Managing counterparty risk with collateral

Before the 2007 financial crisis, collateral management was just a simple, cash-denoted process to insure firms against the risk of default by their counterparties.  But, regulatory aftershocks in the form of European Market Infrastructure Regulation (EMIR), Dodd-Frank’s Title VII and the Alternative Investment Fund Managers Directive (AIMFD) disrupted traditional cash models for collateralization.  New laws require that banks fund deals over longer terms, while holding more capital against unsecured trades.

Buy-side firms, on the other hand, have to exchange their high-yielding instruments for cash and government bonds to meet regulator demands for higher quality and more diverse collateral.  In the OTC derivatives market, collateral management has become more than a risk-management tool – it’s a strategic process to drive profitability.

In a recent Bloomberg webinar, corporate treasury market specialists, Leonid Prujanski and Simone Mecca, discussed how collateralization helps mitigate counterparty risk in OTC derivative transactions.

OTC derivative collateral: A history

The collateralization of OTC derivative contracts optimizes efficiencies between counterparties by reducing credit risk, improving pricing and expanding market access.  The practice of collateral management has existed since the 1980s when Bankers Trust and Salomon Brothers began taking collateral against credit exposure.  Derivative collateralization became more prevalent in the 90s, which led to the development of standardized rules by the International Swaps and Derivatives Association in 1994.

Despite the proven benefits of collateralization, it is still not an established practice among corporate treasurers today. Many treasury officers do not even fully understand the extent to which collateralization impacts their operations on a daily basis.  Take for example the counterparty value adjustment and direct value adjustment calculations, which became standard during the global financial crisis.  CVA and DVA valuations calculate the non-performance-related risks of derivative assets, or the liabilities of the contract’s counterparty.  Additionally, many banks have begun applying OTC derivative pricing conventions like dual curve stripping and overnight interest swap discounting, once exclusive to interbank contracts, to their trades with corporate counterparties.

Liquidity risk vs. credit risk

A poll conducted during the webinar found that the majority of respondents avoided the practice of collateralizing their OTC derivatives due to liquidity concerns.  Liquidity presents a roadblock for many treasurers because they project scenarios where adverse market movements inflict punitive capital outflows. Other drawbacks include the complexity of collateral contract architecture and the overconcentration of risk in one or a few counterparties.

Nevertheless, the benefits of collateralization outweigh the disadvantages.  Strategic collateral management mitigates current and projected exposures to losses in the event of counterparty default, ensures better pricing through credit-risk reduction and enhances access to markets through additional counterparties who would otherwise decline to transact on a non-collateral basis.  This enhanced market access helps diversify and further mitigate counterparty risks.  And in an evolving global market, where OTC pricing norms are increasingly being defined by the surging volume of outstanding collateral and margin calls, Treasurers whom defy the status quo may suffer adverse and unprofitable contract terms.

Managing counterparty relationships

Collateral management is a proven solution to improve OTC derivative transactions between counterparties.  Eligible collateral includes cash, bonds, gold and other company or bank assets.  Interest earned on collateral can be complicated by the current negative-rate regime dictating monetary policy in Asia and increasingly in Europe. The anomaly can be resolved by negotiating a floor with the bank when the rate hits zero or following ISDA’s 2014 guidance, which assesses the absolute value of the negative rate.  Additionally, the valuation agent should be clearly defined in contracts to mitigate time-intensive and resource-exhaustive legal risks.

Technology is key

With the right technology, corporate Treasurers can address the escalating volume, regulatory complexity and frequency of collateralized transactions.  Treasurers are searching for a way to monitor, centralize and manage all derivative-collateral exposures and related legal documentation in real-time with a reliable workflow, integrated with market-leading data.  It’s critical that this tool also be fully compliant with the most recent Dodd-Frank and EMIR regulations.

For all Treasurers, a resource that mitigates counterparty risks and optimizes return on equity is the ideal solution.  The sprawling, accelerating and diversifying collateral ecosystem demands a nimble solution that can adapt to challenges and empower Treasurers with a strategic asset that drives value, where spreadsheets would compound risk.