Over US$2 trillion of margin will be needed to cover OTC derivatives positions by the end of next year, requiring firms to take a holistic view of their collateral needs, according to new research.
The study, called ‘Cracking the trillion dollar collateral optimisation question’, from consultancy Celent, estimates up to 50% of swaps could be centrally cleared by the end of 2013, leading to a collateral shortfall of up to US$2.5 trillion.
"Collateral optimisation activities are evolving towards a front office focus, where front line trading decisions take into account a more cohesive strategy for ranking collateral," said Medy Agami, Celent analyst and co-author of the report.
The need for quality collateral will only grow – with a potential US$6 trillion required by 2016 – if, as Celent predicts, 80% of swaps are cleared through central counterparties by this time.
As such, firms should be already considering their approach to optimising and allocating capital through the services beginning to emerge from custodians, dealers and settlement houses.
"Current-generation approaches to collateral optimisation (e.g. merely at business unit level) and hard-wired optimisation algorithms (e.g. cheapest to deliver) will no longer suffice," read the report.
A key aspect of managing collateral effectively will be having the tools for the efficient distribution of collateral across front-office functions typically held in different offices, through various instruments and for different purposes, said Celent.
This can be achieved by taking an inventory of all the collateral a firm has in place and integrating it with an enterprise infrastructure across the front-, middle-, and back-office.
The more challenging aspect of managing collateral, according to the report, is achieving the best value decision in terms of balancing risk management and profitability.
"The degree of sophistication in collateral optimisation will be contingent not only on what one can achieve with smart analytics, but also on the connectedness and timely delivery of the broader information ecosystem," said Cubillas Ding, research director, Celent, and co-author of the report. "Financial firms should execute delivery in this area in close tandem with other risk and regulatory reform initiatives. For most firms, the journey has begun, but there is still a long road ahead."
Under new rules for OTC derivatives, which are due to come into force in the US and Europe from the start of next year, contracts will be standardised, where possible, so they are suitable for trading on exchange, cleared through central counterparties and reported to newly-created data repositories. Those swaps that cannot be standardised will be subject to higher margin requirements.