Financial firms will need to be a lot smarter about how they use collateral once OTC clearing mandates kick in.

Swap dealers, major swap participants and private funds active in the swaps market have all been required, from March 11, to begin clearing certain index credit default swaps and interest rate swaps.

All other financial entities will be required to clear swaps beginning on June 10, 2013, for swaps entered into on or after that date. Buy-side market participants transacting swaps must determine whether they are subject to the mandatory clearing requirement.

Mandatory clearing of OTC derivatives transactions has dealers and swap participants scrambling to marshal their assets to meet collateral obligations, a process known as “collateral transformation.”

4sight Financial Software has added new features to its collateral optimization system to automate collateral recalls and substitutions.

“Collateral substitution is one of the biggest operational headaches of the collateral management process,” said Martin Seagroatt, 4sight’s head of marketing. “We developed new automation around this process to reduce the level of manual effort involved, while also minimizing collateral costs through intelligent asset allocation.”

Typically, CCPs will request a start of day cash collateral movement to cover margining requirements. However, many CCPs will then allow clearing brokers/direct members to substitute pledged cash collateral with cheaper to deliver assets.

The 4sight collateral system can receive an automated feed of collateral eligibility schedules from CCPs. When a CCP’s eligibility schedules change and collateral pledged with the CCP becomes ineligible, the 4sight system can alert the user and propose substitutions.

Collateral transformation is a form of collateral optimization – which is making sure that collateral is allocated as efficiently as possible, and the process will include swapping bad collateral for good collateral. If properly optimized, the lowest acceptable grade collateral is pledged, working from worse to best.

“With the upcoming clearing deadline for Category II clearing, market participants have to be a lot smarter about how to allocate margin across deliverable swap futures, and both cleared and non-cleared swaps,” said Mas Nakachi, CEO of OpenGamma, a provider of risk analytics software.

The SEC has promulgated rules for determining margin for cleared and uncleared SB swaps, which stipulate that margins for uncleared swaps be higher than for cleared swaps because of the perceived higher risk associated with uncleared swaps.

Futures exchanges offer “swap futures” that they say are the economic equivalent to OTC swaps, with some added benefits.

Swap futures offer lower initial margin requirements [the holding period for calculating initial margin for cleared swaps is five to seven days depending on the clearing house, compared to one to two days for futures], and eliminate the need to report to swap data repositories, which is required for swaps. Furthermore, firms trading swap futures benefit from more established trading mechanisms, which allow for faster and more transparent trade execution and settlement.