Time is getting short for buy-side firms to prepare for the transition to a centrally-cleared over-the-counter derivatives environment, with collateral and margin requirements at the top of the list.

By the end of 2012, the majority of trades in OTC derivatives will have to be executed through swap execution facilities (SEFs), directed through derivative clearing member (DCM) banks and cleared through central counterparties (CCPs).

“Before the financial crisis of 2008, OTC transactions were typically bilateral agreements between parties with established relationships,” said Liam Huxley, vice-president of product strategy at Advent Syncova, a software and service provider. “Margin calculations were fairly straightforward and collateral was called infrequently.”

Under the new regulations, however, firms will have to make higher margin commitments and are likely to see more frequent margin calls.

“Different CCPs will have different asset valuation methodologies and margin calculation models,” said Huxley. “Firms risk being overcharged or having to put up excess collateral unless they have a way to replicate and validate CCP margin calculations.”

Asset eligibility requirements will most likely be narrower and more stringent, requiring more collateral transformation from third-party dealers to get the right types of assets.

The forthcoming derivatives regulations in the U.S. and European Union represent a huge operational challenge for asset managers and other investors; and a potential drain on collateral liquidity.

Firms that participate directly in the $700 trillion swaps market will be forced to undertake collateral optimization programs in order to unlock an expected $1.6 trillion to $2.0 trillion in collateral shortfalls, according to research firm Tabb Group.

In the OTC derivatives market, collateral messaging and management is an area where data workflows need to change or risk being overwhelmed.

“Buy-side firms are seeing increasing pressure to provide not only the data for regulatory reporting, but also the controls to ensure quality while capturing audit and data lineage,” said Daniel Simpson, managing director and head of Markit EDM, a financial data vendor.

There is also a greater requirement to store and retrieve historical information, which increases the volume of data by orders of magnitude, putting pressure on legacy systems not designed to cope with data on this scale.

“Use of spreadsheets and manual extraction of data from multiple silos are a red flag to auditors,” said Simpson.

Advent has been co-ordinating with many CCPs as they have been developing their margin calculation models. Last month, Advent introduced a new collateral management toolkit designed to help both buy- and sell-side firms address these issues.

Part of the Advent Syncova suite of margin and financing management products, the new toolkit incorporates rules packages for each clearing house’s calculation methodologies for each type of centrally cleared product, with the first phase providing an interest rate swaps package.

“It will enable firms to replicate and validate any clearing counterparty’s margin calculations,” said Huxley at Advent Syncova.

The new tools will help buy-side firms manage their costs and reduce their margin levels through optimized asset placement.

“Firms will be able to manage all CCP, bilateral and prime broker margin call requirements on a single system,” Huxley said. “And they can perform what-if analyses on proposed trades to determine the optimal combination of DCM and CCP to clear through.”