The new world beyond the call
13 January 2015
Proper collateral management processes and systems are critical to the success of all stakeholders, says Armando Hernandez of Lombard Risk
Image: Shutterstock
We are now six years on from the 2008 financial crisis and the financial services industry has learnt many difficult lessons. Market practitioners are now making a stronger effort to manage credit risk, liquidity risk and to strengthen operational efficiencies. The fear of another financial crisis, alongside the pressures and uncertainties of regulatory reforms, has thrust us towards a collateral management landscape that is changing for both the buy and sell sides.
Understanding counterparties
Since the first margin calls were made back in the 1980s, the desire to understand and mitigate counterparty risk has been core to effective collateral management: the creditworthiness of trading partners has been the main focus in these efforts. It is critical to take a comprehensive consideration of counterparty risk when selecting trading partners and integrating them into the collateral management process. Counterparty risk management should be looked at more holistically than it has been in the past.
Identifying changes in the level of risk that a counterparty poses to a trading relationship is imperative. Many current processes use the assumption that only derivatives-related factors can negatively affect the trading relationship with a counterparty. This has proven to be too narrow an approach time and time again. Only enterprise-wide methods have proven to be safer and more practical.
Understanding my available collateral
Current pressures to provide more and, more importantly, more high-quality collateral is changing the markets and increasing volume and complexity along the way. New regulations will most certainly further increase the amount of collateral required to satisfy new calls from central counterparties.
Additionally, the use of highly liquid collateral will be mandated, requiring collateral management practitioners to secure access to quality collateral. The availability of collateral in general is not a major concern, however, the availability of high-quality collateral is.
This ‘collateral squeeze’ has brought about the necessity for a new process, known as ‘collateral transformation’. Some firms will find themselves in a position of needing to convert some of their less desirable assets into securities or cash that can be used to satisfy collateral calls with higher grade asset requirements. Buy-side firms may potentially look for a service offering to help with these efforts while sell-side firms will employ the use of their securities lending or repo departments to provide this service.
Understanding the new
world reforms
New regulatory reforms are moving traditionally OTC trades onto exchanges. The mandate to have a central counterparty stand between trading parties to clear swaps is a significant change to the world as we know it. Cleared swaps will now require the posting of initial margin for the first time for the vast majority of these trades. Trades such as TBAs (to be announced) must also be collateralised under very rigorous Financial Industry Regulatory Authority (FINRA) rules.
As such, fund managers that historically did not see the need for a full collateral management system are now requiring IT investment to put one in place. Given the fact that derivatives are not going away, volumes are not declining, and the fact that regulations are here to stay, the obligation is put on all market participants to do their part in mitigating risk across the board.
Employing the right collateral tools
Something that is sometimes overlooked or underestimated is the selection of appropriate tools to ensure that day-to-day collateral management operations run smoothly in an unpredictable environment. New collateral requirements brought about by reform mandates and regularly occurring market events make for very tumultuous surroundings for collateral management practitioners.
There is a greater need now, more than ever before, to ensure that trades are mitigated properly, that collateral is closely monitored, and that users from business to IT are given the tools to handle this without adding more challenges to their day.
A proper and thorough procurement process is critical to ensure that an organisation selects the right company and solution to support these efforts. Although all collateral management software products may seem to be the same, or of equivalent functionality, there are significant differences once the companies offering services are thoroughly vetted.
The industry changes noted above are forcing the need for scalable collateral management systems that can be integrated with up and down-stream source systems. A fair amount of due diligence will be required to discover the vendor that will provide a combination of usability, flexibility and scalability. It is also imperative to find a vendor that has a capable team to address current, new and upcoming functional requirements. This is critical to operational efficiency and successful risk mitigation to ensure that the team selected to run an implementation project is both experienced and skilled.
One must be prudent in selecting a vendor to partner with for a collateral management system implementation. A vendor should prove that it can put in to effect an implementation team that has an in-depth understanding of business requirements. Just as important is to ensure that the vendor of choice also has a solid and allied technical team to round out the implementation team.
