Is Collateral Management a Front Office Function?
Going back ten years or more, Collateral Management was in many firms seen as an adjunct to their Operations or Credit risk teams. Given the easy profits from trading, little attention was made to the flow of margin assets or their cost, as these were a side-line in the overall profits of a firm. The first step change for a CM team was the arrival of SwapClear in 1999, and the take up of clearing by a core group of banks in 2000 with the drive to automate the clearing process. SwapClear requires Initial Margin which was a new idea for OTC products. Most Credit Support Annexes at the time required net mark-to-market (or Variation Margin as most call it now), and no additional amounts (other than some customised CSAs for FX or Prime Brokerage).
Initial Margin became a new cost to the CM team, and forged a new relationship with the Repo / Treasury desks – as someone had to bear the funding cost of the IM, and it couldn’t be the CM team itself who have no profit to spend. This became the genesis of an evolving relationship between the front office and the CM teams – and also the Risk Management team to understand why the IM at SwapClear is driven higher or lower, and therefore increasing or decreasing costs.
Firms chose to utilise clearing due to the saving on regulatory capital, which for quite some time was zero weighted for cleared trades – a big saving. The growth in membership at SwapClear was relatively slow until 2008 when the Lehman default occurred, at which point the other benefit of clearing, the default management process, showed how the surviving members need not lose money.
Around the same time, Credit Value Adjustment (CVA) also came to wider acceptance, the need to transform residual Coun- terparty Credit Risk (CCR) into hedge trades and the resulting cost of hedging. Some firms created specific CVA desks to per- form this role, and some firms aligned the CVA role alongside CM as a combined method of transforming CCR into more ac- ceptable forms.
Since 2008 with the G20 pronouncements and the Dodd Frank Act in the US, clearing has become mainstream with a high proportion of OTC Rates and Credit business now cleared. In the US the CFTC also mandated electronic trading, something other countries have not taken up with the same enthusiasm. The need to trade some OTC products on a Swap Execution Facility (SEF), brought new complications to the trade workflow – the need to quote an all-in price on SEFs but also the need to measure and manage limits and margin requirements as early as possible in the execution cycle.
In a nutshell – for a firm to comply with the clearing mandate, they must have sufficient credit limits and margin capacity with their Futures Commission Merchant and with the destination CCP, to avoid having their trade rejected. This then forms anoth- er circular loop where the limits allocated to a Client, must reflect current liabilities minus collateral assets plus any CVA activity, to arrive at the headroom to take on new business. This means the assets held by the CM team versus the margin requirements at the CCP and trades from the CVA desk must all be recorded in real-time against each Client, and sent upwards to SEFs to enable pre-trade checks.
A future impact to CM teams will occur in December 2015 when firms with more than €3trn notional of un-cleared OTC business must begin to exchange Initial Margin using a VaR or schedule based approach. The rules will apply to new trades from 1st December 2015, therefore splitting the OTC world into two sets of rules, those pre-Dec 2015 and those post. Firms are still considering how to adapt to these requirements as the details in the proposed rules need bilateral agreement on an IM model, plus custody of the IM assets in favour of the exposed party, without allowing assets to leak into any bankruptcy proceedings for your counterparty.
The structural changes and extra margin requirements for both cleared and non-cleared trades mean that the cost of collateral is now an integral part of firms’ profitability. The mechanics are needed to calculate the expected cost of funding of collateral through the life of the trade and to allocate the actual costs of the collateral program back to the trading desks.
To get back to the point, all the above have meant that the tra- ditional role of a CM team managing a portfolio of CSAs has now been expanded far beyond that scope, giving that team a mandate to become a much higher value added team in manag- ing the complexity of CCR in relation to trading and clearing, a great opportunity for the CM team to become a positive force for cost reduction and business expansion, but also a brake on unlimited trading.
Does this mean the CM team should now sit on the trading floor? Probably not, the real requirement is for the CM team to build and manage their relationships with the rest of the busi- ness, and invest in systems which support the new requirements, both for number crunching and data interchange to support the new more complex OTC market infrastructure.