The ability of regulatory reform to increase market stability, enhance transparency and reduce risk will be partly dependent on the efficient processing and allocation of collateral. The industry’s ability to meet this challenge, however, rests upon cross-border collaboration and development of industry-wide solutions.
The ability of regulatory reform to increase market stability, enhance transparency and reduce risk will be partly dependent on the efficient processing and allocation of collateral. The industry’s ability to meet this challenge, however, rests upon cross-border collaboration and development of industry-wide solutions.
Derivatives regulations and new capital and liquidity requirements for financial institutions remain the key drivers of new collateral demands. While these drivers are well known, estimates on the amount of collateral required vary among the industry. The Bank of England estimated in 2012 that the amount of additional collateral needed to meet requirements posed by new regulations globally could reach $800 billion. A more recent study by the Bank of International Settlement estimated this to be around $4 trillion.
Estimates on the likely increase of margin calls also vary across the industry. Dealers estimate margin call increases of between five to 10 times as a result of clearing requirements, bifurcated derivative portfolios and clearing fragmentation across asset classes and regions.
The scale of the challenge is unprecedented. Many institutions do not currently have a clear picture of their pools of eligible collateral. They need to first establish the inventory and location of collateral, before they can look at optimising its use, but the challenge does not stop here. Optimising collateral not only requires reviewing the eligibility criteria and understanding the terms of the collateral agreement, but also calculating the costs of putting that collateral to different uses, moving the collateral and following its settlement status across the extensive network of depositories and custodian banks.
Many firms’ systems and workflows are ill prepared to meet this challenge. A combination of these legacy workflows, and an increase in both the collateral required and margin activity will impact balance sheets and operational costs.
Capital charges will increase as firms are required to fund larger amounts to support the lack of certainty around intraday collateral required. But the challenge does not end there, as firms must account for the additional charges associated with moving collateral from the dealers’ balance sheets to segregated accounts.
Operational costs will also rise. The process of identifying collateral transactions and tracking that collateral through to settlement is likely to be overwhelming for current systems and operations. Furthermore, the segregation of accounts required by new regulations, while improving the safekeeping of collateral, will add complexity to the collateral management process. Many firms will find that their existing technology will be challenged to support this process.
There are currently multiple collateral management solutions available to individual firms, encompassing anything from portfolio margining to collateral optimisation, that address specific segments of the collateral challenge. However, the situation urgently demands an industry-wide solution that can address both the scale and the efficiency challenges of collateral processing, as well as the gap between the supply and demand of collateral. Without it, hedging risks will become more expensive, profit margins will continue to be squeezed, and investment returns will become more challenging.
Recognising that the industry requires a solution to address both the scale and the efficiency challenges of collateral processing in the new environment, DTCC has been working on a key initiative with Euroclear, the Margin Transit Utility (MTU).
Utilising DTCC-developed infrastructure, the MTU will provide straight-through processing of margin obligations between market participants, automatically creating appropriate settlement messages for cash and securities transfers and pledges, which will be enriched with the ‘golden copy’ of standing settlement instruction data contained within Omgeo ALERT. The MTU will support all appropriate segregation and safekeeping instructions for the applicable depositories, custodians, clearinghouses and member banks, culminating in full consolidated reporting and record-keeping of all collateral movements.
This facility will mitigate systemic risk and provide additional risk and cost benefits to both sell-side and buy-side market participants by increasing scalability and operating efficiency, as well as providing greater transparency across all their collateral activity.
A broad global cross-section of the industry is currently engaged in the development of the MTU, including dealers, buy-side, global custodians, administrators, clearinghouses, central securities depositories and other service providers. The MTU is expected to be rolled out during the course of 2015.
The evolving regulatory environment will continue to place significant pressures on financial firms and create myriad challenges for managing and processing collateral. In an environment where cost benefit analysis rules the day, we are continuing to work with market participants and market infrastructures to help solve these issues.
