Buy-side braced for collateral challenge – The TRADE Poll

Readers of have overwhelmingly identified the cost of clearing and collateral as the primary concern for institutional investors in light of the impending shake-up of the OTC derivatives market.

Readers of have overwhelmingly identified the cost of clearing and collateral as the primary concern for institutional investors in light of the impending shake-up of the OTC derivatives market.

Just over 54% of respondents selected clearing and collateral costs as the issue money managers should be most worried about, followed by 16% each for reduced hedging opportunities and liquidity fragmentation and 13% for counterparty management.

All four aspects will be key considerations for buy-side firms as the new swaps rules draw closer, but issues related to collateral have been thrust firmly into the spotlight.

“Nobody is any doubt that the cost of doing swaps business is going up,” said Jane Lowe, director of markets at UK buy-side trade body the Investment Management Association. “The cost of clearing is a large part of this as buy-side firms can no longer be as dependent on their counterparties as service providers in this area. The question is whether is this added cost is worthwhile, in terms of the additional security the industry will get.”

Under the new rules – enacted in Europe under the European market infrastructure regulation and MiFID II – the demand for high-quality assets to mitigate the risk of counterparty failure will increase exponentially. Many trades in OTC derivatives, which have hitherto been largely traded on a bilateral basis with no need for margin payments, will be transacted on exchange-like platforms and centrally cleared. While some aspects of the regulation, i.e. the instruments it will cover and the types of collateral that will be accepted by clearers, remain unresolved, the International Monetary Fund estimated in a recent report that up to US$3 trillion worth of extra collateral could be sought after the new rules have been implemented.

Entering the new world 

Ted Leveroni, executive director of derivatives strategy and external relations at post-trade processing firm Omgeo, said the results of the poll tally with client feedback.

“The cost of clearing and collateral is a real and very new issue for the industry,” Leveroni told “The other options in the poll are relatively similar to others the industry has faced before, such as fragmentation of liquidity and the ability to find appropriate hedges for tailored exposures, which is essentially one of the buy-side trader’s core competencies.”

Leveroni added the uncertainty in how market participants will change their derivatives trading policies in light on the new rules further complicates the size of the collateral challenge the industry will face.

“Following implementation of the new rules, swaps trading could increase or contract,” he said. “Some firms may opt for listed futures or options that require lower collateralisation, while others may feel more comfortable using OTC derivatives when there is a central clearing obligation. This makes estimating future collateral needs very difficult.”

The danger of burdensome collateral and clearing requirements could hit smaller firms or those that typically trade a low number of OTC derivatives, claims Anthony Belchambers, CEO of trade body the Futures and Options Association.

/uploadedImages/Anthony Belchambers, FOA.jpg“If you assume margin costs will rise to meet regulators’ countercyclical buffer requirements, margins could be called more frequently as risk management moves into real time, collateral transformation services could become extremely expensive if there is a collateral crunch and that clearing members may have to increase fees to make their business viable, it is clear we are reaching a tipping point,” said Belchambers. “Buy-side firms will be faced with the decision of taking risks that are unmanaged, or pricing this risk into their fees and passing this on to end-clients.”

While admitting that issues around counterparty risk aren’t being as closely scrutinised as collateral, Belchambers added the buy-side is thinking about how to manage their counterparty obligations.

“Buy-side firms and end-users will need to decide whether they prefer to take counterparty risk with a recapitalised bank via title transfer or link to clearing houses directly,” he said. “This is hard to judge at the moment and will depend on the level of segregation firms opt for.”

He added that when it comes to liquidity fragmentation, although competition between trading platforms will be healthy for the swaps markets, the concept of best execution could change to one that now includes certainty and likelihood of execution in addition to finding the best price.