The evolving regulatory environment will continue to place significant pressures on financial firms and create myriad challenges for managing collateral, according to a white paper by Depository Trust & Clearing Corp.

With margin call activity expected to increase by as much as 1,000% and given the increasing demand for collateral, this will have a major impact on both liquidity and risk – the operational nightmare scenarios are endlessly identifiable. In an environment where cost benefit analysis rules the day, the industry is looking to harness market infrastructures to help solve this issue, according to DTCC.

Firms are growing wary of fragmented approaches that may deliver limited operational cost and risk benefits. The reality is that collateral challenges will be far more extensive than what has been reported thus far, and in many cases, fragmented solutions will only address certain parts of the problem.

“Collateral management can be the Achilles heel in a firm’s operations and create significant risk due to the preponderance of manual processes that exist in this area,” said Ted Leveroni, Omgeo’s executive director of derivatives strategy.”

The DTCC white paper estimates the potential for a ten-fold increase in margin calls that need to be processed.

“It stands to reason that such a drastic increase in call activity and counterparties will increase the cost of operations as well as test whether firms have the right levels of automation and controls in place,” Leveroni said. “A lack of automation can open a firm up to not only increased risk, but significantly increase a firm’s operational costs.”

Collateral systems now need to manage exposure for both cleared and bi-lateral OTC agreements in addition to other asset classes. While most OTC derivatives will be required to centrally clear, many will remain bi-lateral due to their complexity or a lack of liquidity.

“Adding to this complexity is the fact that firms take on counterparty risk from other investments beyond cleared and non-cleared swaps,” said Leveroni. “The result is, if a particular counterparty defaults, the firm is exposed to losses stemming from the multiple business lines of that counterparty. This can include exposures to the counterparty’s OTC derivative desk, cleared OTC and/or exchange traded derivative desk, futures/ listed options desk, Repo desk and TBA desk, to name a few.”

The central clearing of OTC derivatives will result in an increase in the number of collateral/margin calls that need to be processed due to several factors. In a centrally cleared environment, calls are required for both initial and variation margin.

At the same time, the mixed clearing environment will create an increased number of collateral relationships with new counterparties. Further, the use of minimum transfer amounts and call thresholds will decrease due to the shift from the bi-lateral to cleared model, Leveroni said.

Increasing collateral and margin requirements, coupled with a shorter list of eligible collateral instruments, will likely result in a collateral shortage. As a result, there will be an overriding need for many buy-side firms to be able to optimize their collateral use.

“As market participants discovered during the financial crisis, even if they held collateral to cover their counterparty risk, during times of market stress, the value of the collateral, especially collateral whose value was tied to specific sectors or issuers, fluctuated significantly, resulting in large uncollateralized exposures,” said Leveroni.

This problem can be exacerbated when collateral is managed in siloes. Firms must not only ensure they take in the appropriate amount of collateral, but they must monitor the types of collateral accepted to ensure their collateralization levels are not disproportionately impacted by market fluctuations of a specific asset class, sector or security.

“In order to prosper in the derivatives market of the future, industry participants must ensure they have an automated solution in place that mitigates risk, processes collateral information consistently across all clearing methods and asset classes, and meets evolving regulatory demands and industry best practice,” said Leveroni. “Automation is the only way to bridge the gaps and drive consistency and operational excellence across a firm.”