May 17, 2017

Get Ready – A $13 billion Collateral Headache is Heading in Your Direction

Banks and other financial institutions that use derivatives as investments or to hedge risk need to get ready, otherwise they are heading for a $13 billion headache as new collateral and margin requirements continue to be phased in later this year.

Banks and other financial institutions that use derivatives as investments or to hedge risk need to get ready, otherwise they are heading for a $13 billion headache as new collateral and margin requirements continue to be phased in later this year.

Get Ready – A $13 billion Collateral Headache is Heading in Your Direction

In order to ease that pain (they will still have to stump up the $13 billion) they will need to be able to accurately calculate the margin amounts to not only ensure optimal collateral allocation, but also to prove compliance with the new regulations.

Although March 1, 2017 is being billed as ‘big bang’ when new rules from Basel’s BCBS regulators require more specific margin calculations and collateral obligations to be extended to uncleared OTC derivatives, a handful of the world’s biggest banks in the US and Japan started adopting this practise last September. The EU (and some other jurisdictions) sought more time to comply and, as a result, the next wave of inclusion will see probably another 20+ banks added to the list in March.

But the real test of these new rules will be as the regulations are phased in to virtually every financial institution (many of whom have no previous experience of collateral) over the next three years.  So far the implementation of both new Initial Margin and Variation Margin calculations for collateral will only see those institutions with an Aggregate Average Notional Amount (AANA) of uncleared OTC derivatives in excess of 3 trillion (Euros or Dollars) initially affected. But this threshold reduces to 8 billion in four more steps up to September 2020.

And although many small banks and investors will still be well below even this, the larger businesses that are included will impose the expectation (and pass on the margin cost of the risk mitigation) to their counterparties.

According to HSBC, the new margin rules originate from a global policy framework and timetable from the Basel Committee on Banking Supervision and the International Organization of Securities Commissions (BCBS-IOSCO). They are a key part of the reform agenda put inIt said the incremental... place by the G20 countries as a response to the 2008 financial crisis. They are intended to reduce systemic risk in the non-centrally cleared OTC derivatives markets by ensuring appropriate collateral is available to offset losses caused by the default of a counterparty.

The International Swaps and Derivatives Association (ISDA) estimates there are total derivatives in circulation with a gross notional outstanding value of some $700 trillion. Of that amount some $86 trillion are uncleared and will be subjected to the new rules.

Analysis by Deloitte estimated this will require the posting of an additional $13 billion a year in collateral that would not be asked from derivatives cleared through a central counterparty. It said the incremental costs of the reforms for uncleared derivatives will be ten times that of those cleared. On the basis that the average portfolio size of non-cleared Euro interest rate derivatives is €85 million, the additional average costs amount to around €14,500 per transaction, it concluded.

Given the implications of other regulations on capital requirements and the wider costs of capital it will be essential to have these calculations completed accurately. But, while this requirement only applies to new contracts entered into after 1 March 2017, an extensive list of lifecycle events may bring legacy trades into scope. The list includes but is not limited to amendments and cancellations, partial termination, allocation and partial novation, etc.

The two-pronged approach means firms will have to provide an initial margin when establishing a derivatives transaction (calculated on the basis of a formula that weighs the risk involved, the nature of the transactions, the currencies and credit risk of counterparties among other factors). But they will also have to calculate an ongoing variation margin that requires adjustments to the IM based on marking to market the collateral, often close to real time. This could easily see the need for adjustments to the collateral already posted on an intraday basis to account for any deterioration in the value of the IM.

Those affected will therefore not only be required to be able to filter inventory to see what assets are eligible for collateral, but also what is available, at what time, and what is the most cost effective. There will have to be complete confidence in being able to trust the source of that information. It will be critical that the analysis is not only delivered fast, but is reliable. Partial views could prove to be not only expensive mistakes, but possibly contravene the new rules.

Of course, these services will be offered by third parties (or even the large bank counterparties themselves on an outsourced basis) as some are already doing.  But it will be in every organisation’s interests to have its own version of the truth, particularly when it comes to disputes resolution.  This latter aspect will be essential to resolve quickly, both because of the costs involved, or the risks of default.  They will need to be ready to calculate, exchange, settle and challenge VM. Many smaller counterparties will not be used to this activity and are only now realizing they not only need to do this, but that there could be incremental benefits in doing so.

The key to success will be better data analysis that integrates Front Office activity with the OTC portfolio descriptions, including market data for mark to market activity and variation calculations, right through to back office settlement processes. Fortunately, the technology is available to provide this that can aggregate data from multiple and disparate repositories, delivering fresh calculations when required to the firm’s decision-makers.

Like all new regulations this brings new challenges and new overheads. But, by taking a strategic approach banks and other investors will be able to mitigate both the risk and the costs involved. The key will be to start planning now. This must ensure the optimum capabilities are in place that provides full and accurate visibility of collateral assets and deploys them in the most advantageous manner for the business.

The new rules mean that collateral management is no longer just a back office appendage, but a key function with close links to trading, risk, liquidity management and capital optimisation. This shift into the spotlight means it has to be taken seriously. Anything less could have severe consequences and make the $13 billion additional costs the least of their worries.

This article was first published in edition 9 of Rocket, our magazine. Download available Rocket editions here, and save your up to date address in your profile to to indicate your interest in receiving a printed copy of the magazine. Copies are also available to purchase and subscribe to via the shop.Rocket 9

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