The Importance of Collateral Management in our Brave New World
If you take only a cursory interest in the financial headlines, you might be forgiven for thinking that the need for bi-lateral collateral management of OTC derivatives will soon disappear; that we can rely on central clearing to solve all of counterparty woes, and we can all now kick back and relax, safe in the knowledge that the world is a safer, cuddlier, more comfortable place to be. Unfortunately the truth is somewhat more opaque.
Firstly let me premise this by saying that, for the majority of firms, their Collateral Management processes worked reasonably well during the firestorm of 2008 and protected them from losses from a catastrophic counterparty default that could have been far greater. That is, they worked as they were designed to do. However, they could have worked better and the next time it happens (and it will) firms must realise that they need to invest time and effort into upgrading their processes and governance.
My first point is about culture. For too many people Collateral Management is a “just a back office process” that can be set up (or outsourced) and forgotten about. This is anathema, and the notion should be consigned to pre-Lehman’s financial history. It has been, and shall remain, the paramount weapon for counterparty risk reduction regardless of what happens with central clearing, and as we shall see, can even become a profit centre if managed correctly. If I seem proselytising about this, it is because I am fundamental in my belief that processes throughout the industry can and must be improved.
At present there is a myriad of regulators, industry bodies and associations that are looking into ways to mitigate the risk of a similar financial crisis happening again. These include the PWG, IOSCO, CRMPG, CESR, SEC, EC, FSA, SIFMA, IMA, and others. Whilst in no way denigrating what they are doing, their focus seems to be on the issues of standardising OTC derivatives, creating and requiring central clearing for certain OTC products and (in some cases) looking at moving trading of products onto exchanges. These issues will undoubtedly add to the mitigation of systemic risk (at a cost), but do not tell the whole story. In particular the establishment of central clearing houses will certainly increase the robustness of the OTC infrastructure, but not all OTC instruments are or ever will be suitable for clearing. To work in a central counterparty model instruments must be liquid, have standard terms, and be price transparent. Many current instruments (such as CDS on exotic indices, single name CDS, and bespoke interest rate products) do not have these qualities. Firms must perforce maintain and enhance their bilateral infrastructure in order to ensure firm and industry-wide counterparty risk management.
ISDA has recently released a comprehensive “Market Review of OTC Derivatives Bilateral Collateralization Practices” that should be required reading for any firm transacting in OTC instruments. In it they suggest that firms perform a review of their processes and agreements, with especial focus on the following:
Netting – exploring the potential for cross product netting (ie netting off in and out of the money positions)
Reconciliations – looking to move towards daily, proactive reconciliations; a process made easier by the existence of services provided by the likes of TriOptima and Markit. (NB ISDA has also developed new standard processes for valuation dispute resolution)
Contracts – revisiting the levels of MTAs (Minimum Transfer Amounts), IAs (Independent Amounts) and Thresholds (especially the use of credit based thresholds that reduce as credit ratings decline or spreads widen)
As a general rule any counterparty risk management process that leaves an unsecured exposure is bound to attract regulatory scrutiny, so firms would do well to revisit them before the regulators and auditors come knocking.
Financial firms that use OTC derivatives must also ensure that they are utilising their collateral optimally, and their optimal collateral (depending on whether it is non-cash or cash collateral). They should remember, or realise, that the use and choice of collateral is an investment decision that can not only save you money, but can make it for you as well.
In the case of Non-Cash, the choice of which securities should be used as eligible collateral is a decision that must be made with careful consideration. Firms should revisit their eligibility parameters with a mind to the following:
Volatility – will the price of the collateral security be substantially the same when you come to liquidate the asset?
Liquidity – will you be able to sell the collateral security easily in the open market?
Credit quality – will the issuer of the collateral security itself be subject to default or distress?
Price transparency – can you easily price the collateral security using market data vendors?
Concentration – is the collateral held concentrated in any one issuer?
Correlation – is the collateral held closely correlated to the counterparty whose risk you are trying to mitigate?
In the case of Cash collateral, many firms are now realising that internalising the re-investment of their cash in order to match the re-investment rates enshrined in their contracts, rather than merely farming it out to external money market fund providers (who take a cut themselves) can be an important source of profit. In current conditions firms should be able to achieve SONIA/EONIA/Fed Funds (+/- a few bps) with relative ease in other markets such as the repo and lending markets. To my mind there is an intrinsic existential link between stock lending, repo trading, OTC derivatives and collateral management and one that many firms would do well to explore more deeply. Clearly this is dependent on your contracts and your internal expertise, but it is this sort of lateral thinking that often reaps great rewards.
So to conclude, I urge firms not to rest on their laurels or to focus all of their time and energy on central clearing to the detriment of their bilateral collateral management processes, as this is not a function that will disappear any time in the future. Recently I have found myself using this Darwinian quote with increasing monotony, but in this case it is most certainly apt:
“…It is not the strongest of the species that survive, nor the most intelligent, but the most responsive to change...”
This article first appeared on Derivsource in April 2010