With rules governing how the new over-the-counter derivatives landscape will look still yet to be fully decided—and with clearing obligations set to come into play from July—firms are facing a race against time to be ready due to seemingly constant alterations to the legislation.

And one of the main worries is how firms will cope with the new collateral demands that will be asked of them as demanded by regulations such as the Dodd-Frank Act in the U.S. and Emir in Europe, which will see all standardized OTC derivative contracts shifted on to a centralized clearing model in a bid to reduce risk and increase transparency following the financial crisis.

“Financial institutions are facing enormous challenges brought about by the Emir and Dodd-Frank regulatory schemes and rapidly evolving regulatory structure in Europe and the U.S.,” said James Malgieri, executive vice-president, global collateral services at custody bank BNY Mellon.

“Central clearing is a cornerstone of those changes and has seen attention increasingly focused on collateral needs. Collateral is a critical part of the risk mitigation framework of these new regulations. However, it brings its own challenges around selection, valuation and time-sensitive collateral delivery.”

According to research firm Tabb Group, there will be an expected $1.6 trillion to $2.0 trillion in collateral shortfalls once the post-Dodd-Frank and post-Emir regulatory environment takes hold due to investors having to post margin on previously private bilateral swaps trades.

Margin calls will be moved to the same day and many firms are likely to struggle to continue to manage their collateral in-house, as they will have to manage margin calls from a broader spectrum of counterparties who will all have different eligibility criteria and settlement timeframes.

“Many sell-side and buy-side firms are inadequately prepared for the coming changes,” said Alec Nelson, a specialist in securities finance at Rule Financial, an IT consultancy, in a recent blog.

“The Dodd-Frank and Emir reforms are having a major impact in the way market participants engage with one another. The mandatory central clearing of swaps is giving rise to a new market infrastructure that introduces more roles and processes, all requiring computer systems to make them work efficiently.

“Risk management has always been a core strength of any clearing house, with risk systems integrated into the trade acceptance process. Collateral management was much more of a back office process somewhat separated from the real-time world of trade registration. But this is changing—the collateral process needs to get much closer to margin calculation and clearing.”

Nelson added: ““This means real-time links to all of the banks, depositories, custodians, tri-party agents in order to achieve this. It’s technically possible, but it’s likely to require significant changes—to systems and business procedures. Complying with such demands is likely to require deeper integration of risk and operations functions and the implementation of expensive technology solutions to crunch the data.”

Financial institutions are, thus, having to spend vast amounts of time and money to comply with the upcoming regulations.

“Deadline delays and alterations to legislation have made it very difficult for financial institutions to know where to invest to achieve compliance, with the result that a significant proportion of the industry is still not ready for change,” said David Field, executive director of Rule Financial.

“Many financial institutions, particularly on the sell side, are still employing a ‘wait-and-see’ approach as they anticipate further regulatory amendments. This pragmatism will undoubtedly spark a rush to implement adequate systems at very high cost, while at the same time competing for the limited quality resources on the supply side that are able to solve the complex issues faced. Dodd-Frank and Emir both demand clearing obligations by July 2013.

“Financial institutions do not have much time to get sufficient solutions in place. If they believe they are going to miss these deadlines, problem areas need to be identified and resolved immediately. Emir will also see the mandatory reporting begin to be phased in at the same time, which presents an opportunity to support the buy side, which is notably struggling with legal document and CSA management.”

Nelson, also at Rule Financial, added: “It is likely that interim solutions will be introduced, such as providing intra-day credit-lines that are drawn down by new trades and topped up periodically through margin calls and ‘batch updates’ from settlements. Either way, a lot more collateral will need to be processed, stretching people and systems until long-term solutions are introduced.”

With more trades set to be cleared, participants face the risk of being short of highly liquid and high-grade eligible collateral that clearing houses will request—which is already in demand due to other regulatory and capital adequacy reforms—with demand set to spike for eligible collateral, as well as being able to transform the assets they do have into an eligible form.

But out of these problems could come solutions, at least for some.

“There is an opportunity here for those institutional investors that are natural holders of CCP-eligible collateral, and these assets will be subject to intense demand from banks and other institutional investors to cover margin,” said Nadine Chakar, executive vice-president for global collateral services at BNY Mellon.

“The ability to lend such assets, subject of course to adequate risk controls, could therefore be a means of offsetting some of the costs of compliance with the new rules as well as augmenting depressed yields.”