Collateral Rises To Top of OTC Agenda

Terry Flanagan

Move to central clearing places new burdens on end users.

With the Dodd-Frank Act in the U.S. and European Market Infrastructures Regulation set to drive a significant amount of OTC derivatives onto electronic platforms which will be cleared by central counterparties, banks and their corporate customers are faced with collateral management issues for swaps portfolios.

New regulations mandating that OTC derivatives be centrally cleared are placing a burden on end users, who have historically been used to dealing with non-centrally cleared OTC swaps face new requirements in the form of increased margin and collateral.

That’s spurring banks to launch services aimed at simplifying the collateral process in order to help clients avoid the associated funding costs and increased complexities.

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.

The impact of new legislation on collateral management will be immediate and deeply felt.

The need to manage collateral on cleared trades will result in significant changes to operational processes, and initial margin requirements by CCPs will decrease the amount of high-quality collateral in circulation.

The most immediate change on non-cleared trades will be an increase in the number of collateral agreements (obligations of collateralization for many institutions) and in the amounts of collateral exchanged.

While initial margins are already a common practice for hedge funds, the DFA regulation, as per its current progression, will likely drive the majority of users of OTC derivatives to post initial margins to their counterparties – a practice they are not used to.

In the interbank market, the Dodd-Frank Act and EMIR mandate central clearing and collateral as the principal means for managing counterparty risk, according to a white paper by David Kelly, director of credit products at Quantifi.

In the corporate derivatives market, however, uncollateralized exposure is far more prevalent, and banks compete aggressively on credit value adjustment (CVA) pricing; a CVA is the monetized value of the risk of default by either counterparty to a transaction, the white paper said.

That’s triggering concerns that corporate users will be disinclined to have their swaps centrally cleared due to perceived higher margin and collateral costs.

“Early this year, U.S. Treasury Secretary Tim Geithner called for the world’s major financial institutions to agree minimum initial margin requirements for uncleared OTC derivatives contracts, on the grounds that we must avoid a race to the bottom and incentives that make it unattractive to clear bilaterally rather than via a CCP,” Paul Tucker, deputy governor for financial stability at the Bank of England, said in a speech on Monday.

Tucker went on to say that polices should be extended to cover all classes of products, not only OTC.

If policies apply only to OTC contracts, exchange-traded contracts might be subject to different requirements, he said. And if applied only to futures, “we could see the economic substance of futures synthesized via cash repo markets or looser terms,” he said.

“We should take care to avoid regimes that give market participants incentives to choose between economically equivalent transactions and post-trade processing on the basis of different margin or haircut requirements,” he said.

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