Now that Reporting for Europe has come into effect I am looking further into the next challenges that await for us just around the corner and I would like to share some thoughts in this post and in others coming soon on what I believe will be one of our major headaches the years to come. 

With the regulatory response to the global financial crisis now moving into the implementation phase, the practical implications of these new measures are becoming increasingly clear. The fundamental overhaul of the over-the-counter (“OTC”) derivatives articulated in legislative measures all around the globe is a key element of the reform process.

It’s more than obvious why a great deal of attention has been focused on the operational burdens of adapting to the new market environment. However, there are also significant portfolio management-related issues to be both addressed and resolved. In particular, market participants need to take into account the imminent material change in collateral requirements if the investment process is not to be unduly constrained, nor excessive costs incurred.

So what’s the big picture?

OTC derivatives will either be centrally cleared or remain bilateral yet subject to a higher capital charge & collateral requirements.

We have to cope with current regulations (Dodd-Frank Act (DFA) and European Market Infrastructure Regulation (EMIR)), and supervisory frameworks (BASEL III and Basel Committee on Banking Supervision (BCBS) International Organization of Securities Commissions (IOSCO)) which translate into:

• Mandated clearing for certain product types
• Mandated higher quality two-way margin
• Contributions to CCP default funds
• Reduced netting capabilities from CCP product fragmentation compared with bilateral netting opportunities  
• Restrictions on rehypothecation
• Segregation of collateral
• More stringent regulations around collateral for bilateral trades
• Higher capital requirements requiring banks to hold more liquid assets

The rules — and the complexity of the investments to which they're applied — have meant what originally was simply matching credit with collateral has become far more complex. The changing regulatory environment is creating increased demands for collateral in both the cleared and uncleared markets, across all financial products.

The implications for both buy- and sell-side participants in the derivatives market will be far-reaching. It is now undisputed that there will be a ‘collateral squeeze’ – the only item left for debate is how severe and imminent the drain on liquidity will be. As a result there are direct and increasing pressures on both the availability and cost of collateral. Collateral management, largely an afterthought in the less regulated environment, will become an imperative and unless firms take measures to streamline the process and mitigate the impact of the new regulations, it will consume time and resources and potentially eat into profitability.

And this exactly the point where the so-called “collateral optimization” steps in.

Before going any further, I would really like to hear your thoughts on what “collateral optimization” means for you.

Maria L.