Earlier this year, the Basel Committee on Banking Supervision (BCBS) and the International Organization of Securities Commission’s (IOSCO) recommendations on variation margin exchange for non-centrally cleared OTC derivatives came into effect, affecting both buy- and sell-side firms, and with initial margin exchange being phased in by 2020. But, rather than purely focus on back-office readiness, firms should take the time now to recognise the regulation’s rippling effect on bilateral trading operations in the front office.
At this critical juncture, a fundamental front-to-back operational shift is needed, not only to safeguard against risk associated with counterparty defaults, but to best fulfil investment objectives in an increasingly challenging market.
While posting upfront initial margin and daily variation margin as a means of tackling counterparty risk is a tactic commonly used in cleared derivatives, its introduction in non-centrally cleared OTC derivatives is relatively new. Given the complexity of the change from both a documentation and operational standpoint, the regulation’s full market force, complete with fines, was postponed until 1 September. A welcome move, granting the financial services sector the grace-period it needed to consider the technology systems in place and whether it can support this and future regulatory changes.
Though collateral management has traditionally been a back-office function, operating on a periodic basis, the new regulation will see it flooding into the front office’s daily workflow. In fact, in a recent poll conducted by SimCorp, one of the primary ‘pain points’ in collateral management, identified by buy-side firms, was increasing volumes. This is likely to surge, as pledged and received collateral will no longer be periodically exchanged in arrears and at high thresholds. Instead, asset managers will need to mark their books to market daily, and at much lower thresholds.
To add to these new and intensified volumes, trades with counterparties prior to and after 1 March 2017 could have not one but two margin calls: legacy and regulatory. In addition, while there is a general global consistency in implementation, there remains important regional differences. Examples include the scope of covered products, such as deliverable foreign exchange trades, which are excluded from US regulation, and the treatment of non-netting and segregation jurisdictions.
A good majority of firms, including many of those responding to SimCorp’s poll, named manual workflows and a lack of automation as barriers to efficient collateral management, and this is further echoed in the recent SimCorp-commissioned report from InvestOps, Front to Back: Optimising Cross Asset Investment Operations, which found that 64 percent of European buy-side firms operate collateral management on only a partially-automated or worse still, manual basis. Leaving aside the significant proportion of counterparty agreements that still need to be redrawn, the conditions within the regulation will only serve to continue the data explosion that firms are currently firefighting.
In this new world, front-office investment decisions and collateral allocation are bound to be affected. Portfolio managers in the front office will now need to consider collateral requirements in their OTC investment decisions, given the need to post margin. This includes the availability of collateral and the levels of—and timely access to—liquidity in a portfolio. Therefore, a re-evaluation of investment strategies may be required, comparing the cost of a bilateral OTC investment decision with cleared OTC or exchange-traded alternatives. Furthermore, on the funding side, the need to access liquidity could increase the use of repo markets, whether bilateral, triparty or cleared. Repo is a market that has been synonymous with the sell side but is now opening up to the buy side, in the continued search for new liquidity sources.
A change will also be seen in the way margin call decisions are made. Asset managers in the front office will need to have oversight of what collateral, ie, cash and securities, is going out by way of pledge to counterparties, to make the most optimal investment decisions at any given time.
Fig 1: Most popular investment areas
There is, in fact, a real opportunity to optimise these collateral management workflows, by organising pre- and post-trade in one system, and increasing profitability. Not only by enabling the front office to make better informed decisions, and to fulfil their investors’ objectives successfully, but to use the timely overview of positions, cash and securities collateral and exposure to understand what collateral should be used, when, and to what gain.
There is of course an operational burden in making this happen, and while some may look to outsource parts of the process to a custodian or triparty agent, perhaps the majority are realising technology investment is the only way forward.
Indeed, 78 percent of those surveyed in the InvestOps survey considered front-office technology to be the most popular investment area.
Overall, firms need to look beyond siloed, short-term fixes, and to operational change that transforms front-, middle- and back-office technologies on a single core platform, where one source of real-time data can traverse the whole office.
Fig 2: Automation of operational activities
