Beyond Standard Two-way Margining

Two way margin calls are the bread and butter of collateral management, but there are alternatives emerging. Read on and find out new ideas driven by the margin regulations. Beyond
April 26, 2016 - Editor

Two way margin calls are the bread and butter of collateral management, but there are alternatives emerging. Read on and find out new ideas driven by the margin regulations.

Beyond Standard Two-way Margining

The shape of the OTC derivatives landscape continues to evolve and at great cost to dealers and more recently, end-users.  Layers of regulations across products and jurisdictions will change business processes and costs to the market, as the number of directly affected participants increase over the next five years.  As part of this evolution, new regulatory deadlines such as Initial Margin (9/16) and Variation Margin (3/17) are on the immediate horizon.  Recognising these regulatory changes, financial institutions have been compelled to change business processes, compliance, reporting requirements and outsourcing strategies, while also measuring the attendant impact of regulation to the cost of credit, capital and liquidity.  Suffice to say, it has produced a more complex landscape requiring a more sophisticated approach.

The Impact of New Initial Margin Requirements

The principles of BCBS, Dodd Frank, EMIR, MifiD II, and Basel III create a complex web of individual responses by participants, which by their nature will not be consistent across products, entities and jurisdictions.  The regulatory driven increased demand for collateral for non-centrally cleared OTC derivatives will certainly help achieve many of the principles of the 2009 G20 regulatory initiatives; however, the resulting impact to capital, funding, and operational risk will significantly increase the cost of trading. Specifically the BCBS set of rules, impose strict requirements on market participants in the way collateral is held and segregated and will result in the need for a new network of multiple custodial accounts to manage the delivery and receipt of initial margin (IM).  The scale of newly-required bilateral IM accounts across combinations of all portfolios imposes new and increased costs and operational risk to financial institutions.

Mandatory IM for non-cleared OTC derivatives, as expressed under the rule BCBS-261, specifically obliges financial institutions to post collateral to their counterparties to cover related exposures arising from their own potential default (defaulter pays).  The implementation of this two-way margin requirement has far-reaching implications for the operational processes and infrastructures underpinning banks’ liquidity and collateral management.  Commencing in September 2016, and expanding to a majority of OTC derivative participants over the following four years, the impact has just begun.  

Implementation Challenges of Initial Margin

As institutions look to implement mandatory IM bilaterally, they seek to do so in tandem with other regulations and require an optimised and ordered approach.  Scalability is also required to ensure that the flow of margin is calculated, agreed, posted and safeguarded consistently to meet the principles of BCBS-261 with all of their counterparties.
Each GSIFI bank, for example, requires unique entity-to-entity margin agreements with daily reconciliation and exchange of Initial Margin.   The complexity of managing the supporting legal documentation alone is enormous.

Additionally, calculated initial margin will be open to disputes arising from differing underlying approaches employed by the different market participants.  Even with participants sharing similar methodologies, results will vary significantly resulting from subjective data inputs and the quantum of the portfolios involved.

Market participants face significant challenges in developing operational and technological systems to manage all steps of the IM process with their many derivatives counterparties.  This includes the task of bringing sufficient standardisation to legal agreements, data standards, and margin models to reduce (and near eliminate) anticipated disputes.  Thereafter, the creation of industry-wide approaches to optimise payments, segregate collateral and introduce post-default processes is required.

Many of these problems can be eliminated, at reduced cost, if the processes of calculating, delivering and holding collateral were consolidated through a market-neutral centralised infrastructure. 

The Order of a Centralised World

Being compliant with new regulations and minimising trading costs are achievable only with an efficient and scalable process. Centralisation and standardisation lead to significant financial advantage, which should not be underestimated.

Centralised and standardised benefits are plentiful and obvious: a single point of integration for technology, standard legal documentation, a central calculation which reduces IM disputes, consolidated collateral calls and a standard post default close-out process, to name but a few.

With these benefits in mind, NetOTC has developed NetOTC Bilateral- a powerful and sophisticated IM solution that goes beyond the calculation and calling of standard two-way margining.  

A Consolidated Approach with NetOTC Bilateral

NetOTC Bilateral is a central infrastructure for financial institutions that tackles the key challenges for integrating bilateral IM fully into the collateral process.
As an end-to-end platform that works with existing data and suppliers, NetOTC Bilateral addresses key IM implementation challenges that include dispute processing (and minimisation), collateral segregation, and post-default collateral distribution.

At its core, NetOTC Bilateral is a central margining platform that enables the gathering, matching and contrasting of risk data designed to facilitate the calculation, agreement, and settlement of initial margin on a daily basis.  NetOTC Bilateral is neither party to trades nor has control over assets within the structure.

Beyond standard two-way margining, NetOTC Bilateral provides a central approach to all steps of the IM process.   In such a consolidated solution, the regulatory principles for the implementation of the mandatory exchange of IM, set by BCBS 261, are addressed.

NetOTC Bilateral aims to reduce mandatory IM implementation, operational and related trading costs.  NetOTC Bilateral is complementary to existing data and supplier services and is designed to integrate into a financial institution’s target collateral management ecosystem.

In addition, enhancements are planned that will include superior credit risk protection and IM optimisation, translating into funding and capital benefits and reducing liquidity and collateral exhaustion concerns.
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