Collateral Issues Weigh Heavily on OTC Markets

Terry Flanagan

The possibility that every OTC relationship may need collateral accounts under new regulations has driven demand for more efficient services to streamline the technical and operational challenges of managing all types of collateral assets across multiple counterparties.

“We’re seeing increased demand for segregated collateral, potentially driven by OTC regulations, such as the Dodd-Frank Act in the U.S. and Emir in Europe,” said Fergus Pery, director and global product head for OpenCollateral in Citi’s Securities and Fund Services.

From a technological standpoint, collateral optimization required cutting-edge technology to identify, prioritize and deliver the lowest grade of accepted collateral across an entire organization.

Fergus Pery, director, Citi Securities and Fund Services

Fergus Pery, director, Citi Securities and Fund Services

“As buy-side clients understand the ramifications of the regulations they are re-examining their use of derivatives,” Pery said. “The increased costs of collateralization may lead some clients to reduce use of OTCs while the increased security offered by CCP clearing may encourage others to increase their use of OTC derivatives.”

International securities regulators are seeking to establish standards for margin and collateral requirements for OTC derivatives that are not cleared through a central counterparty (CCP).

On October 17, 2012 the SEC issued proposed rules to address capital, margin, and segregation requirements governing transactions in security based swaps (“SBS”) by security based swap dealers (“SBSD”) and major securities based swap dealers (“MSBSD”). SBSDs and MSBSDs, which are not supervised by a prudential regulator, will be subject to the proposed rule. The segregation rules will apply to all SBSD and MSBSB.

The proposed rule provides a collateral segregation set of rules that applies to all SBSDs and MSBSPs regardless of whether they are banks or bank holding companies.

“They would be required to notify counterparties at the beginning of a non-cleared swap that the counterparty has the right to have its collateral segregated that is posted for initial margin,” said William Despo, a derivatives attorney with LeClairRyan. “The right to segregate does not apply to variation margin. The counterparty can waive the right to segregate and enter into a subordination agreement.”

The Basel Committee on Banking Supervision (BCBS) and the International Organization of Securities Commissions (Iosco), in a consultation paper on margin requirements for non-centrally-cleared derivatives released in February, are proposing that all financial firms and systemically-important non-financial entities that engage in non-centrally-cleared derivatives must exchange initial and variation margin as appropriate to the risks posed by such transactions.

“The detailed requirements under both the Dodd-Frank and Emir regimes in terms of what collateral will be required, particularly for uncleared swaps, haven’t been determined,” said Pery. “However, the recent Iosco proposal sets out the basic structure.”

Citi has expanded its Citi OpenInvestor suite of investment services to include Segregated Collateral Custody Accounts that help clients better mitigate counterparty risk, provide asset safety, and improve collateral efficiency. This capability adds to Citi’s existing agency collateral management service, OpenCollateral.

“These structures [segregated collateral] have been in place for some time, but the regulations will make them commonplace,” said Pery. “Citi is addressing issue of scalability; as the number of these accounts increases, we are making it easier for market participants to access these accounts in high volumes, via substitution management, collateral monitoring and cash reinvestment.”

For tri-party account control arrangements (ACA), Citi will act as an intermediary between the pledgor and the secured party, holding pledged collateral in a segregated custody account.

“Within the terms of each ACA, Citi will allow pledgors to instruct transactions on the collateral account and secured parties to monitor pledged collateral positions in a highly automated manner,” said Pery.

For rapidly changing collateral portfolios, Citi’s Automated Substitution Control facility enables automated processing of substitution transactions while maintaining collateral values above the agreed initial margin level.

“Citi has sought with automated substitution control to streamline the process so the collateral provider can substitute assets freely, providing the value of collateral is maintained,” Pery said. “We’re providing the capability for collateral to be held remotely in an operationally efficient manner.”

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