Counterparty Exposure Gets Sell-Side Attention

Terry Flanagan

Faced with new regulations, such as Basel II, the Dodd-Frank Act, and Emir, banks are developing more systematic approaches to measuring and managing counterparty risk.

BNY Mellon has received a patent for a process enabling the secure management of collateral via its Margin Direct service.

Margin Direct was created by BNY Mellon to help clients limit exposure to trading counterparties. The patented Margin Direct product provides custody and liquidity services for posted margin collateral in counterparty transactions, offering a strong element of risk mitigation between counterparty relationships and helping to facilitate marketplace liquidity through the use of a third party custodian.

“One of the most important lessons learned from the financial crisis is that institutions require capabilities that help maximize liquidity and access to collateral,” said Kurt Woetzel, CEO of BNY Mellon’s Global Collateral Services business. “With today’s new regulatory requirements, there is an increased emphasis on collateral – clients need to know where to find it, how to protect it and how to unlock additional investment potential, while also working to reduce counterparty exposure.”

Kurt Woetzel, BNY Mellon

Kurt Woetzel, BNY Mellon

Basel III introduces two required liquidity ratios: a Liquidity Coverage Ratio requires a bank to hold sufficient high-quality liquid assets to cover its total net cash outflows over 30 days; a Net Stable Funding Ratio requires the available amount of stable funding to exceed the required amount of stable funding over a one-year period of extended stress.

Dodd-Frank and Emir have led to the creation of central counterparties (CCPs), through which the majority of OTC derivatives will be cleared.

More extensive use of collateral has led the most sophisticated banks to migrate responsibility of collateral management from its traditional home within operations to a front office function, where emphasis is placed on collateral optimization, according to a white paper by Quantifi and InteDelta.

“We are living through an era of rapid change in the field of counterparty risk management, much of it driven by new regulation. Banks need to invest in their operating models, methodologies and systems to ensure they meet evolving best practice and the expectations of their regulators,” said Michael Bryant, managing director of InteDelta, a risk management consulting firm.

This involves a split of collateral management responsibilities between operation teams, risk teams and front office teams (e.g. front office inventory management, collateral trading, and CVA teams).

Accounting and regulatory changes have forced banks to measure CVA (credit value adjustment) and to take a P&L and capital charge, the white paper said.

This has resulted in many banks establishing active CVA functions to hedge CVA exposure, in order to ensure that counterparty risk is adequately priced into deals as a basis for inter-desk charging within an institution.

However, the data, technological and operational systems and process needed for measuring add managing exposures and CVA in an integrated fashion can be a challenging undertaking, the white paper said.

Centralizing counterparty risk management for the entire trading book places a high priority on scalability, while providing near-time performance for marginal pricing of new trades.

“The ability to calculate CVA and exposure metrics on an entire portfolio, incorporating all relevant risk factors and the dynamics between them, adds substantial analytical and technological challenges,” said Avadhut Naik, global product manager at Quantifi.

BNY Mellon, which services $2 trillion in global collateral (including tri-party repo collateral worldwide), offers Global Collateral Services to help clients address collateral, liquidity, and securities financing needs.

“The Margin Direct process helps our clients achieve their investment goals, while also helping to minimize counterparty exposure,” said Jonathan Spirgel, head of liquidity services and sales and relationship management, Global Collateral Services at BNY Mellon. “This patent demonstrates both innovation and the powerful combination of BNY Mellon’s expertise and its market-leading practices.”

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