Rick Enfield from Omgeo explains what the buy-side need to be doing, to prepare for existing and future regulatory change.

Buy-Side Prepare: BCBS-IOSCO Recommendations Adopted by global regulators in 2015
By Richard Enfield, Omgeo

The need to efficiently monitor and process collateral will have an increasing impact on the buy-side from both inventory/liquidity management and cost perspectives.  Regulations and common market practices are coalescing around requirements governing margin practices for centrally cleared and bi-lateral derivatives: position reconciliation with counterparties, & transaction, position and collateral reporting to data repositories.

Regulatory Impact

There has been a great deal of focus on the clearing, reporting, and reconciliation requirements of Dodd-Frank and EMIR.  The transition to clearing for standard swap transactions has gone fairly smoothly in the US and nearing implementation in Europe.  Reconciliation practices are also well established, although many firms are still relying on manual processes to manage their collateral operations.  However, complying with reporting requirements has been bumpier due to the lack of clarity around the requirements, lack of legal entity identification standards and the multitude of firms looking to service the global reporting requirements.  

Less attention has been paid by buy-side firms to the upcoming impact of the BCBS/IOSCO requirements and standard CSA currency basis margining standards. However this trend will likely shift, since the proposed rules by BCBS/IOSCO has been recently published by global regulators. Beginning by the end of 2015 and phased in over several years following  compulsory margin requirements for non-cleared derivatives covering Variation Margin (VM) are anticipated to  be mandated in both the U.S. and Europe by the following regulatory bodies: ESMA (European Securities Markets Authority), the Federal Reserve and CFTC (U.S. Commodity Futures Trading Commission). Between existing regulations and these newly established requirements, with respect to margining practices buy-side firms should expect:

1. For cleared derivatives there will be a requirement to deposit initial margin and adhere to daily variation margin calls with no minimum transfer amounts; 
2. For bilateral swaps there will likely be a need for both initial and variation margin, with variation margin calls subject to minimum transfer amounts on a periodic basis;
3. Satisfaction of margin calls needing to be made by exposure currency rather than agreement currency, with significant  haircuts if margin is satisfied with assets with a currency basis different from the exposure currency and/or with less liquid assets; and 
4. Tightening definitions of eligible collateral with a tendency towards restricting variation margin to cash, widening eligible collateral restrictions for initial margin, and large haircuts for assets deemed less liquid – potentially creating a liquidity crunch if optimal or more appropriate assets are not available for delivery.                                        

These four areas have the potential to stress a firm’s ability to provide operational support for asset allocation and hedging strategies where derivatives represent high notional amounts and a significant number of transactions.  There are a number of processes and procedures that need to be enacted in order to support derivatives trading in compliance with existing and proposed regulations.

Operational Impact

There are a number of operational areas impacted:

• Trading activities – where determination of optimal execution needs to take into consideration where a derivative is best executed from a total cost perspective.  Decisions need to take into account factors such as different initial margin requirements depending on the execution/clearing facility, potential exposure netting benefits, whether to trade on exchanges, or achieve similar economic impact by trading bi-laterally, and where initial margin may need to be delivered on the trade date; 
• Risk – where exposure analysis can serve to direct counterparties and their associated concentration limits;
• Reconciliation requirements and resolution timings – where long-running disputes might need to be reported;
• Collateral management operations – since the requirements for collateral movement across both cleared and bi-lateral derivatives by exposure currency will dramatically increase call volumes; and 
• Reporting of transactions and collateral balances to a variety of jurisdictions.

Focusing on the collateral management operations, the impact of both the active and proposed regulations is going to be significant.  Large derivative transactions may require initial margin to be deposited on trade date depending on the trading/clearing venue.  Virtually all derivatives – whether cleared or bi-lateral – will require delivery of collateral on either a daily or periodic basis.  Cleared swaps will be subject to daily collateral delivery, with no minimum transfer amounts.  Collateral delivery will need to be assessed and delivered on a currency exposure basis.  Market practice is starting to shift to separate communications for calls for initial margin, variation margin, and fees.

All of this means that the number of processed calls will increase substantially.  More critically, the analysis of securities or cash to deliver or be received will become much more complex as the demand for more liquid assets grows and haircuts start to have a larger impact on the values of assets available for delivery.  Having sufficient assets shouldn’t be a problem for most buy-side firms, although it is possible that having sufficient eligible assets might be difficult depending on how various rules end up.  A more significant challenge for many firms might be the ability to effectively allocate available assets across the myriad of usage demands in an efficient and effective manner.

Firms need to analyze their own unique business operations and determine whether or not their systems and processes will support their future needs. While businesses may choose to develop a bespoke solution in-house, a range of collateral management systems already exist. These have been developed to support best practice capabilities and should allow for quicker implementation, greater cost effectiveness and easier & faster adjustments to future changes in industry practice. 

Leverage the knowledge and expertise of the Depository Trust & Clearing Corporation (DTCC), with its robust collateral management platform – Omgeo ProtoColl – to implement automated straight-through-processing in order to manage margin and collateral calls across the entire trading operation. The automation of the collateral management lifecycle minimizes manual intervention, thus enabling firms to increase operational efficiency while making smarter, more effective use of their collateral and subsequently reduce counterparty risk.
Omgeo and DTCC are focused on providing solutions to mitigate post trade operational risk.  Our suite of offerings enables firms to meet the increasing challenges of derivative processing and collateral management as a result of more complex and stringent global regulations.