Collateral Gets Ahead of the Curve(s)

Terry Flanagan

Changes in the way that financial institutions value their portfolios of OTC derivatives, combined with new OTC regulations such as Dodd-Frank and Emir, have fundamentally altered their view of collateral.

Historically, financial institutions used a single standard curve—Libor–to value derivatives.

Post-crisis, however, market participants have moved away from a single curve for both discounting and forecasting. Instead, they are using multiple curves, each playing a specific role in valuation.

Forecast curves continue to be based on Libor, but are built specifically for different tenors. Also, a significant number of participants construct discount curves based on overnight indexed swaps (OIS) rates.

“Today’s market participants are looking to develop more complex, short-term scenarios to observe multi-curve sensitivity,” said Satyam Kancharla, chief strategy officer at Numerix. “As spreads between OIS and Libor rates remain wide, impacting collateralized derivatives exposures, portfolio managers have increased concerns over financing and funding, in addition to managing CSA [Credit Support Annex] optionality and future collateral forecasting needs.”

The International Swaps and Derivatives Association recently announced the publication of the 2013 Standard Credit Support Annex (SCSA), which seeks to standardize market practices in collateral management for over-the-counter (OTC) derivatives. It removes embedded optionality in the existing CSA, promotes the adoption of OIS discounting, and aligns collateralization between the bilateral and cleared OTC derivative markets.

“Changes in financial market dynamics have shifted and advanced risk measures are needed to monitor and actively manage risk over time, of both trade and portfolio concentrations,” said Kancharla. “This evolution has emphasized the need to design robust stress tests and manage comprehensive risk scenarios from the ground up, where portfolio-level market sensitivities can be used to customize the way risk is viewed and managed.”

Numerix, a provider of cross-asset analytics for derivatives valuations and risk management, has unveiled the Numerix Risk Scenario Framework, a scripting language for defining bespoke risk scenarios, stress tests and greeks.

Market dynamics and the search for increased transparency are pushing participants to implement a robust risk mitigation framework around collateral management.

Incoming regulation, in particular Emir and Dodd-Frank, has increased the need for collateral for all OTC derivatives, whether cleared or non-cleared. The new liquidity standards of Basel III will also affect future demand for High Quality Liquid Assets.

BNP Paribas Securities Services, a global custodian with over $7 trillion assets under custody, has boosted its collateral management platform by launching Collateral Access, service which provided margin requirement simulation, helping optimize collateral allocation and take advantage of financing solutions or lending opportunities.

“Providing a solution to mitigate counterparty risk remains at the heart of customers’ requirements,” said Patrick Colle, CEO at BNP Paribas Securities Services. “But our clients expect even more than that from their custodian. Optimization and protection of collateral are becoming critical decision factors; whether long or short, clients want to be able to maximize the use of their assets.”

“Protection of the collateral portfolio is also a key concern,” said Colle. “As a custodian with Global SIFI status and a unique combination of buy- and sell-side clients in our books, we are naturally best placed to safe keep, optimize and transform clients’ collateral.”

Since the financial crisis, stress tests have been consistently implemented at the largest financial institutions. Now a regulatory requirement, from stressed VaR under Basel capital requirements to Fed reporting requirements in stress testing, stress tests have become an onerous task, according to Kancharla.

“The implementation of base and bespoke tests is driving banks to seek more automated approaches where a robust stress testing framework can be leveraged for daily risk management purposes, and offer better insight into capital needs, liquidity risks and collateral optimization techniques,” he said.

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