Influx of cleared swaps will lead asset managers to outsource collateral management to banks.

Collateral management, once a backwater of post-trade processing, has leaped into the spotlight with regulatory reforms that require many OTC derivatives to be centrally cleared.

The Dodd-Frank Act has generated numerous rules proposed by the CFTC on protection of collateral for cleared swaps, as well as provision of collateral for uncleared swaps. That, in turn, has upped the ante for maximizing the efficiency of collateral management.

“Collateral costs are going to go up significantly if transactions are processed through CCPs and collateral is required,” Robert Park, CEO of Fincad, told Markets Media. “It could cost billions in aggregate. This will make it more difficult or even impossible for some end user organizations such as industrial companies performing genuine hedging activities to avail themselves of these useful and important strategies.”

The upshot is that asset managers, even the largest ones, will be looking to outsource their collateral management operations, which have traditionally been done in house, and banks in turn are building out collateral management infrastructure and technology to handle the expected increase in cleared swaps.

“While banks continue to struggle with unanswered questions about OTC derivatives and collateral management, they are investing for a range of potential client solutions, including plug and play options,” said Josh Galper, managing principal of Finadium, in a Nov. 2011 report.

BNP Paribas Securities Services is extending its collateral management service to include centrally-cleared OTC derivatives. The service, which will be fully operational in early 2012 and delivered via a real-time view of both centrally and bi-laterally cleared trades, helps institutional investors manage both collateral and risk measurement across multiple counterparties – dealers, clearers and central counterparties – and changing eligibility requirements.

BNY Mellon has enhanced its derivatives collateral servicing platform for institutional clients with new margin management capabilities delivered through a secure web-based portal.

As part of DM Edge, the company’s derivatives margin management service – the enhancements provide clients with a fully automated system that facilitates the entire margin call and collateralization process, improves reporting capabilities and reduces operational risk.

Only the largest asset managers would consider an internal installation of collateral management technology, with others looking for a hosted solution or to outsource both technology and process management to a bank provider, Galper said.

The foundation of collateral management is the credit support annex (CSA), which is an agreement to an OTC derivatives contract that governs the calculation of collateral. In technical terms, “a CSA is a complex derivative on a portfolio of underlying derivatives, with contingent daily flows of collateral and embedded exotic options,” according to the International Swaps and Derivatives Association (ISDA).

According to the ISDA Margin Survey 2011, there are roughly 150,000 collateral agreements outstanding for OTC derivatives, with an estimated 220,000 CSAs.

Of these, only 15 percent are currently outsourced to bank service providers, with the rest either managed by broker-dealers or by end-users using spreadsheets.

“Few managers have yet committed to a specialty technology platforms dedicated to collateral management,” said Galper.

ISDA’s launch of a standard credit support annex (SCSA) is intended to eliminate “embedded optionality” in CSAs, which will standardize collateral management practices.

The SCSA also seeks to promote the adoption of overnight index swap (OIS) discounting for derivatives.

Discounting methodologies that take into account OIS spreads—that is, the difference between OIS rates and LIBOR—are increasingly popular and are progressively replacing LIBOR-based methodologies.

“The new standard focuses on the fact that LIBOR rates are not considered to be the best indicative rates to price financial instruments,” said Park. “From a technology perspective, this requires the system to be updated to accept these new rates and build these new curves. Many organizations that trade these instruments now use OIS for discounting.”

An overnight index swap (OIS) is an interest rate swap where the periodic floating rate of the swap is equal to the geometric average of an overnight index (i.e., a published interest rate which is also called Overnight Rate) over every day of the payment period. The index is typically an interest rate considered less risky than the corresponding interbank rate (LIBOR).

In the United States, OIS rates are calculated by reference to daily federal funds rate.