It is clear that proper collateral management processes and systems are critical to the success of all stakeholders—front office, middle office, back office, operations, credit and legal. The lack of a suitable collateral management process or absence of a comprehensive collateral management system can result in extremely adverse financial consequences.
Understanding counterparties
Since the first margin calls were made back in the 1980s, the desire to understand and mitigate counterparty risk has been core to effective collateral management: the creditworthiness of trading partners has been the main focus in these efforts. It is critical to take a comprehensive consideration of counterparty risk when selecting trading partners and integrating them into the collateral management process. Counterparty risk management should be looked at more holistically than it has been in the past.
Identifying changes in the level of risk that a counterparty poses to a trading relationship is imperative. Many current processes use the assumption that only derivatives-related factors can negatively affect the trading relationship with a counterparty. This has proven to be too narrow an approach time and time again. Only enterprise-wide methods have proven to be safer and more practical.
Understanding my available collateral
Current pressures to provide more and, more importantly, more high-quality collateral is changing the markets and increasing volume and complexity along the way. New regulations will most certainly further increase the amount of collateral required to satisfy new calls from central counterparties.
Additionally, the use of highly liquid collateral will be mandated, requiring collateral management practitioners to secure access to quality collateral. The availability of collateral in general is not a major concern, however, the availability of high-quality collateral is.
This ‘collateral squeeze’ has brought about the necessity for a new process, known as ‘collateral transformation’. Some firms will find themselves in a position of needing to convert some of their less desirable assets into securities or cash that can be used to satisfy collateral calls with higher grade asset requirements. Buy-side firms may potentially look for a service offering to help with these efforts while sell-side firms will employ the use of their securities lending or repo departments to provide this service.
Understanding the new
world reforms
New regulatory reforms are moving traditionally OTC trades onto exchanges. The mandate to have a central counterparty stand between trading parties to clear swaps is a significant change to the world as we know it. Cleared swaps will now require the posting of initial margin for the first time for the vast majority of these trades. Trades such as TBAs (to be announced) must also be collateralised under very rigorous Financial Industry Regulatory Authority (FINRA) rules.
As such, fund managers that historically did not see the need for a full collateral management system are now requiring IT investment to put one in place. Given the fact that derivatives are not going away, volumes are not declining, and the fact that regulations are here to stay, the obligation is put on all market participants to do their part in mitigating risk across the board.
Employing the right collateral tools
Something that is sometimes overlooked or underestimated is the selection of appropriate tools to ensure that day-to-day collateral management operations run smoothly in an unpredictable environment. New collateral requirements brought about by reform mandates and regularly occurring market events make for very tumultuous surroundings for collateral management practitioners.
There is a greater need now, more than ever before, to ensure that trades are mitigated properly, that collateral is closely monitored, and that users from business to IT are given the tools to handle this without adding more challenges to their day.
A proper and thorough procurement process is critical to ensure that an organisation selects the right company and solution to support these efforts. Although all collateral management software products may seem to be the same, or of equivalent functionality, there are significant differences once the companies offering services are thoroughly vetted.
The industry changes noted above are forcing the need for scalable collateral management systems that can be integrated with up and down-stream source systems. A fair amount of due diligence will be required to discover the vendor that will provide a combination of usability, flexibility and scalability. It is also imperative to find a vendor that has a capable team to address current, new and upcoming functional requirements. This is critical to operational efficiency and successful risk mitigation to ensure that the team selected to run an implementation project is both experienced and skilled.
One must be prudent in selecting a vendor to partner with for a collateral management system implementation. A vendor should prove that it can put in to effect an implementation team that has an in-depth understanding of business requirements. Just as important is to ensure that the vendor of choice also has a solid and allied technical team to round out the implementation team.
It is clear that proper collateral management processes and systems are critical to the success of all stakeholders—front office, middle office, back office, operations, credit and legal. The lack of a suitable collateral management process or absence of a comprehensive collateral management system can result in extremely adverse financial consequences.
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