Collateral management needs integrated approach

If firms do not integrate collateral management processes with operations, funding, trading, risk management and liquidity, they are risking their bottom line and falling foul of new regulations.

If firms do not integrate collateral management processes with operations, funding, trading, risk management and liquidity, they are risking their bottom line and falling foul of new regulations. But there are a number of systems on the market that will make calculations and compliance seamless, according to a new report.

As a result of G-20 efforts to centrally clear OTC derivatives, as enshrined in Dodd-Frank, pre-trade analysis of margin, capital, risk and liquidity will play a significantly greater role in counterparty, venue and product selection in the OTC derivative markets, as the buy-side considers the best way to hedge its risks through the use of swaps.

Because of this, firms will need enhanced analytics to evaluate a greater number of variables, warns financial consultancy Woodbine Associates in a new report entitled ‘Collateral management and vendor systems: Requirements and solutions in the new regulatory framework’ 

“Two years ago we were focused on central clearing and knew it would be the next big hurdle, and this goes hand-in-hand with collateral management. Once you take the risk from T+1 to real time with central counterparties (CCPs) and swap execution facilities (SEFs), efficient processing and inventory management become key requirements,” Sean Owens, director of fixed income and derivatives at Woodbine Associates, told

The report looks at the challenges associated with central clearing of OTC derivatives and increased margin requirements and evaluates the capabilities of the nine leading vendor systems.

Starting next year in the US and Europe, most standardised OTC derivatives must be centrally cleared, placing more onerous collateral requirements on buy-side firms that typically paid only variation margin – not initial margin – against swaps trades. Instruments that cannot be standardised and remain bilaterally traded will require margin payments that are much higher than cleared OTC products.

Picking new partners

Owens explained that firms would need to manage new relationships with CCPs and adhere to new counterparty requirements, including more frequent margining and more selective collateral eligibility requirements.

“When choosing solutions, you can look at it as just making sure you have a system to facilitate collateral processing, but that’s only one component,” said Owens. “We think firms will look at it more holistically – making it fit with a larger, more integrated approach to risk, funding and front-office trades.”

Woodbine warned that collateralisation and initial margin requirements will affect a much larger universe of transactions and subject to more stringent constraints. Owens said this would increase the operational complexity of collateral processing and make efficient allocation of pledged cash and securities more critical to firms seeking to minimise associated costs.

“When a firm fails to deliver sufficient and acceptable collateral or when there is disagreement among counterparties on their exposure and necessary collateral, users initiate a dispute resolution process to identify discrepancies and rectify differences in exposure and collateral requirements,” Owens explained, adding while this was not uncommon for bilateral transactions, it seldom affected centrally cleared transactions. Clearing members and customers are required to accept CCP valuations and margin calculations and post required eligible collateral or they will be considered in default on their obligations to the CCP.

Depending on what firms have in-house, they could bolt on a solution or change trading platforms to help them manage collateral in the new regulatory environment. The report critically reviews vendor solutions to evaluate their offerings for firms seeking to enhance their internal collateral management capabilities and for service providers seeking to enhance the collateral management capabilities offered to their customers.

The solutions reviewed represent both stand-alone systems that can be integrated with existing portfolio management, trading, risk management systems or operating platforms, and integrated components of broader trading, risk and operating platforms. Solutions assessed include IBM Algorithmics Collateral Operations, Lombard Risk Colline, Omgeo ProtoColl, Openlink Financial (Findur), Murex MX Collateral and SunGard Apex Collateral.

“Central clearing, initial margin requirements and the cost of collateral will force many firms to significantly upgrade their systems. Users need a flexible, automated workflow that centralises collateral management for all traded products and securities,” said Owens.

“They also need enhanced analytics, forecasting and inventory management. Under the new regulations, collateral and margin will play key roles in OTC derivative transactions, including pricing, counterparty, product, venue and CCP selection. Systems will have to seamlessly integrate collateral management with risk management, funding and trading.”