily variation margin (VM) calls, initial margin (IM), eligibility monitoring, concentration limits, haircuts and valuations.
Focus on full collateralisation
Since finalisation of the BCBS-IOSCO proposals for non-cleared margin last September, there have been abundant industry discussions on IM, particularly around calculations (see Box 1 overleaf).
These are important discussions and we expect them to continue. However, outside of the IM calculation question, the remainder of the BCBS-IOSCO framework reflects market best practices for risk mitigation through prudent collateralisation—quite apart from the question of future regulatory compliance.
The proposed European technical standards, which have been developed based upon the BCBS-IOSCO framework, also gives equal emphasis to these best practices.
At the core is the daily exchange of VM.
Key risk principles in the exchange of margin
To ensure controlled risk management, a valuation margin framework should recognise the following principles:
Failing to receive sufficient VM on a daily basis creates counterparty risk.
Failing to properly implement and monitor eligibility, concentration, haircuts and valuations creates counterparty and operational risk.
It is essential that operational processes ensure timely receipt of the full amount of collateral that a firm’s risk assessment has deemed prudent.
Posting collateral also creates counterparty risk if too much collateral is posted or it is not properly segregated (see Box 2).
If firms focus only on minimising operational costs by over-collateralising to limit margin call volumes, they expose themselves to greater potential costs in the event of counterparty default.
Key requirements and scope
In particular, the final BCBS-IOSCO report specifies requirements of derivatives parties in a number of key areas which prudent strategy should follow:
Collateral eligible as margin will be specified by national regulators but should include cash, high-quality government securities, corporate and covered bonds, major (eg, index-featured) equities and gold.
Haircuts on posted collateral, ranging from zero (cash matching the derivative currency) to 15 percent (gold and major equities). These are relatively high and firms have the option to produce dynamic model-based haircut calculations, which have to be agreed upon with counterparties, adding further operational challenges.
Individual credit support annexes must be adjusted to protect concentration of collateral in a specific issuer, asset class, sector, or country.
BCBS-IOSCO rules allow one-time rehypothecation to hedge other positions with the same counterparty. This is on the condition that the collateral is adequately protected and such rehypothecation requires tracking. But European regulations rule it out entirely.
Segregation of collateral assets to ensure they are speedily accessible in the event of a default.
Thresholds currently €50 million for IM and zero for VM. Minimum transfer amounts for both IM and VM are €500,000.
Collateral management best practices
Given that the BCBS-IOSCO recommendations provide a best-practice blueprint to manage counterparty risk via efficient collateralisation, the challenge is how to implement them.
A solution needs to consider that counterparty risk can arise in both delivery and receipt of collateral. To mitigate the counterparty risk associated with inefficient collateral use, firms must develop an architecture supporting regular posting and receipt of VM. Effective posting ensures inventory is adequately used, and the operational process that delivers it is efficient enough to prevent over-collateralisation and the risks it creates. Effective receipt ensures supplied collateral is adequate, eligible and doesn’t create concentration risk.
Firms need to analyse their own unique business operations and determine whether or not their systems and processes will support their future needs. While businesses may choose to develop a bespoke solution in-house, a range of collateral management systems already exist. These have been developed to support best practice capabilities and should allow for quicker implementation, greater cost effectiveness and easier and faster adjustments to future changes in industry practice.
Leverage the knowledge and expertise of the DTCC, with its robust collateral management platform—Omgeo ProtoColl—to implement automated STP in order to manage margin and collateral calls across the entire trading operation. Automation of the collateral management lifecycle minimises manual intervention, enabling firms to increase operational efficiency while making smarter, more effective use of their collateral and subsequently reduce counterparty risk.
box1
Initial margin requirements
The current BCBS-IOSCO recommendations require the mandatory exchange of both initial (IM) and variation margin (VM). While VM is intended to cover the daily change in value of the derivative being collateralised, IM is required to cover the potential future change in value of a derivative, including in a period of stress—ie, one consistent with a one-tailed 99 percent confidence interval over a 10-day horizon. Current proposed initial margin requirements require the following:
By the end of the phase-in period in December 2019, IM requirements will be imposed on all firms whose non-centrally cleared OTC derivatives activity exceeds €8 billion in gross notional outstanding amounts. The threshold above which a firm must start collecting IM from a counterparty is currently set at €50 million. This threshold will be applied on a consolidated group basis to prevent the creation of affiliates and other legal entities to get around the threshold. Where netting agreements are struck with counterparties that are subsidiaries of the same group, the group can decide how to allocate the €50 million benefit among its entities. Home supervisors will be required to judge whether local subsidiaries of a group comply with the thresholds. As with VM, IM transfers are all subject to a minimum transfer amount not to exceed €500,000.
Calculation of IM may be done either by a firm’s own quantitative margin model, which must be approved by the national supervisor, or by a standard schedule.
IM should either be segregated or otherwise protected to preserve its ability to offset the risk of loss in the event of a default.
Two-way (gross) exchange of IM.
box 2
What are the risks in placing collateral?
The risks involved in not receiving sufficient collateral are self-evident, but how does placing too much collateral create risk for a firm? The collapse of Lehman Brothers provides some answers:
Hedge funds that were over-collateralised in trades with Lehman Brothers waited for years while administrators untangled their assets from the melee.
Even when assets were held without transfer of title, because they were physically delivered, the trustee put a ring fence around the assets when Lehman Brothers entered bankruptcy, from which many assets did not emerge for five years.
Even when assets are retrieved in the event of bankruptcy, differences in local insolvency regimes mean that the resolutions of bankruptcies may not allow customer first claim. Under UK (and most European) laws, title transfer retains some rights. In the US, segregation creates considerably less protection: client assets and company assets are co-mingled.
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